Is it really going to work?

Despite a lot of talk about boosting growth the government has announced only a modest scheme to help and much of it is only an extension of previous measures.

The scheme will underwrite construction projects, allowing lower borrowing rates because the government will guarantee repayment. A third runway at Heathrow is to get another hearing.

The main measure is a promised relaxation in planning laws. At present it is very difficult to get approval in some areas for new building, partly because of objections from those protecting their own vested interest. This simply holds up projects and so delays growth.

These are supply-side measures that will not necessarily act very quickly, although they will help in time. Some people call for tax cuts.  For households, cuts in VAT or Income tax, to boost Consumption and so AD. For firms tax write-offs to cut the costs of new investment and so boost AD.

The argument about whether further boosts to AD or AS are most appropriate will continue. However both sides cannot escape the fact that confidence is so low and uncertainty over so many variables is so high, that governments are almost powerless to influence growth rates by more than a fraction of one percent.

The BBC report the 'new' initiatives here

The bailout explained

The European bailout plan is complicated. This movie was created by Tom Meltzer of The Guardian to explain the situation.

A video is here

Accuracy of inflation measures

Firstly I should declare an interest. This story affects my well-being in retirement and I'm not very happy about the pension changes currently proposed by the Government.

But the economics of this story, whether CPI or RPI should be used to annually adjust public sector pensions, is a relevant economic issue.

All price index's are compromises. They are based on the cost of a 'typical' basket of goods, discovered by a survey of consumer spending. However there are no 'typical consumers' the basket of goods is just an average. For some households the cost of living rises faster, for others slower.

The CPI was introduced when there were thoughts Britain might join the Euro (although it was never a serious option) and became the UK's 'official' measure of inflation. The CPI is more comparable with other EU countries measurement of inflation, but the British spend their money on slightly different things. So to construct the CPI the basket of goods had to be adjusted, reducing the impact of housing costs and including other items that did not actually affect UK residents.

The CPI is statistically more elegant. It reduces the effects of rouge price changes and deals with complex goods, such as the price of 'white bread' with its many varieties and easy substitution in a way that makes the RPI look clumsy, if not crude. But CPI will usually give a lower inflation rate than RPI (initially estimated at 0.5% it has actually been 0.75% since 2003).

The result of indexing pensions by CPI and not RPI will then lead to a 0.75% smaller rise in pensions each year and will save the Treasury £40bn in this parliament alone.

Actually neither CPI or RPI are the right measure to adjust pensions. A Pensioner Price Index should be used based on the typical basket of goods a pensioner household buys. For example fewer pensioners have mortgages and so both CPI and RPI overstate the effects of the housing market and mortgage rates on them. A Pensioner Index (PePI) is child's play to construct and indeed one already exists!

Of course the PePI may actually give smaller rises to pensioners!

The Guardian cover the story here

Operation Twist - Probably misinterpreted

I know this post is challenging and is aimed at A2 students only. However it is a very important recent development in monetary policy.

The Federal Reserve has undertaken a restructuring of the debt it holds in an attempt to lower long term interest rates. This has become known as 'Operation Twist', but this is mainly because people want more.

The Fed has tried to lower long term interest rates by causing an excess of demand in the market for long term government debt. This is done by withdrawing from the market long term debt by buying it themselves. Such government debt is an important part of many investment funds portfolios, for example pension funds.

As a result there is less long dated government debt on the market and so the price of the remaining debt is bid up. A government bond pays the holder a fixed amount each year, say $2 for each $100 of the face value of the bond.

As the price of the government debt rises then the annual payment made by the government to the holder of a bond is a lower percentage of the market price. This means long term interest rates are lower. For example a $100 bond pays $2 a year. The market price of the bond is forced up t0 $200 and so the $2 paid now represents a rate of interest of just 1%.

So the Fed have tried to buy up long term bonds, taking them off the market, and replacing them with short term bonds. This will hopefully reduce the rates on all long term loans and so stimulate, for example, mortgage borrowing. This would encourage a recovery in the housing market which remains crucial in the USA.

The markets have taken this as a sign of panic. This has not helped confidence, hence the plunge in the stock markets. The markets also wanted more Quantitative Easing as they feel the economy needs a bigger boost.

I am far less clear on the Fed's motives. There was a time when central banks structured the debt in a way that was consistent with the interest rate set. Having more short term bonds on the market certainly increases the liquidity of the market and most commentators seemed to have missed this.

This is an unusual move by the Fed. It has been, at best, badly received and at worst seen as a sign that the policy options have run out. Most economists also doubt that the move will actually be effective.

The Guardian explains 'Operation Twist' here

Dr Death suggests Greece default on its' debts

Dr Roubini (Dr Death) is renowned as one of the world's most pessimist Economists and has been credited with predicting the Global Financial Crisis in 2008. He has suggested that Greece default on their debt and leave the Euro.

His justification for this is because of advantage of floating exchange rates. He states that if Greece leaves the Euro and returns to the Drachma then they would be in a stronger position to recover. This is because a return to the Drachma would lead to a dramatic depreciation of the currency. This depreciation would improve competitiveness and growth.

A depreciation of a currency will make exports cheaper and imports more expensive therefore improving conditions for local producers. He also examines the success of Argentina and Iceland after they defaulted in 2001 and 2008 respectively to successfully recover.

