Debt Spiral Explained

by

A debt spiral refers to a situation where a country (or firm or individual) sees ever-increasing levels of debt. This increasing levels of debt and debt interest become unsustainable, eventually leading to debt default.

Types of Debt Spirals

  • Public sector debt. This is debt that the government owe to the private sector (e.g. UK public sector debt). Some government debt may also be sold to overseas investors.
  • External debt. This is debt that a country owes to other countries. It includes both government external debt and private external debt.

A debt spiral could occur with just government debt. However, if a country also has high levels of external debt, it makes a debt spiral more likely because foreign investors are more likely to withdraw funds at signs of difficulty; this is termed ‘capital flight’.

Stages in debt spiral

  1. Debt Levels increase. (This could be due to overspending, inefficient tax collection, bank bailouts or economic slowdown)
  2. Markets become concerned about debt levels leading to higher bond yields (higher rate of interest)
  3. Higher cost of servicing debt. Rising debt increases debt interest payments. But, also Governments have to pay higher interest payments on debt because of rising bond yields. This increases government spending even more.
  4. To reduce bond yields, governments need to cut spending and increase tax.
  5. Trying to reduce debt can cause a recession. The Impact of spending cuts leads to lower aggregate demand more unemployment and lower economic growth. Lower economic growth leads to lower tax revenues.
  6. The shrinking economy means it is harder to meet debt repayments. Confidence falls. Bond yields remain high despite the spending cuts.
  7. With a shrinking tax payments, the government struggles to meet interest payments. Also markets no longer want to buy more government debt, leading to partial or total default.

Read more

The problem with politics and economics

by

When I do mock interviews for PPE at Oxford, one of my favourite questions to ask is. –

Who should manage the economy – unelected professional economists or politicians who get elected but might not know about economics?

There’s no easy answer. In practise it is an element of both. But, essentially, in a democracy, we would rather have elected politicians making the key economic decisions, especially on issues such as tax and spending. At least, we can vote them out if we don’t agree with their general approach. There is also no guarantee that professional economists will do a particularly good job. The technocrats in the ECB are hardly covering themselves in glory in their management of the Eurozone economy in recent years. However, in recent decades, we have seen moves to make monetary policy managed by an independent Central Bankers. The government nominally retain control over the inflation target, but it has placed significant economic influence in the hands of ‘professional economists’ rather than politicians. The argument is that independent Central Bankers are less likely to be swayed by political pressure to cut interest rates before an election.

The hope is that elected politicians will take advice from impartial economists and make the decisions based on evidence rather than looking for something to justify their political ideology or finding a justification for what they did in the past.

However, there are quite a few times, when the political process causes great frustration. One of the most obvious problems is the difficulty that politicians have in admitting they are wrong and changing their point of view. There is great political capital in sticking to your guns. Mrs Thatcher was lauded for her ‘this lady’s not for turning speech’ But, despite the success of the rhetoric, it’s easy to forget she was sticking to highly deflationary fiscal and monetary policies, which caused UK unemployment to increase to 3 million and stay there for several years.  At the time, over  300 economists wrote to the Times to argue for an easing of policy. An easing of policy would have mitigated the worst of the recession, whilst still bringing inflation under control. But, it was better politics to stick to extreme policies and concentrate on blaming the problems on other parties.

Read more

Negative Interest Rates

by

Readers Question: Is it possible to have negative interest rates?

Negative interest rates occur when a bank charges you money for the privilege of looking after your savings. It is  possible to have a negative interest rate (e.g. -0.5%) Although it is quite rare. The Bank of England have recently talked about the possibility of a negative interest rate for commercial bank deposits at the Bank of England.

Why is Bank of England Talking about a negative interest rate?

The UK economy is still stagnant with little sign of economic growth. Usually, a prolonged recession would lead to lower interest rates to encourage borrowing. However, since interest rates fell to 0.5% in March 2009, interest rates have stayed the same as there is little precedent for cutting interest rates further.

The Bank has tried quantitative easing but this has not really encouraged bank lending and normal economic activity.

The Bank of England, in particular want to encourage lending to small businesses – small businesses have complained it is very difficult to borrow from commercial banks in the present economic climate.  At the moment, commercial banks prefer to increase their cash reserves, which they deposit at Bank of England and not lend. At the moment commercial banks get a small interest rate payment 0.5% on their deposits. However, if there is a cost for depositing money at the Bank of England, they would have a greater incentive to lend money. In theory, commercial banks will lend more and this would stimulate business investment and economic growth. Higher lending would also help to reduce unemployment and reduce the cyclical budget deficit.

see more on: basic economics of cutting interest rates

How would it work?

The Bank of England would probably introduce a new deposit rate. For example, deposits over £1billion at the Bank of England would be charged the negative interest rate.

The first £1 billion may still receive the base rate of +0.5%. This means that small building societies would not face a negative interest rate. This could cause problems because a negative interest rate could mean they would have to pay people with tracker mortgages (mortgages that follow base rate), and they could go out of business because they couldn’t recoup money from savers. The deposit rate would mainly affect the large commercial banks with high cash reserves.

What would happen to saving rates?

If the Bank of England had a negative interest rates on deposits, commercial banks would be less keen to encourage banks deposits, therefore they may reduce interest rates on saving accounts.  Savers would see a fall in income.

In theory, lower interest rates may encourage spending (rather than saving (substitution effect). However, consumers may be quite inelastic to the interest rate. It may also be outweighed by the decline in income of savers who rely on interest payments (income effect).

