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

Inflation targets and QE - lessons from Japan

The Japanese economy has been struggling for a while, since before the Global Financial Crisis. The problem has been a period of prolonged recession and deflation and virtually all policy attempts have failed to correct the situation.

Exports are now falling, previously one of the few bright areas for Japan, and now a serious situation faces the country.

One problem is that the Japanese people just don't want to spend and domestic demand is weak. This is encouraged by the falling price level (deflation), why should you buy goods today when in a few months they will be cheaper? The mentality of the population needs to be changed to help boost Aggregate Demand.

What does not work is lowering interest rates, they have tried that and actually had years of negative real interest rates. There have also been fiscal stimulus packages that have seen tax cuts and more government spending,  things would have been even worse had they not done this but the problems continue. So what can they do?

One suggestion is that the Bank of Japan raise its inflation target from 1% to 2%. One reason why the Bank of England has a target of 2% is to prevent any chance of a slide into deflation. This seems sensible, but all a bit late now.

The next alternative is massive Quantitative Easing (QE). Print Yen and pump them into the economy. Here they will rely on households and firms having very high money balances as a result and so they will want to spend the cash to re-balance their portfolios. (The resulting fall in yields - already very low - has already failed to work).

Of course Japan also requires Europe to sort itself out so they can start buying Japanese exports again. But when you here people telling you that QE has gone too far and will be inflationary you must point of that this is exactly what is needed - higher demand and stable inflation - not deflation.

The BBC report Japan's woes 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

Bank's latest attempt to get lending going

Today the Bank of England started providing cheap loans to banks. This is effectively the same tactic as increasing the money supply, but deals with a problem in the system.

With Quantitative Easing the money supply rises and, in theory, asset prices rise and market interest rates fall. This should lead to more investment and so rising AD and output.

But the problem QE encountered was that banks were reluctant to lend the extra money that would make this process work. This was known before the process began, but it was hoped enough money would get through to make a difference.

Banks are, quite rightly, concerned with building up their balance sheets so that a future financial crisis will not lead to their collapse. As the Euro crisis and double dip recession show there are more than a few reasons to be cautious. So this scheme encourages banks to lend.

The scheme overcomes the QE weakness by lending to banks at very low interest rates on the, fairly weak, condition that their lending will be monitored. The implied threat is that if banks don't up lending to households and firms then the loans will be withdrawn.

The signs are that market rates for borrowers have fallen already and so that is the first objective achieved. Next will be getting firms and households to actually borrow. So far firms have claimed they can't get funds, but we will now see if they are really confident enough to borrow.

The BBC covers the story here

Helping ease the credit channel

The government is to help ease the tight credit situation by providing 'soft loans' to banks so they can in turn lend to businesses and households. The Independent described it as a 'panic measure' but that seems more than harsh.

The measure is presented as a precaution against a second 'credit crunch' which might follow a partial collapse of the Euro area. This is too simple because one of the major issues preventing recovery is that when firms or households approach banks for loans they are turned down. Although the banks deny it, they are very cautious and this caution is stopping growth.

So banks will be able to borrow around £5 bn a month which they can then pass on in loans to firms and households. The risk to the bank is reduced as the cost of these funds is lower than the market rate and as the funds can only be used for relending they make nothing if they don't use the funds.

The result should be a rise in bank lending, followed by higher Consumption and Investment and so an increase in AD.

Ed Balls says it won't work. Odd as his entire economic plan relies on exactly the same principle. He also says that the previous policy has failed and this acknowledges that. Well that may well be true, QE and low interest rates have not persuaded banks to lend and the recovery has stalled, this can only help. The sensible question (something Balls can rarely ask) is will it be enough?

The Independent covers the story here

Monetary policy dilemma continues

It is possible that we are now approaching the point at which we can say interest rates will move up, possibly at the end of the year. Adam Posen, the most enthusiastic member of the MPC on easing monetary conditions, believes that the Bank has now done enough (or at least all it can).

