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

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

Greece! Should the euro stay?

Increasing the British government is becoming sceptical about Greece's ability to pay back its' public debt and has not attended the latest bailout meetings. The issue is: Can Greece be saved and is it worth saving? Few doubt that the failure of Greece will lead to lower growth in the Euro region (where over half of the UK exports are sold). However the bailout seems to be increasingly viewed as a simple delay tactic and that defaulting on the debt is unavoidable.

http://www.guardian.co.uk/politics/2011/jun/20/treasury-minister-faith-in-euro-falters

How tough is it going to get?

It is tough being British! Over the last 5 years energy prices have risen 76%, flour 89%, bread 50% and petrol prices 42% whilst real wages have fallen. While inflation presently remains high at 4.5% average wages rose just 2.3% (in the year up to March). This means a significant fall in the standard of living for many British people especially those low or fixed income earners. Please read the attached article from the Daily Mail.

http://www.dailymail.co.uk/news/article-1391434/11-million-British-workers-pay-flatline-2015-warns-think-tank-Resolution-Foundation.html

The £ depreciates but what about Growth?

The continued depreciation of the £ has caused significant debate over the costs and benefits of a falling currency. Initially there was a strong belief that this could be the answer to the stagnating growth with calls for an "export led" recovery (exports become cheaper therefore more exports are demanded), however, as the pound has continued to fall others have expresses concerns about inflation (imports are more expensive) therefore leading to upward pressure on interest rates which diminishes the likelihood of a recovery. Either way more people will be staying in the UK this summer and London can look forward to becoming a tourist Mecca for the Europeans.


http://www.torfx.com/blog/index.php/exchange-rate-news-the-pound-declined-against-the-euro-falling-back-towards-1-1470/10213

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/

There is a problem with the internet for those studying economics.

Take as an example www.jarvmp3.com This is a free music download site was valued at $16,000 after only a month being online. Today it's value is substantially more. The site allows you to search for music and download it legally.

This seems like a free good. Of course its not a pure public good. You have to have internet access so the service is excludable. But there is no rivalry, any number of people can download music without diminishing the ability of others to do so . Yet it is not a private good - there is no price. That leaves us with some sort of mixed good.

There are external benefits for sure and the people who produced the music get nothing - a clear private cost but not to the buyer. Its worth thinking about.

The service gains its value from advertising. the more visitors the more it is worth (so if you use it click on some ads for the benefit of the person who created it).

The trade war within

The article attached below is perfectly timed for the 585 stimulus (extract 4). It examines the complexity of European trade relations especially when dealing with developing countries. The article correctly preaches reciprocity is desirable when adopting openness but not when it includes raising barriers. The other interesting point is that whilst open trade would greatly benefit Europe with price stability and competitiveness it would only further expose the southern nations desperately sinking in debt.

http://www.economist.com/node/18586846?story_id=18586846

Oh no its worse than we thought!

Today it turns out the recession is worse than we thought with a much larger fall in national output than initially reported. This despite suggestions that things were getting better.

This apparent contradiction may be due to the data being old and the rumours of improvements being more recent. This report refers to FIRST QUARTER data, that means January to March,

The BBC report is here

Recession bottoming out?

The OECD, an organisaion made up of the 24 richest countries, is an important forecaster of global economic trends. They suspect that the recession may be reaching a point where it gets no worse and that the most catastrophic scenarios have been avoided. The BBC story on this can be found here.