Bank loans and reserve ratios

Readers Question: I have a question on the credit crunch – if banks are operating fractional reserve banking then why would they cut back on lending to businesses as every loan increases their money reserves? Surely they would only suffer a shortage of credit if they reduced their lending so they are in effect cutting …

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The case for austerity

I’m currently writing a 2,500 word essay on ‘UK Austerity’ for the magazine Economic Review. I think the idea of these magazine articles is to present a ‘balanced view’ so I’ve been looking up the case for austerity as well as the case against. As far as I can see the economic rationale for austerity includes some or all of the following:

1. Rising bond yields. Starting with Greece, several Eurozone economies faced sharply rising bond yields in the period 2009-12. Investors were no longer confident in the ability of European countries to repay government debt or at least stay liquid. Therefore, they demanded higher bond yields in compensation for the increased perceived risk.

eu-bond-yields-7-countries

Rising bond yields were taken as a sign that debt levels were too high and unsustainable. Therefore, to reassure bond markets, governments pursued austerity / spending cuts to reduce budget deficits and hopefully reduce bond yields.

In the case of the UK, the government argued that if Greece, Ireland and Italy could all have rising bond yields, the same could happen to UK bonds. If government bond yields did rise, the government argued it would have many adverse consequences for the economy:

  • Increase cost of debt interest payments.
  • Make it difficult to sell sufficient bonds to cover the large budget deficit.
  • Rising bond yields can create a knock on panic to other bond investors. The nervousness was potentially contagious.

2. Crowding in.  There is a view that if the government reduces spending and reduces government borrowing, then this enables a growth in the private sector. The argument is that government borrowing restricts private sector investment because when the government borrows it takes money which could be used to finance private sector investment.

3. ‘Expansionary austerity’ This was a view offered at the start of the crisis. The argument is that uncertainty over rising bond yields was holding back private sector investment. If the government pursued austerity and proved to the market it was serious about reducing the deficit and bond yields, markets would be more confident about the future. The sound money of the government would encourage private sector investment and higher economic growth.

4. State is too big. Mixed up in the case for austerity is the more general argument that state spending had got too big. The recession was seen as a good time to cut away inefficient government spending. In particular, some economists were critical of the bloated size of the welfare state and pension commitments.  Often critics of Keynesian economics argue that if you pursue temporary spending to boost demand, this temporary stimulus ends up being permanent, due to special interest groups. Instead, the opposite should occur, and governments should take the opportunity to cut spending.

 

5. Debt is too high. The credit crunch was caused by banks taking on too many ‘bad’ debts. Because the excess accumulation of  private sector debt caused the credit crunch and recession, it was easy for governments to make a link that we need to tighten belts and reduce government debt burdens.

EU debt levels debt / GDP % 2007 – 2010

debt

e.g. Ireland debt to GDP ratio rose from 27% to 97% between 2007 and 2010

In the great recession, budget deficits did rise rapidly because of the  fall in tax revenues due to recession, rise in welfare spending due to unemployment, and bailing out banks.

One influential paper (2010) by Carmen Reinhart, now a professor at Harvard Kennedy School, and Kenneth Rogoff, an economist at Harvard University, suggested that when debt / GDP  levels rose above 90%, then it leads to significantly lower economic growth. (90% question at Economist) Therefore, this provided an argument for tackling government debt.

6. Countries with austerity have had positive growth

Every country which pursues austerity has at some time seen economic recovery. Latvia experienced a strong recovery (after very sharp fall in GDP during the recession.) Now positive growth in UK is seen as vindication of austerity.

Criticism of Austerity

A quick evaluation to these points

1. Rising bond yields. The assumption was that rising bond yields were due to high levels of debt. But, with perhaps the exception of Greece, rising bond yields were primarily due to having no Central Bank willing to act as lender of last resort. Evidence for this comes from:

  • Countries like US and UK with very large budget deficits saw falling bond yields during the recession. These countries had own currency and Central Bank willing to ensure liquidity.
  • In 2012, when the ECB finally became willing to buy unlimited bonds, bond yields fell sharply.
  • Austerity policies often caused bond yields to rise because markets feared falling GDP would make debt levels more unmanageable.

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EU success or crisis?

The German Finance Minister Wolgang Schauble has been a strong advocate of austerity, supply side reforms and ‘sound money’ policies. (i.e. sticking rigidly to inflation targets). Generally, this has been the preferred approach of Europe to the ongoing debt crisis and recession of the past few years. Recently, he has claimed that the European economy is recovering well and this is vindication that the broad approach of fiscal discipline and structural reforms are laying a foundation for strong economic growth in the future.

Writing in the Financial Times, Schauble states:

While the crisis continues to reverberate, the eurozone is clearly on the mend both structurally and cyclically.

