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.

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

Growing deficit just part of policy conflict issue

Click on picture to enlarge

In 2010 the government set out its deficit reduction plan. The aim was to reduce the amount the government borrowed each year through tax rises and expenditure cuts and they dared to hope they might start repaying debt by 2015.

This plan lies in ruins and yesterday it was revealed that so far this year the government have borrowed five billion pounds more than they planned.

There are good reasons for this situation. In 2010 everyone expected growth to be much higher than it proved to be. The government were, as they must be, more optimistic than others, but the slowness of the recovery worldwide has taken its toll.

When the economy shrinks the automatic stabilisers kick in. Government tax revenue falls and expenditure rises. While this moderates the depth of any downturn it has the exact opposite effect to the planned the public finances

The linked Guardian editorial highlights the difficulties of achieving all macroeconomic aims at the same time. The government needs economic growth but the measures it could take to promote this in the short term will cause the deficit to become larger. There are painful choices to be made.

The Guardian editorial is here

Transfer pricing - legal but is it right?

Today a Parliamentary Select Committee questioned senior executives of Amazon.co.uk, Starbucks and Google as to why their companies pay virtually no corporation (profit)tax.

The firms concerned are able to minimise the profit tax they pay by declaring profits in countries with lower tax rates. It works like this:

Suppose Amazon sells a book in the UK for £20. The book cost £10 from the publisher giving a gross profit of £10. Amazon incurs other costs of £5 running their business in the UK meaning they have made £5 net profit.

So Amazon pay corporation tax on £5 profit? Well that could happen but not if they do it like this:

Amazon UK sells a book in the UK for £20. The book cost £15 from Amazon Luxembourg giving a gross profit of £5. Amazon UK incurs other costs of £5 running their business in the UK meaning they have made no net profit.

Amazon Luxembourg bought the book from the publisher and made £5 profit in Luxembourg which has a lower rate of corporation tax.

Amazon do pay tax where they declare the profit. But by selling goods between subsidiaries they can make the profit appear where they want it to; in the countries that tax least.

This is all totally legal. Amazon, Starbucks and Google are multinational companies and are able to do this, but a firm operating only in the UK can't. Some feel that this is unfair as in my example Amazon UK really made the money by its UK operations and they should pay tax on their real profits here.

As the companies made clear to the committee, they do pay tax. Millions of pounds in payroll taxes such as employers National Insurance Contributions, local Business Rates and VAT. However in these days of poor public finances many will have little sympathy with them.

A Guardian article explaining Amazons actual operation here

The EU Budget - should it rise?

The Government suffered a defeat in the House of Commons because some members wished to see a cut in the spending of the EU. 

It would be tempting to say this was because they disagreed with cutting public spending and preferred instead to see higher spending to boost economic activity. Interestingly the Labour Party supported an amendment to cut the EU budget despite opposing cuts at home. The Conservatives who rebelled may have done so to give the UK a stonger bargaining position to oppose the rise in the EU budget.

The European Commission (the group of appointed officials who run the EU) wanted a 6.8% rise in the EU budget and were backed by the EU Parliament. The committee of governments - the EU Council - only agreed a 2.79% rise.

The BBC show how the budget is spent here

There are a number of issues, among them:

The EU spends 32% of its budget supporting farmers. 

The EU spends 36% of its budget supporting poorer areas of the EU

The EU budget has risen every year since 2000 

A few countries are large net contributors to the budget - this includes the UK

All EU countries have had to cut expenditure since the recession to balance budgets

The debate about UK membership of the EU may depend on how fair our contribution to the EU budget is seen to be. Iain Duncan-Smith (Works and Pensions Secretary) said he could see the UK 'thriving' outside of the EU over the weekend - it's not clear if he or Michael Gove had the brain they share at the time. But there is a lot at stake.

A strong EU with a large budget could help to stabilise Europe and provide economic management of the continent. However many oppose this view and prefer nation states to run their own affairs.

Both visions may be unrealistic. No nation can stand alone, but the political integration needed for the EU to be the economic manager of Europe is unacceptable to most at present.

