Changing the basket for CPI

The ONS have looked at spending patterns in the economy and decided to change the basket of goods which the CPI is measures by.

Remember that the CPI is based on the change in the prices of the representative basket of goods. The goods in the basket are based on the share of total expenditure of the average household.

Each good is given a weight according to its share of the total basket. If the average household spends 10% on a good then its weight (share) of the CPI basket is 10%.

Well almost. Not every good is included, only those which are significant enough and only about 700 goods make it.

The ONS have changed the basket to take account of changing spending over the last year. The BBC explains what is in and what is out in the article below.

The BBC article is here

Policy options? Blue sky thinking

The Budget will take place next week and this year the calls for radical policy options are louder than usual.

The reason for this is that after over four years of economic stagnation people are getting desperate. Usually recessions end quickly and life returns to normal, the pain of recession concentrated on the unfortunate few.

It is difficult to find anyone who has not been affected by the current crisis. Lower real wages and lost purchasing power of savings has lead to the pain being spread widely. Of course those who have lost their jobs, or left education and failed to find one, have been really hurt.

So what could be done? The BBC have a survey of some interesting alternatives. George Osborn is unlikely to listen.

The BBC article is here

Credit rating downgrade - does it matter and who does it help?

Moody's, one of three 'Credit Ratings Agencies' has downgraded the UK governments credit standing from AAA (the best rating meaning 'very safe' to lend to) to AA1 (meaning 'pretty much safe' to lend to).

So what difference does this make? All loans require a rate of interest to be paid. The rate charged is made up of several elements, such as a 'pure' element - the profit to the lender - an 'inflation protection' element - the lender gets back what they lent in real terms - and a 'risk of default' element. The last one means the premium charged to protect the lender against the chance of not being repaid. The credit rating is about that element. When a country or firm has a AAA rating then this element can effectively be zero; there is no risk of default.

To the extent that the UK government will always repay its debts then there is no risk of default. So AA1 shouldn't really make a difference to lenders. But if it did and lenders started demanding higher interest rates then this will increase the already significant interest rate bill to be paid by taxpayers each year (currently about £50 billion).

Further if the government has to pay more to borrow so will everyone else. Lenders will be attracted to lend where rates are highest. To get them to lend to mortgage borrowers the interest rate will also have to rise, otherwise they will lend their money to safe governments. So, as the Chancellor has been at pains to point out, the government paying more interest affects all borrowers.

If firms and consumers have to pay higher interest rates then Consumption and Investment will not rise as fast as hoped and recovery will be further delayed.

Ed Balls blames the government and says it is all their fault for not borrowing more. If they had done then the economy would have grown faster and this problem would have been avoided. (Moody's blame slow growth for the downgrade).

The Chancellor says had the government not cut the deficit (well tried to) then this downgrade would have come much sooner.

It is not clear which version of events is right. Balls has the problem that a credible deficit reduction plan is essential to keep the credit rating and must contend with the ineffectiveness of stimulus policies generally. Osborne faces a rising deficit and missed targets with very poor growth.

Whoever is right the downgrade will make little difference in reality. France and the USA continue to borrow at record low interest rates despite being downgraded already. Two of the three rating agencies have not yet downgraded the UK.

Perhaps the most obvious point to make is that these same rating agencies stamped the mortgage backed securities that turned out to be worthless and caused the Global Financial Crisis 'Triple A'. Their credibility is pretty low and one of them is currently being taken to court by the US government for their role in misleading investors.

The BBC covers the story here, but look at the website directly to cover latest updates.

Fighting the fat

Denmark's 'Fat tax' has been repealed but doctors are pushing for a similar tax in the UK backed up with supporting measures.

For doctors in the UK the big problem is fizzy drinks, which are basically water and sugar. They want a tax which will arise prices by 20%.

Of course the PED of these drinks might be quite inelastic, but with so many potential substitutes, from juice to water, we might be pleasantly surprised by the effectiveness of such a tax. (However you can see the dentists getting ready to warn us against the effect of acid in fruit juice.)

