Plan B for the economy

I’ve never been in favour of the government’s Plan A for the economy – austerity in a recession was also going to risk pushing economy back into double dip recession and simultaneously fail to reduce the budget deficit. Even if the austerity was mild by comparison to the rest of Europe, it was just enough …

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Money Supply in the credit crunch and recession

Question: re: article on the great recession. How did the money supply affect the credit crunch and recession?

Firstly, we can look at the statistics for the money supply growth rate in the UK.

m3-m4

Source: Bank of England

This shows strong growth in the broad money supply in the years leading up to the credit crunch. – An annual growth rate of 10%. By 2010, broad money supply growth had become negative. This is a result of the fall in bank lending we saw in the recession, and the corresponding effect on broad money supply growth.

Did money supply growth play a role in the credit boom? The main issue was the rise in bank lending, and the type of unsustainable bank lending. The growth of the broad money supply didn’t give a clear sign of an underlying boom. If you look at the money supply from a historical perspective, it has always been difficult to see an easy link between the money supply and the rest of the economy.

Broad money supply over past 100 years.

UK broad money supply

source: Bank of England

Money Supply in the credit crunch

This first graph suggests that at the heigh of the credit crunch 2008 to May 2009, the money supply was rising at a fast rate, which you wouldn’t expect. This is true, but it only tells half of the story.

Money supply and velocity of circulation

The money supply is the stock of money in the economy. However, it is also very important to know the velocity of circulation of money. The velocity refers to the amount of times this money changes hands in a year. The velocity of circulation has been in long-run decline because of various changes to financial sector. But, in the credit crunch, the velocity fell sharply.

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Which is best – variable or fixed mortgage rate?

Yesterday, I had a chance to use economics in a  practical way. My previous fixed rate mortgage deal came to an end. This means the bank would return my mortgage rate to the Standard variable rate, which is currently 4.99% (4.49% points above the base rate). (monthly payments of £703)

The first and most important thing is always to ring up and bank and see if they have any better deals than their standard variable rate. Invariably, the standard variable rate is not the best deal. It took nearly an hour of answering questions, but it was worth re mortgaging.

When I first bought the house in 2005, my mortgage payments were £950 a month. Interest rates were higher (about 5%), and I had a standard 30 year repayment. I didn’t like paying £950 a month, so extended my repayment term to 47 years. That helped reduce the mortgage cost.

In the past two years, I had a fixed rate mortgage rate of 4.5% (£680 a month) I though this was pretty poor given base rates were so low. It was a practical example of how bank lending rates were divorced from the Bank of England base rate. (bank rates vs base rates)

However, this time, I was eligible for a better rate because I have 60% LTV (home is worth £240,000. Outstanding mortgage debt £130,000.) Also, helped by lower inflation and a slight easing of credit conditions, bank lending rates are lower than 2 years ago. The choices I had were:

  1. 2 year fixed at 2.18% (plus £999 charge) – my monthly payments would be around £492
  2. 5 year fixed at 2.88% (plus £999 charge) – monthly payments around £530
  3. 10 year fixed at 4.99% (plus £1,100 charge – monthly payments around £702
  4. Tracker of – Bank of England base rate + (2.5%) = 3% monthly payments around £500

Barclays fixed rate mortgages (link)

I snapped up the 5 year fixed rate. My logic is that the Bank of England base rate is likely to stay at zero for the next one or two years. But, after that, there is a reasonable possibility, we will exit the liquidity trap and Bank of England base rates could return to 5%. If that happens, a tracker mortgage would become very expensive. If base rates rose to 5%, I would be facing a monthly mortgage bill of 8% – £961.

Because of this possibility, I’d rather get a 5 year fixed than 2 year fixed.

It is possible we could replicate Japan’s prolonged decade of stagnation and ultra low interest rates. In this case, a 2 year fixed would be the best, because mortgage deals will still be very cheap in two years time. However, on balance, I think the likelihood of that occurring is receding, and given a five year fixed is not much more expensive than a two year fixed, I’d prefer the security of fixed payments for the next five years.

Maybe I should have taken 10 year fixed whilst I can. In 10 years time, interest rates could conceivable 5-10%. But, I’m quite attracted to 5 years of very low monthly payments, and who knows about next year, let alone six years hence.

Economics of mortgage payments

As a homeowner, it shows the importance of the base rates to disposable income. If I chose a tracker and the bank of England base rate increased, that’s a substantial fall in disposable income.

Low interest rates will definitely help to increase my spending over the next five years.

There is strong time delay between interest rates and consumer spending. The past two years, I’ve been on a fixed rate of 4.5%. Only now with the credit crunch receding am I am going to be benefiting from low base rates. Because I have a five year fixed rate, future changes in the interest rate won’t really affect my disposable income.

Personal preferences

Generally, I like to have lower payments now. I was quite happy to extend my mortgage term, even though it means higher overall payments. One important factor is that I expect inflation to reduce the real cost of mortgage payments over time.

In the past 10 years, inflation in the UK has averaged 3.2%. £720 in 2002 would now be worth £991.20 (see also mortgage payments and inflation)

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How Much Has Government Spending Been Cut?

According to one Bond trading firm, austerity is a con and government spending hasn’t fallen significantly. (Telegraph) Government Spending 2011-12 – £681.4bn Tax 2011-12 – £558.1bn Deficit in finances – £123.3bn Changes in government spending 2009-10   +4.6% Changes in Government spending 2010-11  +0.3% Change in government spending 2011-12   -1.5%   Tulllet Prebon, a bond trading …

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How successful have Central Banks been in managing the economy?