Of course this had to happen. The markets decided this was a bit of a surprise and the pound was bid up in price, as the expected rise in interest rates was moved forward. The link between exchange rates and the interest rate couldn't be more clearly indicated.

But Posen also makes the point that interest rates alone are not enough to induce growth. Expectations, based on business confidence, are also crucial, but so is the ability to borrow money.

If the financial sector cannot lend money to businesses then even when firms believe it is worth investing and can afford the loan then the investment won't happen. The attached article shows how important it is to get all the pieces in the jigsaw in place.

The Independent article is here

Does this mean QE has failed?

Today it has been reported that the high street banks are raising their mortgage rates by between 0.25% and 0.5%. This is despite the fact that the Bank of England is unlikely to raise rates for at least the rest of the year and there has been more Quantitative Easing.

The problem for the economy is that higher rates of interest, especially for mortgages, will lead to lower discretionary income and so lower aggregate demand. This is exactly the opposite of what the economy needs at present.

The aim of Quantitative Easing is to increase the liquidity in the money markets and so reduce the market rate of interest. Yet the high street banks say that they are finding it more expensive to obtain funds and hence the rise in mortgage rates.

The problem for the banks is that they have to pay somebody for the use of the funds they lend to customers. This may be those who save with them or they may borrow in the interbank market.

Karl Popper, a philosopher of science, urged theorists to set out falsification conditions for their ideas.  These are things that would be observed if the theory is wrong. It would seem that after three rounds of QE and the ECB lending billions to UK banks, the rise in market rates qualify as a falsification condition for the effectiveness of monetary policy.

The Independent covers the mortgage rate rise here

The Telegraph covers British banks borrowing from the European Central Bank here

Written from my sick bed

Who would believe Keynes still had something right?

Keynes was very concerned that households would not spend all they earned. This would lead to money leaving the circular flow and so national output falling.


This view is known as 'underconsumption'. While shown to be logically impossible by J.S. Mill in work published in 1841, if households continually earned money and did not spend it all then leakages from the circular flow could reduce national output and lead to recession.


Of course Keynes imagined a world where people put their savings 'under the bed' and the money literally left circulation. This does not generally happen in the modern world as people leave their money in the bank and the bank ensures that it is not idle.


There are reports of nearly £6 billion of cash being hoarded as people have lost faith in the banks. This fall in the active money supply is potentially deflationary and would justify the actions of the Bank of England in extending Quantitative Easing.


So how significant is £6 billion of cash hoarding? There are  £54 billion of notes and coin in circulation in the UK according to the February 2012 Bank of England Balance Sheet. 


While this seems a lot M4, the widest measure of the money supply, is well over £1500bn and most transactions take place electronically. Also the velocity of circulation, how often money changes hands, could adjust to a shortage of cash and further the Bank of England would simply supply more cash in a shortage. However we have a modern example of a leakage from the circular flow due to savings behaviour and that has not happened for a while.

The story is here 

New round of stimulus by Bank

The Bank of England is injecting another £50bn into the economy. They say that while many indicators are looking up there are too many uncertainties and the Euro area, Britain's main export market is at best flat.

The aim is to put extra liquidity into the financial markets, push yields (interest rates) down and this will lead to increased demand through higher consumption and investment in the economy and the recovery will be given a boost.

This new round of quantitative easing, which is being called QE3, is drawing both good and bad comments. Some feel that the good January figures for the UK economy are merely a blip and won't be sustained and the others that the 'headwinds' faced with the economy are still strong and so this is a welcome move.

Others say that this is an inflation risk and that the effect on yields is going to seriously affect savers and especially people retiring this year and in the next few years.

All policy is a trade-off and so there are always costs. A more important question is will it work? Monetary policy is a notoriously blunt instrument and has long and variable lags. There are good reasons to think that QE3 is like 'pushing a piece of string', there is no effect at the other end of the process.

