UK economy in 2014

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After faltering for several years, the UK economy shows signs of real recovery, with rising spending, investment, exports and even manufacturing growth. At the start of 2014, there seems to be a virtuous circle of falling unemployment, falling inflation, and rising GDP.

After one of the longest and deepest recessions on record, these signs of economic growth are definitely welcome, yet it is far from a return to normality. Real GDP is still 2% below its 2008 peak, and the economy is being propped up by zero interest rates, quantitative easing and a strong housing market. Stagnant wages and poor productivity growth have led to one of the most prolonged periods of declining living standards in memory. Although there is economic recovery, there is still a fear that the recovery is unbalanced, and that the UK economy could be derailed by problems in the Eurozone and future government austerity measures.

Economic growth

economic growth more on economic growth

The ONS have recently revised annualised economic growth to indicate an annual growth rate of 1.9%. Still below trend rate, but welcome after the several years of falling GDP. For 2014, the OBR forecasts economic growth of 2.4% (BBC link)

real-gdp-00-13q3

 A difficult question is how much of an output gap the UK has. Since 2008, GDP has fallen away from the trend rate of growth. In theory, with output much lower than potential GDP, we would expect a rapid recovery to ‘catch up’ the lost GDP. However, we are unlikely to see this. The great recession has unfortunately led to a permanent loss in real GDP. Economists debate how much spare capacity the UK has. But, for the moment growth rates of 2.5% are unlikely to cause any significant inflationary pressure.

Inflation

cpi-inflation

more on inflation

It is ironic that now we are experiencing economic recovery, headline inflation is finally falling closer to the government’s inflation target. of 2%. During the great recession, inflation was often above target due to cost push factors, such as depreciation, rising oil prices and higher taxes. But, now these cost push factors have evaporated, inflation has fallen to 2.1%. Given the nature of the economic recovery, inflation is likely to stay low in 2014, helped by low inflation expectations.

UK Unemployment

total-unemployment-2007-present

Unemployment

Compared with the rest of the Eurozone, UK unemployment could almost be considered a success story. Unemployment has fallen to 7.4% (2.39 million). There is a record number of people in employment (over 30 million for the first time)

However, whilst this unemployment rate is relatively low compared to Europe and also compared to previous recessions, there are other aspects which make less positive reading. Low unemployment has been helped by a rise in part-time employment, temporary contracts, greater job insecurity and falling productivity. (see  UK Unemployment mystery) Also, there are pockets of high unemployment, especially in the north, inner cities and amongst the young. Unemployment of 2.39 million is still a serious social problem, and it will need a considerable period of economic expansion to help reduce to more manageable levels.

Nevertheless, temporary work is still better than no work. Flexible labour markets have many drawbacks, but it is quite interesting that during the shallower recessions of the 1980s and 90s, unemployment rose to a much higher level. There are also promising signs of firms hiring more workers in areas such as, marketing, sales and business development (FT link) which indicate sign of optimism.

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What happens if China sells its dollar assets?

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Readers Question:

“As for the argument that China can always use its foreign exchange (forex) reserves to provide further stimulus to prop up the economy, the people who purport this have little knowledge of basic economics. 

If China were to use substantial forex reserves in this way, it would become a large net-seller of U.S. Treasury bonds. To prevent a spike in interest rates, the U.S. central bank would have to significantly step up purchases, funded ultimately by private citizens savings. Less of these savings would dampen U.S. consumption and ultimately, Chinese exports to the US.. In other words, a move by China to substantially cut forex reserves would not only be a disaster for the developed world but for China itself.”

China has built up substantial dollar assets, (US treasuries) China has done this for various reasons, including:

  • It wants to make use of its current account surplus.
  • In the past it has sought to keep the Chinese currency undervalued. Buying dollar assets keeps the Chinese currency weak, making Chinese exports more competitive boosting Chinese economic growth. (see: Chinese currency manipulation)

It is estimated that China has over $3.6 trillion of foreign reserves (Bloomberg). Approximately, 60%, of these are in dollar assets. This includes $1,294 trillion of US Treasuries (US government debt). China is the biggest foreign creditor to the US.

However, China has signalled that it will be seeking to hold less foreign reserves and reduce the % of reserves held in dollars – diversifying into other currencies.

Now, the question is what will happen to US / Chinese and Global economy if they start selling these dollar assets.