His article is here

Unemployment rises strongly

There is a problem with all policy choices. There is an inevitable trade off, one goal has to be sacrificed in order to achieve another.

While there have been periods when that really didn't seem too bad (such as the NICE decade), now the costs are transparent. In particular the aim of long run growth and securing a sound budget position is causing a rise in unemployment and the sacrifice of short-run growth.

The recent unemployment figures show this clearly and have inevitably led to a call for a reversal of policy. In this case the costs of the policy are unevenly distributed, those who loose their jobs pay the highest price and for some, the young, there is little prospect of a job anytime soon.

The BBC covers the story and have an excellent interactive map if you follow the links at the bottom of the page!

The BBC coverage is here

A temporary solution?

Yesterday I looked at the arguments on the way UK fiscal policy should be deployed. The alternative short-term policy is to use monetary policy.

Usually monetary policy is about adjusting interest rates. This affects saving, borrowing and so consumption and investment behaviour. In short it pushes Aggregate Demand (the total amount of demand in the economy) up or down and so influences the level of economic activity.

The economic data suggests that the UK could slip into another recession. A more expansionary fiscal policy is ruled out (see yesterdays post) and so monetary policy might be an option. The problem is interest rates are already just 0.5% and so can't be lowered. The alternative is to simply print money.

Printing money in this context is called Quantitative Easing. The money supply rises, people have more money to spend and so consumption rises and firms have an incentive to invest. Easy really.

The problem is that printing money could be inflationary. That is unlikely, the money supply has not grown in the recession and the effect will likely go into demand. But another problem is that confidence among households and firms is so low that the extra money will simply be saved and have no impact on output.

The Monetary Policy Committee of the Bank of England meets today and will leave interest rates where they are. Some want them to do more Quantitative Easing (QE2). It probably wouldn't do any harm, but would confirm that the Bank fears the worst.

The Guardian covers the call for QE2 here

Stick or twist?

The debate on how to manage demand-side macroeconomic policy has been going on since Alistair Darling came up with Labour's deficit reduction plan. The Coalition government have decided to reduce the deficit faster and further than Labour wanted to.

The issue debated is how much support Britain's fragile economy needs to return to growth and how much damage increased levels of public debt would do.

Labour, on the whole, take the view that the government should be doing more to ease the short term pain of low growth, high unemployment and the danger of a new recession. So they urge a slower reduction in the deficit with the government doing more to boost Aggregate Demand.

The Coalition take the view that long term growth is more important and the burden of debt could reduce that significantly. They also point to the debt crisis in the PIIGS and say that creating such a debt crisis would be much worse. So they are happy with a lower stimulus to AD (it is still significant given the government deficit deficit) but the prospect of more secure long term growth.

You will find that differnet newspapers will take different views on this and many other issues. The Daily Telegraph is a supporter of the Coalition Policy and so run stories largely sympathetic to the government strategy. However the Guardian and Independent will be more critical and sympatetic to Labour's view. It is important you recognise bias when reading stories and stick to the economic, not the political, arguments.

The two stories below illustrate the sublte (sometimes not so subtle) differences when reporting the Chancellors speech here. Compare and contrast.

The Daily Telegraph article is here

The Guardian article is here

US economy will affect UK recovery

It was once said that if America sneezed then Europe caught a cold. The phrase was based on the power of the US economy as a buyer of European goods.

If America goes into recession their demand for imports falls. That means European exports fall and so demand falls and jobs are lost here. The UK's biggest trading partner is the USA and so the fact that the US created no jobs last month is worrying. It suggests the US economy is very much weaker than thought and could return to recession.

This is more of a cause for concern for the UK than for other EU countries as the business cycle of the UK is much more closely aligned to the US than it is to the EU. While that is changing (60% of the balance of trade is accounted for by EU trade) America remains a key power in the world economy, roughly equal in size to the whole of the EU in GDP terms.

External factors are more and more important to the way economies behave. No government can fool itself that it has all the policy answers to its own economic problems.

The Guardian cover the US jobs crisis here

Consumer confidence a worry

The level of consumer confidence is a key determinant of Aggregate Demand. Although consumption primarily depends upon income levels households have the choice of how much of that income they put into savings.

When consumers are uncertain they are cautious. Cautious people save 'just in case'. This has the effect of reducing consumption, Aggregate Deamnd falls and there is slower growth, or worse still a recession. The slow growth alone is enough to convince households they were right to be cautious and recovery becomes difficult.

There are two problems that compound this problem at present.

1. Governments are cutting back on expenditure in order to reduce their debt. Government spending is another component of Aggregate Demand and also has a multiplier effect making the cuts here even more effective in reducing real GDP.

2. The banks are being forced to recapitlise their balance sheets. This is because they have had to write off bad debts and the new rules (Basel Accords) that demand a higher proportion of capital to liabilities. This means the banks take the extra savings they receive in deposits and keep them to raise their capital reserves rather than lend it to firms or consumers.

While many welcome the strenghtening of the banks and the reduction in household debt it is not good for the short term.

It is now clear that consumer confidence is falling in Europe. This is a problem as 60% of UK trade is with other EU memebrs and exports are another compnent of AD.

While the double dip recession remains unlikely rapid growth still seems quite a way off.

The Guardian reports on EU consumer confidence here