The Independent covers QE3 here

What to do with Monetary Policy?

This week the Monetary Policy Committee will hold their monthly meeting. Interest rates will stay at 0.5%, that's a given, but further Quantitative Easing is a possibility.

Today there is an opinion piece in The Guardian on what they could do. The piece looks at the cost of the recession, the size of the stimulus package so far and the consequences of the end and reverse of Quantitative Easing.

This article shows just how difficult the decision process is, with various competing factors to consider. Among other points raised is the effect of reversing Quantitative Easing. The government debt that the Bank of England have bought up in the market to boost the money supply will need to be sold. Doing this will push bond prices down and so interest rates up, possibly affecting the pace of the recovery post 2015.

This is an article that should be read to the end, but remember it is an opinion piece, not news and you should remember the writers bias.

The Guardian article is here

Crucial questions on policy

Despite appearances to the contrary most economists do not spend their time on designing policy. They actually spend their time on the 'basic science' of economics. The answers they come up with allow others to design policy accurately.

In a recent FT article by Lord Skidelsky and Felix Martin suggest a 'Plan C' is needed for the UK economy.

Plan A was cut the deficit and by this remove prssure on the hard pressed 'wealth creating' sector.
Plan B was print money to reduce interest rates and encourage investment (Quantitative Easing).


The authors argue that Plan B would not work due to theoretical issues raised by Keynes. They then back this up with evidence from the experience of QE, principally pointing out that confidence is the main determinant of capital investment, not interest rates.


They present Friedman's argument that liquidity is a key element of preventing depression, but don't give it the credit it deserves. Perhaps because it is a short piece, or perhaps because they are both Keynesians and have been waiting thirty years for a chance to get their own back.


Whatever their motives their piece is an excellent survey and shows the requirement to understand how the relationships in the economy actually work before policy is designed. Sadly the theory often lags reality.

The FT article is here

Another chapter in the Euro crisis?

I am not sure if this is a new chapter or just another plot twist, the Euro saga has continued for so long its critical importance is sometimes forgotten.

The crisis deepens as Italy is now on the brink. Italy isn't like Greece or Ireland, it is a big economy with their government owing 120% of GDP to creditors. Italy is the third biggest economy in the Euro zone and even the enhanced €1 trillion bailout fund is nowhere near enough to save it if default comes.

Italy has no credible plan to resolve the problem and the market knows it. The market is demanding higher and higher interest rates (6.69% is the latest) to fund their overspending and the likelihood is that that rate will rise as Italy must borrow over €300bn next year.

There is a solution. Let the European Central Bank (ECB) lend the money to Italy. The ECB could buy Italian Government bonds and can theoretically supply all of Italy's needs. The Germans, at least, completely oppose this move.

If the ECB buys Italian debt they will do so with money they simply create. As with Quantitative Easing this raises the supply of Euro's in circulation (its printing money). The Germans always have in their minds the hyperinflation of the 1920's caused by printing money and the post-war Deutchmark which was managed so well that inflation was only an issue after the costs of unification with East Germany. They don't want the ECB to start a potentially inflationary process.

Most people disagree with the Germans. They see the need to save the Euro as far greater than the risk of inflation. They also point out that the Germans can only be right when the rate of rise in the money supply is faster than the rate of rise in real output. So far in this period of instability monetary growth has been sluggish and over the period 2009 - 10 the money supply would have fallen but for central bank action. The graphic at the top is a little small but shows M1 and M3 growth in the EU.

It is clear that if the ECB does not act and the Italian government does not change then the danger of a collapse in the Euro is imminent.

The Guardian has details here

Monetary boost to avoid inflation being too low

The Bank of England Monetary Policy Committee kept interest rates on hold today. No surprise there, nor in the announcement that that there would be more quantitative easing (QE).

The aim of the MPC is to keep inflation at 2% on the CPI measure. But they can't work in the short term, inflation is a complicated process and monetary policy takes up to two years to take effect, so the MPC must aim to keep inflation on target in two years time.