What is happening turns out to be pretty much what the proponents of Europe’s cool-headed crisis management predicted. The fiscal and structural repair work is paying off, laying the foundations for sustainable growth. This has taken critical observers aback. It should not have, because, in truth, we have seen it all before, many times and in many places. Despite what the critics of the European crisis management would have us believe, we live in the real world, not in a parallel universe where well-established economic principles no longer apply. (FT – Ignore the doomsayers)

Others are much more critical arguing that this view ignores the long-term damage being done to the EU economy by years of deflationary policies. Also, his view ignores the damage of self-defeating austerity which has caused mass unemployment across Europe and rising debt to GDP ratios.

Economic recovery in Europe

EU growth

source: Eurostat

Firstly, the recovery is very timid. The Euro area did grow by 0.3% in the Q2 of 2013, but Eurozone real GDP is still -0.5% lower than 12 months ago. The important point is that since 2008, Europe has failed to reach a normal rate of economic growth – there has been no escape velocity. The recovery of 2010 petered out.

Reasons to hold back on the champagne and not celebrate the EU economy.

1. Quarterly growth figures are very limited in determining the success or otherwise of the economy. The European recession began in 2008. The fact you have one quarter of positive growth in 2013 Q2 doesn’t overcome the five years of recession. Real GDP growth has fallen drastically behind the trend rate of growth necessary to get anywhere close to full capacity.

2. Unemployment. Unemployment is arguably the most useful statistic for understanding the degree of spare capacity and wasted resources in an economy. High unemployment has very high social costs in terms of lower incomes, declining morale, and wider social problems. On this metric, the Eurozone faces an unprecedented crisis. Yet, it tends to be brushed aside by European policy makers.

Eurozone-unemployment

New site and new shop

In the past few weeks, I’ve been working on a new version of the site. I’ve imported some pages from original ‘dreamweaver’ static site and have introduced a new shop for buying products. This shop uses WordPress, Woo commerce. You will be able to buy revision guides using a basket and cart. The home page …

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Government borrowing and effect on bond yields and interest payments

Another few graphs to look at the impact of the UK budget deficit on bond yields and interest payments. Government net borrowing for 2012-12 excluding Royal Mail pension fund transfer and Asset Finance Programme (AFP – the proceeds from Q.E) Government borrowing vs debt interest payments The very large deficits have had  little impact on …

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UK economic recovery 2013

The UK economy has experienced the most prolonged decline in real GDP on record. GDP is still lower than before the start of the great recession in 2008. This unprecedented recession has been prolonged – despite a sharp depreciation in the Pound, and a raft of unconventional monetary policies. However, recent statistics suggest there are some reasons to be more hopeful and the UK economy is starting to recover. Yet, despite the recovery, many analysts still worry that the economy is unbalanced and could be vulnerable to a further economic downturn in Europe and the rest of the world.

Economic recovery

economic-growth-uk-ons-quarter

Source: ONS

The UK recovery since 2009 is best described as ‘patchy’ The important thing is to maintain recovery for a prolonged period and not slip back down into recession. The governor of the Bank of England recently talked about the need for the UK economy to reach ‘escape velocity’ – this means a recovery strong enough for the recovery to be self-maintaining – without the artificial props of quantitative easing e.t.c.

Where is the recovery coming from?

1. Retail spending. Although real incomes remain depressed, retail spending has shown renewed strength. Compared with a year ago (July 2013 compared with July 2012) the quantity bought in the retail industry increased by 3.0% (ONS). Consumer spending accounts for approx 65% of UK GDP and so is the most important component. A rise in consumer spending is good because it shows a renewed confidence about the economy. However, at the same time, it raises concerns. The growth in consumer spending is partly financed by a fall in the savings ratio, it isn’t being met by growth in real incomes. Therefore, there is a danger the UK recovery is falling into the old trap of being unbalanced and relying on consumers dipping deeper into their pockets (and credit cards)

2. Manufacturing. For a long time, manufacturing has been the struggling sector of the UK economy. The weakness of manufacturing is one factor behind the UK’s persistent trade deficit, but recent evidence is more promising. This week, the  PMI survey for the manufacturing sector found the strongest growth in activity for two and a half years, with output and new orders rising at their fastest rate for 19 years. However, although this sounds impressive, it needs to be remembered manufacturing output is still 11% lower than it pre- 2008 peak.

manufacturing-2000-2012

– a long way to recovery.

Construction has also seen growth in the first part of 2013, but, this is from a very weak base, and construction output is still down 0.5% on a year ago. (ONS)

3. Exports to emerging economies. In 2013, we have seen strong export growth to emerging economies. Exports to BRIC countries have performed well. Exports to China have risen nearly sixfold since 2002.

