Economics help blog – Page 163

Budget deficit targets

18 November 201724 September 2014 by Tejvan Pettinger

Politicians are often keen on making targets to eliminate budget deficits by a certain year. There is a strong political motivation to be seen as strong and committed to reducing government debt. Politicians who are vague about the debt are often heavily criticised and it is seen as poor politics. An advantage of budget deficit targets is that it ensure politicians have a stronger commitment to make politically difficult choices – raising taxes or cutting spending.

However, from an economic perspective targets for reducing budget deficits are not always as helpful as they may seem.

Benefits of budget deficit targets

There can be many sound economic reasons for reducing government borrowing. Just because a government can borrow, doesn’t mean it is desirable to.

It can prevent politicians choosing politically popular policies, such as tax cuts and spending increases. A deficit target can help prevent politicians putting off making difficult choices.
Without deficit reduction targets, some economists fear that there is an incentive to keep increasing the size of government spending, which crowds out more efficient private sector spending.
It can reassure markets that the government have a ‘responsible attitude to debt’ and are less likely to rely on printing money to finance the deficit and rely on inflation to inflate away the debt – which can reduce the real value of government bonds.
In some cases reducing the budget deficit can help lower bond yields because – with lower debt available on the market there is downward pressure on bond yields.
Some argue that budget deficit reduction gives consumers more to spend and firms to invest because the private sector have more confidence when the government is reducing its debt and is acting in a ‘responsible manner’. Others criticise this as being wishful thinking (see: Confidence fairy)

Problems of a budget deficit target

To stick to a strict budget deficit target may require tax increases / spending cuts at a time which is not appropriate for the economy. e.g. the UK economy is recovering, but if we increase income tax rates to improve tax receipts it may lead to lower growth and be counter-productive. See: Austerity can be self-defeating
Experience of Eurozone economies trying to meet budget deficit targets has been a deep recession.
Achieving an overall budget deficit means government have to finance investment spending out of tax revenue. But, arguably there is a better case for allowing government to borrow to finance investment.
A zero budget deficit is of doubtful value compared to other macro-economic objectives such as full employment, sustainable economic growth and low inflation.

Economic system to improve income distribution

18 November 201722 September 2014 by Tejvan Pettinger

Readers Question 1) Can an economy that factors in the need for government funded public services and to offer people a living wage, and other more distributive economic strategies such as taxing the rich more, etc. Can it work in purely economic terms?

Essentially the question is

Can we have economic growth and greater income redistribution to ensure everyone benefits from the proceeds of growth?

Redistribution

Economic growth (rising real GDP) makes it easier for the government to spend money on public services and welfare payments. With economic growth, tax revenues rise, as the government will collect more VAT and income tax. This can help reduce absolute poverty. If you compare UK society – 50 or 100 years ago, there have been great strides made in reducing the worst forms of poverty.

However, to reduce relative poverty and inequality may require different policies, such as a more progressive tax system and more generous means tested benefits.

Welfare payments can help economic growth

Unemployment benefit enables people to survive economic turbulence. It helps support them in finding a new job suited to their qualifications. Removing benefits would reduce income and could cause serious social problems as people feel totally excluded from society.

Government funded public services like education and health care play a major role in improving a nations productive capacity and helping long-term economic growth.

A living wage / minimum wage can help prevent monopsonistic exploitation. By increasing workers wages also creates more demand in society for goods.

Factors other than government policy

Also, fairness in society doesn’t just depend on government policy. It depends on the attitudes of firms, workers and society. If people in society value an element of redistribution it is more likely to happen. For example, do firms make workers shareholders in the company or is society dominated by powerful monopolists who want to maximise profits?

In the Nineteenth Century, the Dickensian idea of firms was that they were happy to pay as low wages as they could. The proceeds of economic growth did little to ‘trickle down’ to the poorest workers.