At the moment inflation is well above target and will go up rather than down in the next few months. So why not try to contain inflation? Well the horse is several fields away on that one and so the MPC look past he current inflation figures as they cannot affect them. They see the VAT rise dropping out of the index in January, weak economic growth around the world reducing export growth and domestic inflationary pressures being contained. They believe that without action inflation will drop below 2% in the final quarter of 2013.

So the MPC will boost the liquidity of the financial sector by pumping £75bn of new money into the economy. This will stimulate lending and demand and hopefully assist growth in aggregate demand.

The BBC have helpfully restored their Q&A on Quantitative Easing, explaining how it works, why it is used and why its not going to cause runaway inflation such as the German and Zimbabwe hyper-inflations. The BBC Q&A will answer the questions of Deps on what this measure means, but everyone should read the reports of this move carefully.

The BBC Q&A on QE is 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

Inflation rises to 4.5%

Worse than expected inflation figures have surfaced this week putting increasing pressure on the Bank of England to increase interest rates. These are very tough times with many predicting unemployment figures to rise further. The only good news coming from the article is the hope of inflation figures dropping by the end of 2012. Read the article below.

http://www.bbc.co.uk/news/business-14895510

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

When monetary policy stops working

Growth forecasts for the UK economy have been downgraded in recent months. There seems very little prospect of a return to normal growth until the middle of next year.

What is the standard response to this state of affairs? Economic stimulus packages.

There are problems here. As I pointed out in yesterdays blog the government are cutting expenditure and raising taxes to cut the budget deficit. Some argue this is too much, too soon and that the lost Aggregate Demand will push the economy back into recession, or at the very least inflict avoidable pain on the population. The counter argument is that the level of debt is unsustainable already.

Whatever the merits of the opposing views a fiscal boost to the economy isn't going to happen.

So that leaves monetary policy or supplyside policy. Supplyside policy promotes longterm growth, but will do nothing to aid shortterm growth. So monetary policy is all that is left.

The MPC reduced interest rates to 0.5% and kept them there. There is no more they can do to encourage consumers and firms to borrow and so boost Aggregate Deamnd on that front. Monetary policy in this sense has hit its lower limit.

So the other possibility is to print money. The newly created money will find its way into the pockets of consumers and the level of AD will rise. This is done by 'Quantitative Easing' with the Bank of England buying up financial assets (almost always Government Bonds, but not necessarily) with money they simply create.

Some scream this will be inflationary, but that isn't the case if real output can rise to meet the increased demand. At least one member of the MPC, Adam Posen, thinks more Quantitative Easing is needed and more people are coming around to this view.

The prospect of a stimulus to the British economy may improve consumer and business confidence and get them borrowing at the historically low interest rates on offer. Frankly more 'QE' is unlikely to do any harm.

The Guardian reports Posen's views here

Plan B- the Portugeuse-style deficit and German Style interest rates

Increasing the British Opposition is asking the Government for a Plan B. They are claiming the economy rescue package is not working. Growth has been sluggish and forecasts have been downgraded. The Opposition has suggesting that this is because of the tight fiscal austerity package (tighter fiscal policy in order to control public debt). The Government, however claims that the low level interest rates (German style interest rates) are far more crucial than a few billion pounds in the budgets bottom line. This leads to an interesting discussion on which policy (fiscal or monetary) is best to deliver growth during a downturn. Please read the article below to get a greater understanding of the issue.

http://blogs.telegraph.co.uk/finance/jeremywarner/100010488/imf-maps-out-a-plan-b-for-the-uk-economy/

Lessons for monetary policy after the Global Financial Crisis

In a speech given today at the Annual Conference of the Society of Business Economists in London, Spencer Dale – Chief Economist and member of the Monetary Policy Committee – talks about inflation targeting and the lessons that should be learnt from the financial crisis.

The speech can be found here