Back in February 2007, I wrote an essay – Evaluate the effectiveness of the MPC in controlling inflation.

The last line was:

MPC have done a good job so far. However the real test may come when there is a rise in structural inflation or global instability.

Given the knowledge of the past five years, how should we update this post,?

1. Central Banks should target inflation and growth

In 2007, I wrote The MPC are responsible for setting interest rates and determining UK monetary policy. They seek to keep inflation close to the government’s target of CPI 2% +/-1 %

But, we should start by adding the full remit of the MPC. In their Monetary policy framework, the Bank of England state, their full responsibility is to:

The Bank’s monetary policy objective is to deliver price stability – low inflation – and, subject to that, to support the Government’s economic objectives including those for growth and employment.

By contrast, the ECB seem to give less importance to economic growth, and seem primarily concerned with low inflation.

“The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.”

From: ECB Monetary Policy

A valid criticism of the ECB during the economic crisis has been the fact they have placed too much emphasis on targeting low inflation. For example, the ECB increased interest rates in 2011, even though the European economy was entering a double dip recession. The ECB have been unwilling / unable to consider more unorthodox monetary tools to boost economic growth.

EU inflation

Euro area inflation

From a narrow perspective of keeping inflation close to the target, the ECB have been quite successful. Eurozone inflation is currently 1.7% and is below the target. However, this period has been very disappointing in terms of economic growth. The EU has entered into a double dip recession. If the ECB had given greater importance to economic recovery and willing to tolerate higher short term cost-push inflation, the EU could conceivably have avoided the double dip recession and done more to reduce the record levels of EU unemployment.

  • In evaluation, you could argue that even if the ECB had kept interest rates close to zero, that alone may not have been enough to avoid a double dip recession anyway. However, base rates should not be the only tool that Central Banks consider. Also, the fact that the ECB have been so strident in targeting low inflation, does send signals to European business that policy is more likely to be contractionary.

By contrast, the Bank of England has tolerated much higher headline inflation rates.

cpi-inflation

From the narrow perspective of keeping inflation within target, the Bank of England has frequently missed the target of CPI 2% +/-1. This failure to keep inflation low has also been magnified by the fact that there has been low nominal wage growth. It means that the high inflation rate has led to falling living standards of both those in work, and those on benefits.

However, given the uniquely challenging circumstances of the past five years, it is fair to defend this choice. It made no sense to use interest rates to reduce inflation when the economy was struggling in a prolonged economic stagnation. Firstly this inflation was primarily cost-push. It was due to the effects of devaluation, rising raw material prices and higher taxes. There is also evidence that prices were sticky downwards; the fall in demand didn’t lead to the fall in prices we might have expected.

But, the fact that wage growth was very low, showed there was no underlying demand pull inflation. To religiously keep inflation close to 2%, would have required a potentially very sharp contraction. Given the prolonged recession, you could argue the Bank of England have been too timid in targeting economic recovery. E.g. direct lending to business may have been more successful.

In evaluation, you could argue this might involve the Bank of England extending its original remit, and it would require the government to play a greater role.

2. Limitations of Traditional Monetary Policy

The other lessons of the past five years is the limitations of traditional monetary policy. In normal circumstances a cut in base interest rates from 5% to 0.5% would ensure economic recovery. However, in the great recession, cutting bank base rates has been insufficient.

Firstly, commercial bank rates haven’t fallen to match base rates. This has been a particular problem in the Eurozone with bank rates in Spain and Greece, higher than before the crisis. See bank rates and base rates

In the aftermath of the credit crisis, liquidity shortages have meant the supply of credit has constrained lending, investment and growth. In other words reducing the cost of borrowing is insufficient to boost demand, if the supply of credit isn’t there.

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Is Phillips Curve still Relevant?

phillips-curve2

Readers Question Discuss the view that the Phillips Curve is irrelevant in explaining the relationships between unemployment and inflation in the UK. The standard Phillips curve suggests there is a trade-off between unemployment and inflation. This relationship occurs because of the Keynesian view of the AD/AS diagrams. Diagram showing an increase in AD As AD …

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Over-financialisation of the economy

Readers Question: I am also interested in Marxist economics and they seem to say the 2007-2008 crisis was a result of over-financialisation of the economy, and that investors/owners could not squeeze surplus out of other sectors in the economy as they once could.

Financialisation of an economy refers to the situation where the finance sector takes a bigger share of GDP and employment. The consequence of financialisation include the possibility that:

  • Financial markets have greater influence over firms and the real economy.
  • The economy is more dependent on the strength of the finance sector.
  • Widening inequality as the finance sector is often able to capture relatively higher salaries and profits.
  • Growth in financial instruments has increased the risk of unsustainable debt and lending levels.
  • The nature of the finance sector means that if it fails it is has a much wider knock-on effect to other industries. If coal mines close, it doesn’t really adversely affect other industries. But, if banks get into difficulties, it has severe adverse effects for every other industry.

Epstein (2001) defines financialisation as:

“the increasing importance of financial markets, financial motives, financial institutions, and financial elites in the operation of the economy and its governing institutions, both at the national and international level” (Financialisation and its consequences)

Growth of Financial sectors in developed countries

Between 1970 and 2008, most industrialised countries saw a growth in the importance of the finance industry.  The total share of finance in value added (GDP) to the economy more than doubled in 11 OECD countries. In terms of employment, economies have seen a growth in the share of financial sector employment.

finance-sector

source: Bank of England

UK Finance sector

UK finance sector growth

Source: Bank of England

UK financial sector growth – strong between 1995 and 2008, but experienced a deeper dip in the 2008 recession.

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