For a view on why the EU budget should be raised read The Guardian article here

The case for Plan A

Yesterday the Conservatives put the argument for continuing their plan to reduce the government budget deficit in the strongest terms for over a year.

Fundamentally there is on two types of news on the economy, bad and absolutely awful. Given that the government might as well take it on the chin and express their beliefs.

George Osbourne, The Chancellor, said he would find more money through benefit cuts. This plays surprisingly well outside of the Conservative Party with the general public. It remains to be seen if it can be done and whether people will accept the reality.

The Prime Minister asserted the cuts will continue, despite the growth forecast for the UK by the IMF being cut. (Well we all knew that!). He pointed out that one million new private sector jobs have been created and this is compensating for public sector cuts.

The government argues that the deficit needs to be reduced to avoid problems in the future. The Opposition says a boost is needed to get the economy growing again.

The IMF says that a short term stimulus might be appropriate, but that the markets will take fright on any large scale and longer term rise in spending that will raise the deficit. So some support for both sides there.

One issue that is clear is that the government has not reduced the deficit as far as they wanted to. This shows just how difficult it is to cut spending. Good luck with the plan George.

The Independent cover the current issues here

Can government spending really help the recovery

It is the turn of the Labour Party to have their conference this week and opposition parties generally have a free hit at the government.

The Shadow Chancellor, Ed Balls, used his speech to suggest that the government should spend more money (£4 billion) on building new houses and giving a tax break to first time house buyers to try and boost economic activity.

This is standard Keynesian stuff. The government spends more money to boost Aggregate Demand. The multiplier effect then raises national income and employment by even more than that. Balls claims it will 'kick start' the economy.

It's good politics, but not really believable as economic policy. The government is already spending far more than it raises (around £170 billion) to boost Aggregate Demand. Although using government spending on construction keeps a lot of the spending local at first the multiplier is very low (maybe 1.25?) and so it might raise GDP by £5billion if its new money.

The biggest hole in the Balls argument is how it would be funded. According to him Labour would use the money raised from the auction of 4G licences by the mobile phone companies. That money has already been earmarked for use so actually it would be financed by more borrowing.

The argument about how much to stimulate the economy will go on for ever. See what you think of the Balls plan.

The Independent report the policy proposal here

Public debt rising

The government wanted to reduce the level of annual government borrowing (the public sector borrowing requirement - PSBR) and reduce the proportion of government debt to GDP.

Last month the government borrowed £14.4 billion, well above the projections of the recent budget let alone the 2010 budget plan.

It now seems certain that the government will not meet its debt reduction or deficit reduction targets. But is this really important.

The arguments for deficit reduction are based on reducing the tax burden on the economy and keeping borrowing costs low (for example in Greece all borrowers pay very high interest rates because of the Greek governments excessive debts). That will aid long term growth.

The reason why the Governor of the Bank of England says it is okay to miss the debt targets is because of low growth world wide. If the world does not grow then the UK is unlikely to grow very quickly either. Therefore tax revenues are lower than expected and government spending is higher (on benefits for example).

Some people say that the government should spend even more to boost short-run growth. The same people ridicule the overshooting of the debt target. Am I the only one who finds that odd?

The Guardian explains the debt situation here

A plan to save the Euro - Number 4113

 

The President of the European Central Bank has announced a new plan to save the Eurozone. It's well overdue and just the latest in a long running problem.

The Euro as a currency is in trouble because some of the members economies are very weak. This includes countries like Greece that have crippling debts and Spain who have 25% unemployment as a result of the economic downturn.

Confidence in the Euro is low which has led to the exchange value of the currency falling. There are also worries that some Euro area countries cannot pay their debts and so when they try to borrow more money they pay very high interest rates as the risk to lenders is high. This is making an economic recovery very difficult.

The new plan allows the European Central Bank (the ECB) to buy the bonds issued by countries that are used to raise the money they need. This will help fund their spending if they are new bonds. But more likely the ECB will buy old bonds. Whatever method is used in doing so the price of the bonds will rise.