What are the Problems of a Negative Interest Rate?

  • Some fear a negative interest rate could encourage a new lending boom. Banks might be so keen to get rid of cash, they start lending to business without evaluating how good the loan is. Austrian economists are particularly critical of negative interest rates as they argue it can lead to asset booms and distort the market. However, there is no sign of a new lending boom in the short term, the real problem is that banks don’t want to lend because of the economic situation.
  • Savers will lose out. With inflation already above target, a fall in the saving rate will lead to an even bigger negative real interest rate. Savers will see a fall in their real wealth and living standards.
  • Banks may still not want to lend. The main thing holding back lending may be the overall state of the economy. Even cutting interest rates to negative may fail to increase lending.

Read more

Osborne, UK Debt and Credit Ratings

by

I was going to write a lengthy post on George Osborne, UK debt  and Britain’s credit rating downgrade, but fortunately Simon Wren Lewis said pretty much everything I wanted to say: What George Osborne did with his austerity programme was the equivalent of putting a sick patient on a starvation diet accompanied by cold showers. …

Read more

Is a strong currency a good thing?

by

Readers Comment from post: Should the UK join the Eurozone So now it is 2013. Britain has spent a number of years with its interest rate set at just about zero, has entered a triple recession, has lost it’s AAA credit rating and Sterling is only worth €1.15 a drop of over 30% against the …

Read more

Forecasts for Pound to Euro 2013

by

The recent history of the Pound to Euro, and forecasts for the next few months.

euro-pound-daily

Latest Sterling exchange rates at Bank of England

Since the  summer of 2012, the Pound has fallen nearly 11% against the Euro. The main reason is that the intervention of the ECB has helped to stabilise the Euro and EU debt fears have temporarily receded. As a consequence, money has started to flow into the Eurozone again, and there is less reason to see the UK as a safe haven compared to the Euro.

Secondly, the UK economy has been stagnating. In 2012, we entered a double dip recession, and there is a chance of a triple dip recession in 2013; the UK might avoid a technical recession, but the overall outlook is grim (see: economic growth). Because the UK is experiencing a very slow recovery, it makes it difficult for the government to reduce its debt to GDP ratio.

In Feb 2013, Moody reduced the UK debt rating to AA1 for the first time in history. Moody’s downgrade occurred because they were concerned at the stagnant growth in the UK, which meant tax revenues will be less than expected making it difficult to reduce the debt to GDP ratio. The downgrade was largely expected and won’t have a direct impact on exchange rate, but it is a reflection of the disappointing economic performance.

UK Current account deficit

current-account-balance-actual-2013

Some fear that given the significant current account deficit (UK deficit is around 3% of GDP), the Pound may continue to fall against the Euro. Some commentators feel that the pound will need to fall to £1 =€1 to restore competitiveness and rebalance the economy.

The logic of this negative outlook for Sterling against the Euro, is that there is now nothing about the UK economy which deserves to give it a ‘safe haven status’ compared to the Euro. With the ECB now more willing to intervene against liquidity shortages, the UK has no real value as a safe haven alternative, which is seemed to at the start of 2012. Furthermore, with a credit rating downgrade and poor prospects for growth, the UK economy is likely to struggle, keeping interest rates low and making it less attractive as a place to attract investment.

Weak growth and quantitative easing

The weak prospects for economic growth raise the prospect of extended quantitative easing in the UK. Further monetary easing will contribute to inflationary pressures and weaken Sterling. In recent years, the UK has been more susceptible to cost-push inflation than the Eurozone, the extent of quantitative easing in the UK means that this relatively higher inflation in the UK may continue. Ironically, depreciation of the past few months itself will cause some cost-push inflation, like in 2009.

However, bear in mind underlying weaknesses in the Eurozone

Before, we write off the Pound, bear in mind, that the Eurozone still faces significant structural problems, which have only been temporarily averted by ECB intervention since last year. There is no guarantee that there will remain satisfactory ECB intervention. Also the bond purchases haven’t resolved the more deep-seated problems of low growth and very high unemployment within the EU economy. Markets may worry about the inflationary impact of quantitative easing in the UK, but arguably this is a stronger long-term position than being locked into deflation debt spirals that many southern Eurozone economies are facing. The Eurozone bond crisis has been temporarily been put on the back burner, but it is far from solved.Long-term Eurozone economic problems may return to haunt the Euro.

Euro to £ since 2005

pound-euro

The appreciation from 2009 to Aug 2012 has been wiped away by recent depreciation

Outlook for Pound to Euro in 2013

The Pound may continue to fall closer to 1.0 as we rebalance the UK economy, but any resurgence of problems in the Euro, could lead to a reversal of the Pound’s fortunes.

 

These are the economic factors which will influence the future value of the Pound.

Read more

Panic Driven Austerity

by

One of the striking feature of the Eurozone crisis was how countries with relatively low levels of government debt, rushed into severe austerity. And as a consequence of this austerity saw a drop in the rate of economic growth, and an increase in their debt to GDP ratio. One of the main reasons for the …

Read more

Daily Mail Economics

by

The definition of Daily Mail Economics. The deliberate use of economic data to create fear, worry or exaggerated concerns about the state of the economy and society. Daily Mail economics is not limited to the Daily Mail, it may appear in any newspaper or blog, but the Daily Mail and Daily Express usually have quite …

Read more

Continue Shopping →
Item added to cart.
0 items - £0.00
Checkout