In one sense, these export growth to new markets is encouraging. With Europe stuck in recession, it is good news the UK exporting sector has been able to diversify into emerging markets, which perhaps have greater potential in the long term. However, there have been increasing concerns that the long boom years for China and India may be coming to an end. This would dampen growth in these new export sectors. Also, it is still a small share of GDP for the UK economy.

4. Housing Market. Another staple of the UK economy. A renewed rise in house prices is a mixed blessing. The rise in prices will encourage consumer confidence and improve the balance sheets of banks. It has also encouraged renewed activity in the construction sector. However, house prices are already stretched, with house price to income ratios close to all-time high. Rising house prices as the main source of economic recovery is another sign of an unbalanced economy.

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UK Unemployment Target

The new Bank of England governor, Mark Carney, has implemented a type of unemployment target.

As part of forward guidance, the Bank of England state that:

Interest rates won’t rise from 0.5% until unemployment falls below at least 7%.

Essentially, the bank are committing to expansionary (loose) monetary policy until there is a stronger economic recovery and unemployment has fallen. The hope is that the commitment to low interest rates will encourage firms to invest and consumers to spend.

However, this unemployment target of 7% has a few caveats.  The unemployment target and forward guidance on interest rates can be ignored if:

  • Inflation is forecast to breach a 2.5% target over a 24 month horizon.
  • If there is a sharp rise in the public’s expectations of inflation
  • If low interests are likely to imperil the stability of the financial system, e.g. low interest rates could fuel an asset bubble.

UK unemployment-past-5-years-percent

Under the Bank of England’s latest targets, it does not expect unemployment to fall below 7% until 2016. According to the ONS, unemployment is currently 7.8%. It would require the creation of nearly 750,000 new jobs for the rate to fall below 7%

Equilibrium Unemployment

The Bank of England also mentioned the term ‘equilibrium unemployment’. They believe the equilibrium unemployment rate is around 6.5%. The equilibrium rate means that if unemployment falls below 6.5% it might start causing inflation (e.g. competition for employers pushes up wages). If unemployment is above the equilibrium rate of 6.5% then there is slack in the economy (demand deficient unemployment) and this will keep inflation low.

This equilibrium rate of 6.5% is therefore composed of structural factors / supply side factors (the natural rate of unemployment)

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Forward guidance in monetary policy

Forward guidance is when the Central Bank announces to markets that it intends to keep interest rates at a certain level until a fixed point in the future.

The aim of forward guidance is to influence long term interest rates and market expectations. For example, the Central Bank might want to boost economic activity by convincing markets that interest rates will stay low for the foreseeable future.

It means that Central Banks are pledging to keep interest rates low, even if inflation starts to creep above its target. It can be seen as an indirect way of placing less emphasis on low inflation and more emphasis on economic recovery.

The Central Bank could say it intends to keep interest rates at 0.5% for a certain time period (until 2015) or
it could say it intends to keep interest rates at 0.5% until certain economic criteria are met (e.g. interest rates will stay at a certain level until unemployment falls below 6%).

What are the benefits of forward guidance?

It helps the Central Bank to influence long term interest rates. The Central bank can only directly control short term rates – Base rates. In normal economic circumstances, a change in base rates usually leads to an equivalent change in commercial bank rates (the long term lending rates which are important in an economy) However, in the credit crunch / great recession there was a divergence between base rates and commercial bank rates. Lower base rates were not passed onto consumers.

base-rates-bank-rates-mortgage-rates

mortgage rates and bank lending rates didn’t fall as much as base rates

If commercial banks feel the cut in base rates is temporary, they may not want to cut their long term rates. But, if the Central Bank confirms that it will keep base rates at 0.5% for a considerable time, then commercial banks may be more willing to reduce their long term rates (e.g. mortgage and lending rates) because they know they will be able to borrow from the Central Bank at 0.5%. The hope is that this will encourage banks to cut rates, and increase overall lending in the economy. This increase in lending should boost investment and economic growth.

Inflation / deflation expectations. Another feature of forward guidance is that it might influence inflation expectations. If the Central Bank states that interest rates will stay at zero until unemployment falls below 6%, markets, firms and consumers may be more liable to expect higher inflation than previously. Some economists argue that, if there is currently a risk of deflation, higher inflation expectations can help boost spending and economic growth. This is particularly beneficial in a liquidity trap.

How credible is forward guidance?

There is nothing to stop the Central Bank ignoring its own pledge. The Bank of England could  pledge to keep interest rates at 0% until 2015, but if circumstances change – they could raise interest rates. Markets and banks know this and this could reduce the usefulness of the commitment, but it can still give an indication of how monetary policy will operate. Markets do tend to place a lot of weight on Central Bank pronouncements. 

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