Impact on Chinese economy of selling US Treasuries

  • Appreciation in the Yuan and depreciation in the US dollar. If China sold US assets and held more of its own currency, it would cause an appreciation in the Yuan and fall in the value of the dollar. This would reduce the competitiveness of Chinese exports, leading to lower Chinese economic growth, and possible higher unemployment.
  • Reduction in Chinese current account surplus.

    In the past few years, we have seen a reduction in China’s current account surplus, a sell off of dollars assets would reduce this deficit by even more.
  • Selling foreign assets could be used to boost domestic demand by financing state investment. This could help offset the likely fall in exports. However, the concern would be whether the state could satisfactorily invest the large foreign currency reserves. It may be more inefficient that the private sector exports affected by the appreciation.
  • Reducing inflationary pressures. An appreciation in the Yuan will reduce inflationary pressure in China.

How would the sale of dollar assets affect the US economy?

China holds considerable amounts of US debt. If China stopped buying US treasuries, it would cause a few effects:

Upward pressure on US interest rates. If there is less demand for US Treasury bonds, this will push up interest rates. Making it more expensive for the US to borrow. If China became a big sellers, it might also adversely affect confidence in US Treasuries causing other investors to demand higher rates too.

Higher interest rates on government bonds may push up general interest rates, and may cause lower economic growth in the US. Higher rates increase the cost of borrowing and discourage investment and spending.

However, it is important to bear in mind Chinese holdings of US debt is sometimes exaggerated.
Oct 2012, China holds $1,169 out of a total foreign holdings of $5,526 (20%) (US Treasury) It is less than 8% of total US debt. Therefore, the impact on US interest rates is not necessarily critical if China reduces demand for US Treasuries.

10-year-treasury

It should be remembered US interest rates are close to an all time low (see above). Higher interest rates are not necessarily the end of the US economy. As long as domestic demand is reasonably strong, the US can cope with higher interest rates on US Treasuries.

Also, if China did sell US Treasuries, you may see the Federal Reserve delay its tapering and reversal of Quantitative easing. The US Treasury could absorb some of these Chinese sales by delaying its tapering programme.

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Happy new year 2014

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Firstly, happy New Year 2014. I took an extended break from blogging over Christmas. Firstly, because I was on holiday in Portugal. Secondly because in Portugal, I got knocked off my bike by a crazy dog. I just about managed to hobble home, then the next morning fell over my front door step causing grazes …

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The recession is over but not the depression

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Some thought provoking analysis from NIESR. Firstly, they define recession and depression in an interesting way.

  • Recession – a period of time where output is falling.
  • Depression – The period of time where output is below it’s peak.

The UK economy is now growing, at a decent pace (0.8% in Q3). However, output is still significantly below the old 2008 peak. This means that the recession is over. But, with output still below the 2008 peak, the prolonged period of depression is still not over, according to this definition.

Also, if we compare this ongoing economic downturn (2008-2013) with other periods of serious economic stagnation, the UK economy is performing worse now than even the 1920s or 1930s.

NIERS - UK output
Source: NIERS

The NIERS don’t expect the 2008 GDP peak to be regained until 2015. Meaning, we will have a 7 year period of stagnating real GDP. An unprecedented length of economic stagnation. See also: more on comparison of different recessions

But, it doesn’t feel like a depression?

There are no commonly agreed definitions of what constitutes a depression. Most definitions tend to emphasise a significant fall in real GDP or a prolonged fall in GDP for a period of over 3 years. For example, if real GDP falls by over 10%, that would be classed as a depression. A depression also implies a very high rate of unemployment (perhaps greater than 15%).

The UK unemployment rate is relatively low by the standards of other recessions (helped by falling productivity and flexible labour markets) Therefore, with economic growth, and ‘reasonably’ low unemployment, it feels a different climate to the great depression of the 1930s.

On the other hand, although unemployment could be much higher, there has been a widespread fall in living standards, which is unprecedented in the post war period. Figures show UK living standards have dropped to their lowest in a decade after average real incomes fell a further 3 per cent last year.

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Tapering and the effect on interest rates

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Readers Question: As the FED is talking about tapering and at the same time  keeping interest  rate low. How can they both go together? Tapering will raise yield as bond prices go down in  absence of any freak buying. And interest rate  will chase yield this causes interest rate to climb up.

Fed Tapering means that the Federal Reserve will begin to stop buying bonds, and no longer continue to create money and buy bonds. This tapering could also be seen as a preliminary to reversing quantitative easing and selling the bonds that have been accumulated.