The price of a bond and the rate of interest paid move in opposite directions (they are inversely related) and so the Euro area countries should find themselves paying lower interest rates on their debt. This will reduce pressure on their budgets, allow them to spend more and tax less and hopefully boost economic growth. It will also let households and firms borrow at lower rates, boosting Consumption and Investment.

This move has been bitterly opposed by the Germans, who think that basically it means German money buying other countries debt. But the move is long overdue, although possibly far too late.

The Independent report the plan here

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

Oh dear, oh dear, oh dear

A government statement here

Britain reported a third quarter of falling economic growth on Wednesday. This is exceptionally disappointing news and leads to a situation where action to at least make people feel better seems inevitable.

The raw figures were that GDP fell by 0.7%. There are factors to be taken into account that mean the fall is as not as bad as it seems, but once they are accounted for GDP would still have fallen. This 'second recession' means that the UK is far from a recovery that will provide the income and jobs people need.

It is an odd type of recession however. It's a recession that is creating jobs, 180,000 in the last three months. That is not typical, recessions should see fewer jobs.

So what is the cause of the problem?

* The main problem is the world economic situation. Markets are weak and so sales are down. The continuing Euro saga means that confidence is low in financial markets and with the overhang from the 2007/8 global financial crisis banks are not lending.

* The EU is the UK's largest export market and recession there means that they are buying less from us. This shows how interdependent economies are.

* Consumer confidence is very low which means consumers are saving (about 8% of income at present, up from 1 to 2% during the period before 2008).

* The governments of the world are very concerned about the level of debt they hold and are making efforts to reduce it. This means higher taxation and lower government spending (and jobs) and so in the short term this helps to contract the economy.

Some people argue for greater government short-term stimulus to rectify the current problems. This would mean stopping the deficit reduction program (or at least delaying it). It also means government investment in infrastructure and probably tax cuts.

Most people completely overestimate the ability of governments to influence economic activity. Governments are actually pretty powerless even when they act together, but when they are seen to be acting this often raises consumer and business confidence. That seems to be the key now, not actually what is done, but being seen doing more.

Of course the weakness of the financial system will remain and it is, frankly, a house of cards which could collapse at any moment. But for once the illusion of Keynesian style stimulus packages might actually be what we need and its about time these cheap conjuring tricks were given top billing.

The BBC have the figures here

EU 'not in recession'

'Lies, damn lies and statistics' as Disraeli put it can be illustrated by the way Eurostat has claimed that the Eurozone is no longer in recession.

The attached story has the details, but it shows that Italy, Spain and Greece are in dire recessions, with output contracting and France just managed to maintain output. So what is the reason that Eurostat says the Eurozone isn't in recession? Well Germany grew strongly and overall Eurozone GDP rose when added together.

This means that recessions are now not only defined by arbitrary dates, but also arbitrary borders. It depends how you group countries together.

Of course the real point of interest is the effect of cutting government budget deficits on GDP. As Government spending is a component of AD changes in it have a multiplier effect. Add to that higher taxation and we see disposable income falling and so Consumption dragging AD down further.

Today the new French President, a man worryingly named after a sauce, will argue for more stimulus to boost short-run growth. But today the people of Italy, Spain and Greece, and I think France and Britain, might agree with him.

The BBC cover the story here

Permanent damage to supply side - NIESR

A regular report by the National Institute for Economic and Social Research (A bit like the IFS without the political posturing) has said they expect unemployment to reach 9% and not decline until the end of 2013.

This continued economic weakness will do long-run damage to the supply side of the economy. This will include the loss of motivation and skills of many workers who find themselves in long term unemployment. It will also lead to the loss of productive capacity, which had initially fallen into disuse but is eventually derelict and scrapped.

Interestingly the NIESR suggest, as I have, that there is a need for a moderate and targeted fiscal boost. They say:

It remains our view that fiscal policy could be used to raise aggregate demand in the economy with little to no loss of fiscal credibility. We have never and do not now advocate scaling back the government’s medium- to longer-term policy of fiscal consolidation. However, the UK also suffers from a lack of demand in the short term. As we noted in our January Review, a 1 per cent of GDP increase in government investment this year would boost GDP by around 0.7 per cent, assuming no reaction by the MPC. A temporary boost to net investment, which has been cut extremely sharply, would have no direct effect on the government’s primary fiscal target of balancing the cyclically-adjusted current budget in 2016–17. 