Post Second World War, economic growth was more consistent with reduced inequality; this was partly due to government welfare policies – e.g. unemployment benefit, but also firms were perhaps more likely to see it in their ‘enlightened self-interest’ to pay workers well and look after their welfare. Success in society became a little less judged by monetary gain, but also how you treated other people.

Scotland post referendum

18 November 201719 September 2014 by Tejvan Pettinger

An independent Scotland would have made an interesting economics case study. How would Sterlingisation or a Currency Union have affected the Scottish economy? Now we may never find out. There were undoubted risks involved, though I’m not sure how much the issue affected the outcome. The Eurozone is also an interesting economics case study, but …

Currency substitution – Dollarisation / Sterlingisation

3 April 201915 September 2014 by Tejvan Pettinger

Currency substitution occurs when a country uses another currency without any official backing and without a Central Bank – instead of using its own currency.

For example, Panama uses the US Dollar as its currency. Even though it has no formal currency union with the UK. Jersey uses Sterling unofficially too.

The advantage is that a country like Panama gets to use a currency which has a stable value and international respect. The disadvantage is that it has little control over monetary policy and doesn’t have a Central Bank to act as lender of last resort to print money during periods of liquidity. Also, you lose the ability to devalue the exchange rate (which some may argue has advantages too)

Sterlingisation for Scotland

If Scotland vote for independence, Sterlingisation is seen as the best outcome for an independent Scotland. (Possibly as a precursor to a second stage where Scotland creates its own Central Bank and print its own ‘Scottish Pound’)

Sterlingisation would mean Scotland continues to use the Pound, but without a Central Bank as lender of last resort. It also means monetary policy would be set by the Bank of England.

Does it matter if Scotland doesn’t have a lender of last resort?

Given the problems of the Eurozone in recent years, there is an unfortunate precedent of countries being severely damaged by a lack of a Central Bank willing to act as a lender of last resort. However, there are two possible factors which could help Scotland.

Firstly, some argue that having no Central Bank encourages banks to act more responsibly and avoid taking on excess risks. The Adam Smith Institute have produced a paper which is optimistic about the potential of ‘Adaptive Sterlingisation’ arguing that the period of free banking in Scotland in the eighteenth century was largely successful – with banks secured by shareholders. – How sterlingization and free banking could help Scotland flourish at Adam Smith – Institute.
Would the Bank of England want to allow banks in the British Isles to fail? If Scotland gained independence, the Bank of England would have no compulsion to act as lender of last resort, but the UK banking systems is closely integrated; a collapse in confidence north of the border would have implications south of the border too. Would the Bank of England want to allow a failure of our near neighbour – when the financial and economic fortunes of the two countries are so closely tied together?

Difficulty in switching from fossil fuels and oil

18 November 201715 September 2014 by Tejvan Pettinger

Question and answers on the difficulty of switching from non-renewable energy sources, such as fossil fuels. (from – finding alternatives to fossil fuels)

Readers Question: Why is it that on a global scale, alternative fuels are somewhat being ignored?

Firstly, fossil fuels are still cheaper. However, the gap is narrowing. For example, see how solar panels are coming down in costs.

There can be a reluctance to switch from one mode of production to another. Even if an alternative became cheaper, it requires significant investment to switch from one mode of power to another. For example, the UK kept steam trains running into the mid 1960s. Diesel was more efficient and cheaper many years previously, but it required a lot of investment in infrastructure to buy new diesel trains. Often it’s easier to keep going with old technology out of habit and merely because it is what has been used in the past. In some parts of the world, steam power is still used.

But, on the other hand, if we look back in history, we can see that a dominant technology can quite quickly lose its position. America quite quickly switched from steam trains to the petrol powered car. Once a tipping point is reached the momentum can swing to the new technology.

Also, a factor is that oil and petrol companies are very profitable and it is in their interests to keep oil based industries strong. If they can delay a switch to alternative fuels they might try. How much ability they have to delay an energy switch is open to question. But, there are powerful lobbyists to support the US coal and oil industries.