The problem of fatty and high calorie foods is that they are 'imperfect information goods' and impose significant costs on the consumer and negative externalities on society who must treat their weight related diseases.

So using a price rise alone isn't enough. It is necessary to improve knowledge and directly intervene, such as banning advertising of unhealthy foods and closing take-aways near schools.

The problem of obesity is the 'new smoking'. The 1970's saw us begin to tackle the evils of smoking, but today the threat to peoples health from eating too much is just as serious.

It will take a broad range of measures to solve this. Some will cause a movement along the demand curve, but most will attempt to move the demand curve to the left.

The BBC report the proposals here

Inflation remains at 2.7% for fourth month

Inflation stability is the aim of the policy makers. It allows for certainty in business, anchors inflationary expectations and brings confidence back to households.

So the news that inflation has remained at 2.7% for the fourth month in a row is good news?

Of course there are some prices rising faster and some slower, but stability is good news in many ways. However at 2.7% it is 'above the 2% target, while still within the +/- 1% band that causes the MPC to explain themselves.

The greatest concern about 2.7% inflation is that earnings are going up more slowly. This means in real terms most people are worse off.

There are some other concerns. The inflationary pressure is mainly cost-inflation. Ironically some demand-pull inflation would have been nice as it would represent a return to growth. Also the recent devaluation of the pound will lead to higher import prices and this will feed directly into the CPI.

The Guardian covers the latest inflation figures here

The difficulty with supply-side

This is for the Grecians who have recently looked at the Irish model for Supply-side success.

The problem with supply-side policy is that there is no guarantee of success and the mechanism by which they work is uncertain.

To use a fairly clumsy analogy, you start with a ball of wool that you want to become a sweater, but it is quite possible for the amateur knitter to end up with a bad scarf.

The article below is from 2010, but has some important lessons on the short comings of Irish supply side policy.

The Bloomberg article is here

Practicalities defeat 'Fat tax'

Denmark introduced the worlds first 'Fat Tax' just over a year ago. It was covered in this blog and got one of the highest number of hits of any post to date.

Now Denmark is scrapping the tax. They say its because it has cost jobs, caused people to go into Germany to shop and inflated prices.

Well taxes do raise price! That's the point. This is a disappointing move as it represents a victory political expediency over economic policy.

It would be nice to find out how much the tax changed behaviour, especially in areas a long way from the German border.

If there is an important lesson to learn it is that a country acting alone can disadvantage itself. This has often be said of acting on carbon emissions and pollution. If you impose higher costs on domestic firms in a market with few barriers to international movement then the result maybe that firms move. So perhaps the answer is a European Fat Tax; good luck convincing David Cameron on that one.

The Daily Mail report the story here

It's Demand stupid

The UK economy shrank in the last three months of 2012. The cause is partly due to recession in the EU, they simply can't afford to buy more of our goods.

Ed Balls tries to claim he saw it coming, which he didn't and should be ridiculed as a naive opportunist who got lucky. But his view that there isn't enough demand in the economy is fundamentally correct.

Yet the Chancellor George Osbourne refuses to see to point. He wants to continue his deficit reduction plan, cutting public spending and raising taxes. While the deficit may shrink, so will Aggregate Demand.

Yesterday Oliver Blanchard, Chief Economist at the IMF (a New-Keynsian) said austerity had gone to far and that an easing up on the [plan was called for. It seems like good advice.

The Government could continue with their cost cutting in government, but they need to learn the lessons of their own explanation of the downturn. If Europe can't add to AD by raising our exports  then its time Government spending did. A one off investment in infrastructure, something 'shovel ready', such as offering all schools a new building or subsidising new low cost homes as long as they start the work within 2013 will help. Such programmes can be extended if need be.

The VW recession is now a possibility.

The BBC report the figures here

Blanchard's view is in this article from the Independent

Explaining the rise in employment

After yesterday's unemployment figures I was looking for reasons for the continued rise in employment when the economy is basically flat. I found the article below from October.

In past recessions firms have shed labour and, because the least productive have been allowed to go first, average productivity has risen. This has not happened since 2008.