Interestingly there is a one year estimate of the multiplier effect in that paragraph. Suggesting that governments are not really that powerful when it come to demand management.

The BBC covers the story here

So the Budget.....

As Budget's go this one had a lot of different things in it. You might not agree with the direction but you have to admire the width. There were both demand side and supply side measures.

Demand side measures

Included raising the income tax allowance to £9,205 from next April. This is effectively cutting income tax and so increasing AD by raising consumption.

Indirect taxes have risen on tobacco and alcohol. This will reduce AD by raising prices, but there is a clear justification on this on the grounds of market failure.

The Budget deficit will continue to fall over the rest of the parliament reaching just £21bn bu 2017. This is a contractionary stance and will push AD down.

Corporation tax will fall from 26% to 24% from this April. This should boost profitability and so raise the incentive to invest, so raising AD.

Higher stamp duty and the closing of 'loopholes' means that really high earners are not as well off as tax cuts appear.

On the supply side there were a number of measures.

There is help in gaining finance for small businesses with a loan guarantee scheme.

The top rate of tax will fall from 50% to 45% from NEXT year. It is argued that this will increase incentives to work and will therefore increase output and benefit the economy. Combine this with the cut in Corporation tax and this can be seen as a clear attempt to make Britain appear a better place to locate your business than other countries.

Faster broadband speeds in the major cities to improve infrastructure.

The income tax and corporation tax measures listed in Demand side also have a supply side incentive effect.

Overall

There are a lot of measures! I have listed only a few and you should read the papers on this, but looking at them in a list does not really do them justice. Is there an overall philosophy behind the budget and does it make economic sense?

I think the Budget can be summarised as a mixture of short term details and long term vision:

In the short term the economy is growing, but slowly, and can manage with less fiscal support in the future. Some people are really struggling and the higher tax allowances and concessions of child benefit are designed at help them a little. Some people are too generously dealt with and they must pay more.

In the long term there is a need to re-balance the economy by reducing the deficit and encourage growth. The Chancellor has avoided short-term popular measures in favour of a long term view.  The supply side measures really stand out here.

Of course some policy objectives are so low down the list they have pretty much dropped off. Can you order the priorities?

As usual the BBC provide excellent coverage with plenty of interactive bits

What should be in the budget?

Fiscal policy works well once it actually gets to be implemented. The first stage is the Budget, which will announce the measures that will be put in place over the next financial year (or two or three).

At this stage the long process of considering possible measures is concluding. What objectives the government will try and achieve, and what measures they will use will now have been decided. One thing is for certain, the Chancellor has not wanted for advice.

Some people are very keen to have more supply side incentives, others want an expansionary budget to boost aggregate demand. This reflects the deep concern people have for the state of the economy.

The piece below comes from The Guardian and is an opinion piece on what should happen. This is a thoughtful article, but does represent one point of view (a Labour front bench MP) so please remember that when reading it.

The Guardian article is here

Do governments get more money by cutting tax?

You could be forgiven for thinking that raising tax rates is a way of reducing government revenue. So far various groups have asked for:

* The 50% income tax rate to be scrapped
* The duty of fuel to be reduced
* The VAT on tourism to be cut to 5%
* The passenger duty on flights to be dropped

All four have claimed that as a result:

* The government will receive higher revenue
* Jobs will be created

What are the reasons for these arguments? And does this not imply we should simply cut taxes and solve the economic crisis?

Well on one level these groups are arguing for an old fashioned fiscal stimulus. Lower taxes and raise consumption and so Aggregate Demand. On the other hand they are relying of incentives to change behaviour.

For those advocating the cutting of the 50% income tax rate they suggest people will work harder if they keep more of their wages. This is a supply side measure.

For the other measures its just the law of demand and the proponents are really assuming a lot about the elasticity of demand. More jobs may result, but it seems optimistic to suggest that the government will get more tax revenue due to increased output and sales.

