Readers question: What exactly are the solutions to the EU crisis?

It is a difficult question to answer. The dynamics of the single currency mean that many of the conventional solutions to economic problems cannot be used. The difficult task is to reduce levels of government borrowing whilst also managing to target economic recovery and lower unemployment.

Problems Facing EU

If you looked at an economy such as Ireland, Greece Portugal, or Spain. They face these problems

• High unemployment
• Stagnant economic growth, and the chance of prolonged recession.
• Very large current account deficit due to loss of competitiveness.
• High government borrowing. Higher interest rates on government bonds because of fears over default.

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A joke – Three guys walk into a bakery; an investment banker, a government employee, and a tea partier. The lady behind the counter puts out a dozen cookies. The investment banker pockets 11 and tells the tea partier the damn government worker is trying to steal his cookie.

There was a time when bank managers were seen as the most upstanding member of the community (I think of Captain Waring in Dad’s Army). The bank manager may have been very strict about not giving you a loan to buy a new car, but you knew he was going to be fair. You certainly didn’t expect your bank manager to borrow from an international money market and use the loan to buy into some crazy sub-prime mortgage bundles from Florida.

But, times change. The last two to three decades have seen a real change in the way banking has operated. In the UK, building societies were replaced by PLCs intent on maximising growth and profit. Traditional banking models evolved into more risky models where prudence was given less importance and risk-taking was encouraged. This evolution in banking and finance took place against a backdrop of financial deregulation and widening income inequality. The (largely uncontested idea) was that if firms could make excess profit they could deserve to keep the proceeds. There was a certain logic to allowing free market forces to dictate profits, wages, bonuses and banking activity. Why should government try to regulate an industry they didn’t really understand?

The credit crisis of 2008 exposed these new positions and attitudes as being highly risky and misguided. It led to catastrophic losses in the financial sector, which threatened to undermine our financial and economic system.

Usually in a free market, if a firm goes bankrupt because of misguided investment decisions, that’s it – tough luck. But, in the case of the banking system, banks were seen as too important to fail. Therefore, throughout the Western World, taxpayers were forced to bailout banks to prevent them going out of business.  The logic of the free market was turned on its head. In the good times financers benefitted from huge bonuses, but when things went bad they were bailed out. Heads you win, tails someone else loses.

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Readers Question: What is economic analysis? Can you give some examples? Kindly refer me to an easy to read book on economic analysis.

Economic analysis involves examining issues and problems from the perspective of an economist. Economic analysis would involve some or all of the following:

• Examining the opportunity cost of a decision. (e.g. if the government spend more money on trains it would mean higher taxes or less government spending for other projects)
• Examining whether decisions increase economic welfare (e.g. does the utility to the consumer exceed the marginal cost of producing it?)
• Examining all social costs and benefits in producing a particular good. E.g. is a congestion charge on motorists justified given the external costs of driving into the city centre?
• Examining the wider impact on issues just as equity and fairness (e.g. an increase in congestion charges could cause increased income inequality)
• Using models such as supply and demand to illustrate what could be happening in a particular market or wider economy.

Readers Question: Could you explain this article China had pegged its currency to the dollar, keeping its value artificially low.

To peg your currency against the dollar

This means that China has been trying to keep the value of its currency against the dollar the same.

For example, if 1 Chinese Yuan = 0.16 Dollars . ( 1 Dollar = 6.13 Yuan.)

Then China is trying to keep the Yuan close to this level. e.g. prevent the value of the Yuan rising.

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Readers Question: I am wondering why the 75 billion of quantitative easing that the Bank of England announced today to be “injected into the economy” isn’t spent on infrastructural projects? Why spend those funds on government bonds? This doesn’t seem to be the best way of using these funds. Many thanks.

It’s a good question. I wrote on the latest round of quantitative easing here: Keep Calm and Print Money

I think the Bank of England would respond by saying it is out of their remit to start deciding which infrastructure projects to start giving money to. Their constitution probably doesn’t allow giving money directly to firms who promise to invest. It would make the Bank of England more political. Their remit is just monetary policy not fiscal policy as well.

By buying government bonds (they could also buy corporate and mortgage bonds) the Bank of England takes a more neutral approach. They say it is their job to:

• Reduce interest rates on bonds
• Increase money supply

They hope this will prevent double dip and prevent inflation falling below target in medium term.

But, then it is  up to free market to respond and decide how to use extra money.

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