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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Readers Question: Can you please elaborate on “fiscal devaluation” as a suggested solution for Euro area competitiveness problems?

Fiscal devaluation is an attempt to restore competitiveness through changes to the tax system.

In an exchange rate devaluation, a country allows its currency to fall in value. This makes the countries exports cheaper and more competitive; imports become more expensive. This leads to relatively higher domestic demand. A devaluation can help reduce a current account deficit.

Fiscal devaluation aims to improve competitiveness by changing tax rates which reduce the cost of exports.

1. The government could cut tax on labour (e.g. Employer, employee income tax contributions)
2. To offset these tax cuts, the government could increase VAT

• Lower tax rates on labour effectively reduce wage costs. This should make exports cheaper and more competitive.
• Higher rates of VAT make goods sold in that country more expensive.

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Ireland has faced tremendous economic turmoil in recent years. Government debt has soared after the banking bailout and effect of a deep recession.

The economy has faced a combination of

• Falling house prices
• bank losses and decline in bank lending
• Fiscal austerity (government spending cuts) to try and solve budget deficit.

All these factors have led to a fall in GDP in 2010. In the Euro, they haven’t been able to devalue the currency or pursue an independent monetary policy.

Irish economic performance – slow recovery.

Instead they have had to rely on ‘internal devaluation’. This involves reduced wage costs and inflation to try and regain competitiveness. To some extent, they have succeeded in improving competitiveness. However, unemployment remains high and output remains well below previous peaks.

The Irish Central Bank has forecast economic growth of 1% in 2011. This leaves a significant output gap. If the Eurozone falls further into recession, it will be even more difficult for Ireland to maintain this recovery.

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Readers Question: What is Creating money electronically?

Creating money electronically is something a Central Bank can do when pursuing a policy of quantitative easing. It basically involves making its bank balance bigger.

In quantitative easing, the Central Bank wishes to increase the money supply and purchases bonds from commercial banks.

The Central Bank will decide to increase its level of bank reserves. E.g. suppose it was £100bn. The Central Bank can simply decide to change this figure to £120bn. It’s like going into your bank account and changing your savings account. Instead of having £200 in the bank, you could decide to have £20,000. Except you don’t have the power, the Central Bank does.

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Readers Question: It is unclear what Seasonally adjusted means?

Seasonally adjusted figures take into account seasonal factors in time series.

Unemployment will have seasonal patterns. For example, over the summer holidays extra jobs are likely to be created and unemployment will typically fall. In winter, unemployment may rise as less tourist jobs are available. (apart from a few weeks over Christmas).

Therefore, seasonally adjusted figures take away these usual seasonal changes in  unemployment to give a better guide to the underlying statistic.

At the height of the summer, the actual unemployment figure will be quite low. But, the seasonally adjusted figure will be higher because it takes into account this seasonal fall in unemployment.

Example

For example, unemployment figures for the month of June may show a fall of 10,000 to 7%. However, statisticians may know that on average unemployment falls 100,000 in the month of June because it is the start of the summer holidays (more jobs created). Therefore, the seasonally adjusted figure for June will show a higher unemployment rate than the actual figure.

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Readers Question. If central banks collectively and continuously print money, does this mean there will never be a financial crisis and recession?

If central banks collectively and continuously print money then we could end up with a different type of financial crisis. Instead of a recession (falling output), we could get a situation of high inflation and ultimately hyperinflation.

Printing Money Can Help Solve Depressions

In certain types of recessions (Balance sheet recessions/liquidity trap). Printing money can help avoid deflation and therefore help the economy to recover from a prolonged slump.

In a very deep recession when we have low bank lending,  a decline in money supply growth, it is possible central banks can print money without causing excess inflation. If you look at the policy of quantitative easing in the UK, underlying inflation has remained low. The increased money supply helped the economy to some extent recover.

see: who benefits from quantitative easing?

Printing Money Can Cause Inflation

However, if you ‘continuously print money’ there will come a point when inflation increases above the inflation target and this can lead to sustained inflationary pressure. If you ‘continuously print money’ you will get a situation of hyperinflation. See: Why printing money causes inflation

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