Readers Question: If it is not being ignored, Why is research and development is somewhat slow?

Alternatives to fossil fuels are generally not profitable in the short term. Therefore, private enterprise has limited incentives to research alternatives. This is an example of market failure, because the market ignores:

The long term importance of developing alternatives to fossil fuels, which will one day run out.
The external benefits of developing alternatives to fossil fuels, e.g. improvement in environment and reduced pollution.

Scotland in the UK

18 November 201713 September 2014 by Tejvan Pettinger

Generally I try and remain politically uncommitted. But, in the past few weeks, I’ve been surprised at how much the issue of Scottish independence has affected me. Despite a mental desire to feel nationalistic identity as unimportant, I feel deep down it really means a lot – and I hope Scotland votes to remain part …

EU inflation and deflation

18 November 201712 September 2014 by Tejvan Pettinger

The Eurozone inflation rate is 0.4% (ECB database) (Sept 2014) Eurozone HCIP inflation rate HCIP (Harmonized consumer index prices) Source:| (ECB Inflation graphs, sometimes a few months outdated) Food inflation Food inflation is currently negative. Food inflation tends to be one of the most volatile components. This negative food inflation is one factor reducing the …

The problems of a Scottish currency union

17 January 201810 September 2014 by Tejvan Pettinger

If Scotland gains independence, the Yes campaign has argued that their preferred option is to keep the Pound Sterling and enter into a currency union with the rest of the UK.

This means sharing the same currency Pound Sterling, and having the same monetary policy. Monetary policy would continue to be set by the Bank of England. There would be no exchange rate between the two countries.

Currency Union with the rest of the UK

However, currency unions are problematic. The Eurozone has been a disaster for many European countries who have been saddled with high unemployment and stagnant economies. See all problems of Euro here.

A big problem with currency unions is that in the absence of a lender of last resort, you face pressure to limit budget deficits. Since the Euro was created, Southern Europe has been pushed into more austerity than is desirable. It has left their economies vulnerable and with limited options to deal with trade imbalances and economic downturns.

The Bank of England governor, Mark Carney insisted a currency union with a sovereign, independent Scotland was impossible. “You only have to look across the Continent to look at what happens… A currency union is incompatible with sovereignty.” (Guardian)

Paul Krugman has stated there are great risks of sharing a currency.

Economists (starting with my late colleague and friend Peter Kenen) have long argued that sharing a currency without fiscal integration is problematic; the creation of the euro put that theory to the test. And the results have been far worse than even the harshest critics of the euro imagined, with euro Europe doing worse at this point than Western Europe did in the 1930s:

Krugman goes on to argue that Scotland’s position could be worse than the Eurzone because there is no guarantee that the Bank of England will be interested in acting like Mario Draghi in his support for debtor countries.

An independent Scotland would be dependent on the kindness of the Bank of, um, England, with no say whatsoever in that bank’s policy. (Scotland and the Euro omen)

Currency unions also exacerbate political tensions. People in southern Europe feel let down by economic policy of the ECB and northern Europe. Germany on the other hand is not happy with the perceived need to bailout its profligate neighbours. Currency unions have not been an effective system for encouraging harmony amongst nations – in fact the opposite. There is a real fear that after independence – Scotland could feel exacerbated and frustrated at being at the mercy of English monetary policy.

But could a currency union between Scotland and the UK work?

There are some reasons to believe that a currency union between Scotland and the UK would work better than the Eurozone.

Firstly, there is much better labour mobility between Scotland and England than say between Greece and Germany. If the Scottish economy is relatively depressed, workers could move south and vice versa.

A big problem of the Eurozone was the divergence in wage costs and relative prices. This left southern Europe uncompetitive but without the option of devaluation to restore competitiveness. This is perhaps less likely to be a problem between Scotland and England. If there is a significant divergence in wage costs, readjustment is easier because of the greater capital and labour mobility.