Because of the much more flexible labour market real wages have fallen for those in work and so firms have not had to reduce their labour force as much as in previous recessions. Therefore the productivity 'jump' has not materialised.

Is that really enough to explain the flat productivity levels reported? Well probably not, but add to this low morale of the workforce given the falling real and nominal incomes and maybe this is enough.

Because of falling wages and no productivity increases firms have had to take on more labour to raise output. They can do this because they can offer lower wages for the higher output levels.

The article compares previous recessions and offers some thoughts.

The BBC article is here

Unemployment falls and employment rises

The strange course of unemployment continues with a rise in employment and fall in unemployment.

A rule of thumb is that there has to be around 1% growth in the economy to maintain the level of employment. This is because productivity improvements account for about 1% of growth.

The economy is not growing by anywhere near 1% and so the question has to be asked where are the jobs coming from. Sadly the data does not help us much and more work will have to be done here.

A good sign is that full-time jobs grew strongly. Sometimes the growth in jobs is part time and so the benefits are not as great as they seem. On the down side there was a rise in unemployment for the 18 to 24 year old group.

The BBC report the figures here

Economic integration delivers expected results

When Britain joined the EEC (European Economic Community or 'Common Market') in 1973 the expected benefits were all based on the theory of free trade and the process of 'Trade Creation'.

If trade barriers are removed then countries can take full advantage of comparative advantage. Countries specialise, trade more and as a result not only do the costs of goods fall, but everyone is better off.

As the EEC became the EC, then the EU the process of greater integration has continued and the pattern of UK trade has changed.

In 1973 the USA was Britain's largest trading partner. At some point in the recent past France overtook the USA as our biggest trading partner (I missed that too) and now it is Germany. France will be crestfallen, but who cares?

Recently a government economic adviser claimed that the benefits of joining the EEC were pretty weak and only based on trade. According to him the benefits have been as weak as expected.

The Daily Telegraph has details of the changing trade pattern here

Supply side lessons from France

France has seen an unprecedented level of capital flight in recent months. The cause - the heavy taxes proposed for high earners by President Hollande. Profit and company payroll taxes are already very high in France and the 75% proposed income tax rate seems to have pushed many to move their money.

The Daily Telegraph article shows the extent of the flight but there are important lessons to be learned.

Many people in the UK have doubted the wisdom of cutting the 50% income tax rate to 45%. There is a feeling that it is 'fair' for the rich to pay more than the middle income earners. This may actually be a reasonable point, but the argument is that the disincentive effects of high tax reduce overall economic performance and so make everyone worse off in the long run. While 75% is a lot more than 50% in tax terms there seems to be credible evidence that incentives do matter.

France has been incredibly slow to adopt supply-side reforms. The French industrialist Louis Gallois has delivered a report calling for 'shock therapy' to help improve French competitiveness. His plan includes cutting payroll taxes for employers, spending cuts and higher consumer taxes. There seems little political will to do this. Hollande is an old fashioned socialist who has no experience of government and ideals are yet to be overcome by reality for him. France carries some of the highest labour costs in the world and with a rapidly expanding trade deficit and 27% youth unemployment the Gallois Report may be the thing that comes back to haunt him at the next election.

A further important point to note is the fall in the French money supply that has resulted from the capital flight. This is potentially serious as it represents a deflationary force in an economy already in recession. Falling money supply is going to reduce AD and prevent recovery. In situations like these deflation is the last thing the economy needs and so the French cannot ignore the loss of confidence the capital flight represents. Like so many socialist leaders before him Hollande must realise that it is not possible for a country to be the sole master of its economic policy.

The Telegraph explains the crisis here

Reuters reports Gallois proposals here

EU debate - in or out?

As previously highlighted the debate on the UK's membership of the EU is becoming a major issue. In recent days there have been lots of contributions to the debate in anticipation of the Prime Ministers speech on Europe due on Friday.

One thing most people say is that Britain is a trading nation and they hope the UK can remain a member. However they then go on to make various conditions, saying it must be in the UK's interests to remain and depending on their viewpoints these conditions vary in strictness.