10-year-treasury

Even a suggestion they begin to taper did cause bond yields to rise. See: Why Fed Tapering causes bond yields to rise

Different interest rates

It is important to bear in mind there are different interest rates in the economy.

  1. Discount rate – set by Federal Reserve
  2. Federal Funds rate – short term interbank lending rate, influenced by open market operations of the Fed.
  3. Long term bond yields. – Effective interest rate on 10 year Treasury bonds.

Discount Rate

The Federal Reserve can change the discount rate (see: Federal Reserve discount rate). This is the rate that the Fed charges commercial banks to borrow directly from the Federal Reserve. This is a short-term interest rate because commercial banks borrow from the Federal Reserve to meet temporary shortfalls in their cash flow.

The Federal Reserve discount rate is currently 0.75% (link)

This Federal discount rate does influence other interest rates in the economy. If commercial banks find the discount rate has increased, then they are likely to increase their interest rates on loans to consumers. If commercial banks see the discount rate has increased, they tend to increase mortgage rates. Therefore, the Federal Reserve can influence other bank rates.

It is a similar situation in the UK. The Bank of England change the base rate. This base rate usually has a strong influence on other bank rates in the economy.

Effective federal funds rate

effective-federal-funds

Another important interest rate in the economy is the effective Federal Funds Rate – see FEDFUNDS. This is the short-term inter bank lending rate. It is influenced by the Fed discount rate, but also the willingness of banks to lend to each other.  It is also, influence by the Federal Reserve’s actions in open market operations. The FED has a target for the Federal Funds rate. When the Fed starts to sell bonds, you would expect this to depress the price of bonds and push up the Federal Funds Rate. With the Fed currently buying bonds, this has pushed up bond valued and decreased interest rates.

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Economics of Scottish Independence

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government-spending-region-hm-treasury

A look at the pros and cons of Scottish independence from an economic perspective.

It is said you can’t put a price on freedom and cultural identity. But, when it comes to independence, economics seems to be one of the biggest factors to sway voters in Scotland. When asked in a poll, only 21% favour Scottish Independence if it leaves them £500 a year worse off. Only 24% favour retaining union with Britain if it leaves them worse off. (Economist)

Benefits of Scottish Independence

  • Oil and Gas Reserves in the North Sea are potentially a lucrative source of tax revenue and this has become more profitable with higher  oil prices. According to the Scottish government, Scotland represents 8.4 per cent of the UK’s total population, but they generate 9.4 per cent of its annual revenues in tax — equivalent to £1,000 extra per person. (link) However, with dwindling reserves, income from oil and gas may dry up in future years.
  • Independence may give freedom to set low corporation tax rate and attract business from overseas.
  • Reform of tax and welfare system. Crawford Beveridge, chairman of the Scottish Fiscal Commission, claims that smaller countries, such as Ireland and New Zealand have considerable success in collecting tax. He argues an independent Scotland could scrap 1,000 tax exemptions and make the tax system simpler and encourage greater work incentives.  “The UK tax system is complex and costly, and does not fully reflect the unique characteristics and needs of Scotland. There is considerable room for improvement in its design and operation.”
  • Some argue that independence might increase self-confidence of the country, attracting more business and tourism. It may enable Scotland to have a stronger brand loyalty for its traditional exports like whisky and tartan kilts.

Costs of Scottish Independence

  • Would lose ‘subsidy’ from Westminster.  Scottish people get around £10,212 spent on them every year by the UK government, compared with around £8,588 — £1,624 less — for people in England. Independence may make it more difficult to maintain this spending. Independence may end some of the generous subsidies in Scotland for university education, trains and health care. However, this Scottish ‘subsidy’ is controversial as oil and gas revenues help give a Scotland bigger (£1,000) per capita tax revenue (New Statesman)
  • Debt Levels. After independence, UK debt levels would be share on a per capita or per GDP level. This would leave Scotland with a national debt of £80bn and growing. Although debt would be split according to the respective GDP, the recent experience of smaller countries on the Eurozone periphery mean that Scotland may struggle to meet debt payments

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Did the government use the right policies to reduce the budget deficit?

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Readers Question: Do you believe the Coalition Government has used the right macroeconomic policies with regards to reducing the budget deficit? No. I’ve written a few times that I believe the coalition government made a big mistake in prioritising deficit reduction over economic recovery in 2010. The consequence of trying to reduce the budget deficit …

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