Of course the other interpretation is that the proponents of these tax cuts are all vested interest groups who want a boost to their incomes or their business.

The linked article relates to the latest calls for lower VAT on tourist services.

Call for 5% VAT on tourism

Incentive to work vs revenue from a higher rate

The last government introduced a 50% income tax rate on taxable earnings over £150,000. The aim was to raise more tax revenue by making the rich pay more.

This is a well established principle of progressive taxation. However the trend has been to reduce direct tax rates because of the disincentive effect this has on workers.

The 'Laffer curve' describes how as tax rates rise the government gains a higher tax revenue. As tax raises, however, some people begin to think that working is no longer worthwhile and start to reduce their working hours. Eventually this effect becomes so strong that raising the tax rate even more leads to lower government revenue. The increased tax rates add less to government revenue, due to the higher proportion of income being paid tax, than the loss of revenue due to people opting to work less.

It is very difficult to find the tax rate where the government maximises its revenue but also keeps the labour supply sufficiently high for the economy to grow.

Many people are making a lot a of noise about the "temporary" 50% tax rate and saying that it is already holding back growth. Their argument is basically that the disincentive effect has already kicked in.

The counter argument is, of course, equity. The less well off would have to pay an unfair proportion of the cost of the collapse of the banks and the resulting deficit. Further many might say that having the chance to pay 50% tax is quite a good position to be in!

The Guardian covers the story here

What next for fiscal policy?

Last week retail sales figures in January were reported to have risen by almost 1% on the year before. This was rare welcome good news, although there is more than a passing chance that its a statistical slip up (due to seasonal adjustment).

Despite this its not at all clear that the economy has turned the corner and the question that is now being discussed is what the stance of the budget should be. Budgets can be contractionary or expansionary. An expansionary budget adds more to aggregate demand than the previous one did, so if the deficit is planned to be bigger next year than this that makes the new budget expansionary.

Of course the plan is that the next budget period should have a lower deficit than the previous one. That would make it contractionary. Many feel this would be a mistake, because the economy is doing much worse than was expected when the plan was first formed.

Sadly politics makes sensible decisions on this question difficult. But at the very least there is a strong argument to say that the budget should not attempt to contract aggregate demand. This would involve not making some of the expenditure cuts planned or cutting taxes to compensate.

The linked BBC article gives attention to some options, largely proposed by Ed Balls. It is interesting to ponder what the most effective tax cuts would be and what would be the fairest. But the chances of a tax cut, beyond an over indexing of the tax free allowance, seem remote.

The BBC article is here

Unemployment hits 17 year high

Unemployment continues to rise and there isn't going to be a let up soon. The poor growth in the EU and USA means that the world economy is not growing fast enough to maintain employment.

I have written at length on youth unemployment before, but that has reached a new high, and again this has a way to go.

A factor that is making things worse is the fall in public sector workers. 65,000 fewer public sector workers were offset by only 5000 more private sector workers. Remember the plan was that the private sector would grow enough to allow for the  public sector expenditure cuts.

While the situation gives scope for cheap jibes of 'too much too fast' there does have to be serious questions about how best to deal with the situation. Policy trade-offs are a harsh reality for everyone.

Details from the Independent here

Fall in Real GDP can't be good news

The UK economy shrunk last quarter by 0.2%. This should be a period of recovery and growth after the recession and so not at all what was hoped.

However, if you can see the BBC graphic in the story below, you will notice that the economy shrunk by 0.5% in the equivalent quarter in 2010. After that growth returned, 'caught up' in fact, so this may not be a return to recession. Remember one observation is not a trend.

What is clear is that growth is pretty flat and nowhere near the levels the economy needs. The Deputy Prime Minister, Nick Clegg, has called for a stimulus measure, raising the tax free threshold to £10,000. This will raise the disposable incomes of all tax payers, but the biggest effect will be on the low paid. They tend to spend a higher percentage of their earnings and so this will raise consumption and boost Aggregate Demand.

Would such a stimulus work? Well it depends on whether the tax cut is spent or saved. Also would a boost of £7 a week really help that much?

The BBC cover the growth figures here