For economists the question is about the gains from trade. The lower the barriers to trade the more everyone benefits. There are various grades of economic integration and how far a country goes along this path determines what benefits they get. In order these steps are:

Free Trade Area  - free trade in manufactured goods only as a rule
Customs Union  - common external barriers with free trade inside the union
Common Market - Customs union plus freedom of movement for labour and capital within the Common Market
Economic and Monetary union - Common Market with one currency, eliminating the need for exchange rates
Political Union - One country

There are variations on these. The important point is that as countries allow greater integration they gain more benefits, but there are also some costs which include loss of domestic political control and in some cases the loss of the ability to pursue independent economic policy.

It would be useful to review the economic costs and benefits of EU membership now so that you can tell the political from the economics points that will be made in the next week or so.

A BBC article is here - there are many others

A policy conflict with no easy answers

The government wants to cap benefit rises at 1% a year for the next three years. It's beings strongly criticised as being unfair.

The arguments are actually about two issues. Long term supply-side incentives and income distribution. The first is much more straightforward to explain than the second.

One of the biggest problems faced by those out of work is the difference between in-work and out-of-work income. When the difference between the two is small the incentive to take a job is less and may prompt some people to remain on benefits rather than take a job. This is known as the unemployment trap.

During the period since 2008 the incomes of those in work have risen only slowly and at less than inflation, and for some nominal wages fallen. But benefits have gone up in line with inflation, which in some years has been well above target. So the difference between in and out-of-work income has narrowed. The government argue that the cap on benefits will restore the balance and raise incentives to work.

The case on income distribution can be argued both ways. Those on benefits are the least well off in the UK and it has been long established that they will be guaranteed an income that allows them to at least take a part in the normal activities of society. Therefore raising benefits by less than inflation represents a real cut in their incomes and breaks this social contract.

However against this the case can be made that the faster rise in benefits than in wages has led to an unintended change in the UK's distribution of income. While those on benefits will be worse off through this measure they will simply join the rest of society in the experience of recession. The distribution of income will be restored to the one that existed before.

There is no doubt that the distribution of income is the macroeconomic target which gets the lowest priority. The question really is do we want to prioritise long-run efficiency or compassion. No easy choice.

The BBC explains the measure and the arguments here

Missing the point on Carbon Trading

 Reducing the supply of permits will raise the price and maintain the incentive to cut emissions further

Australians have little grasp of the concept or problems of Carbon emissions and the need to correct this market failure. In the EU the need to reduce CO2 emissions is accepted and is being tackled.

The Age, the Australian daily paper, has got hold of the story that the carbon price in the EU emissions trading scheme has fallen and have interpreted this as a sign that the scheme is somehow failing. It represents the deep misunderstanding of how these schemes work which is prevelant in Australia.

The report that prices have fallen while volumes traded are up 26% in 2012 shows the success of the scheme! It means that firms are reducing carbon emissions and therefore can sell their surplus permits. That is a key incentive provided by carbon trading, those who can reduce CO2 emissions are rewarded by the revenue of the permit sales.

What is required is for the EU to now withdraw, or buy up, surplus permits so that the trading price rises again. The ETS market will then provide a further incentive for firms to cut emissions even more. Here the EU is too slow to act, but this is because it tends to work in 'phases'. It would be better if the EU intervened more actively in the market to stabalize the price of permits both to maintain incentives and provide certainty for firms who need to buy or sell them.

The Age report is here

The price is wrong?

The rise in university tuition fees is supposedly to allow the cost of education to be spread more fairly. The fact that someone has a degree means they can earn more. So the government reason that a student should repay part of the cost of the education which allowed them a higher income.

Most feel that the real reason is to reduce public expenditure, although it does provide universities with a higher net income and this allows them to spend more on their students education.

The problem is that the higher fees put people off from applying to university. They don't understand the full benefits higher education will give them and so see the expenditure as greater than the benefit. This occurs because education is an imperfect information good.

Education is also referred to as a merit good. The market will provide education, but less than the socially optimal amount.

The BBC reports the decline in UCAS applications for the second year running. You can search the blog to find earlier posts on this issue.

The BBC article is here