11 December 2009
18 November 2009
The IMF answered this question in a study it published last month in its World Economic Outlook. The figure shows GDP rising at a steady rate before the crisis, falling in the recession and then rising again at the same steady rate. It doesn't show GDP returning to the old track but rising at a lower level parallel to it. That matters because we previously thought that the economy would get back on track.
This month the Bank of England included a new chart in its Inflation Report. Spot the similarity?
My first thought on this chart is how smooth the upward curve of GDP was leading up to the crisis. We talk about the trend rate of growth but here we see a chart of how consistent the trend is.
My second thought is: do we never get back to the old trend line? The IMF study only looks at the medium term (7 years), perhaps growth is higher after 7 years?
If not my next question is what happens to unemployment? The trend line is often taken to represent the economy's full potential. If GDP is below the trend then resources are idle and more people are without work. Growth at the trend rate should be enough to keep pace with an expanding labour force but not enough to absorb the pool of unemployed labour.
21 October 2009
Battle lines are being drawn up between those who want to reform financial regulation and those who want to reform finance. Mervyn has chosen to be on the right side.
The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion.As the press is reporting he supports splitting the utility side of banking from their speculative activities. He is right; anyone who wants to take deposits from the public shouldn't be allowed in the casino. Or as he puts it:
Anyone who proposed giving government guarantees to retail depositors and other creditors, and then suggested that such funding could be used to finance highly risky and speculative activities, would be thought rather unworldly. But that is where we now are.Splitting utility from casino banks is not his only idea. He wants new tools to:
(a) moderate the growth of the financial sector and
(b) lean against the macroeconomic effects of the credit cycle
This is more than I could have hoped for. The finance sector is too big and finance should lend less in the boom and more in the bad times. Mervyn drops hints that he could be even more radical:
It is hard to see how the existence of institutions that are “too important to fail” is consistent with their being in the private sector.
But he doesn't say what sector they should be in.
It is important that banks in receipt of public support are not encouraged to try to earn their way out of that support by resuming the very activities that got them into trouble in the first place.
Ouch! Who could be encouraging such recklessness?
King for chancellor?
15 October 2009
Here is another example from the BBC: Pound hit by falling UK inflation. The BBC tries to link the fall in inflation with the fall in sterling, as if the first has caused the second.
"This is bad news for the pound," Duncan Higgins, senior analyst at Caxton FX, is quoted as saying. "The CPI figures will weigh heavily on the UK currency and will continue to discourage investment."
Anyone who has ever opened an economics textbook knows that low inflation, relative to inflation elsewhere, tends to push up the currency.
It works like this. Imagine there are just two currencies, pounds used in Britain and FX used in RoW. If inflation is 1% in Britain and 3% in RoW then 100 pounds will be worth 99 pounds next year while 100FX will be worth 97FX (roughly). So 1 pound will be worth more FX next year than now. The pound should rise.
By the way, the falling pound is good news not bad in the current circumstances. It is adding to demand and will help to reduce the current account deficit.
09 October 2009
Now Britain is going to be the first to withdraw the stimulus. From January the VAT rate will return to its old level and government spending will come under pressure. Of course the "automatic" stimulus of more benefit payments and lower tax take will still be there, and the government deficit will be as huge as anywhere in Europe. Which is the reason why the chancellor is reluctant to let the stimulus continue.
When Britain moved aggressively with monetary and fiscal stimulus the pound fell against the euro, potentially boosting demand from net exports. At the time I thought that this was fair as it gave the British economy some compensation for the demand which would leak to countries not making the same efforts to counteract the recession.
Now however, Britain is beginning to look like the free rider, and the low pound could be seen as a beggar-my-neighbour policy. (I remember Paul Krugmann using that expression when he visited Britain earlier this year.) I doubt that the pound will rise much. Monetary easing is continuing and interest rates are lower in the UK than Euroland.
Are we now going to gamble on other countries' fiscal expansion to get us out of recession?
29 September 2009
Government debt is manageable in a growing economy. Get the economy moving and a little bit of growth and a little bit of inflation will deal with the debt. Even with inflation kept to its 2% target, growth at the UK average of 2.5% is enough .
In thinking about government debt and deficits, I find this little equation helpful:
where d is the government deficit (as % of GDP), D is government debt as (% of GDP) and y is the nominal growth rate.
This is the equilibrium debt-deficit equation. If the government consistently ran a deficit of d% then its debt would converge to D%, given a growth rate of y%.
What does this mean for the UK today? Let's take 4.5% as the nominal growth rate (ie growth rate before inflation is stripped out):
This year the deficit is 13% of GDP. If it stayed at that level then debt would stabilise at 289% of GDP. If we felt comfortable with debt almost 3 times national income then a 13% deficit would be sustainable. We don't feel comfortable and the people lending the money wouldn't either.
If debt of 80% feels better then, government needs to bring the deficit to d= 4.5% x 80% = 3.6%.
The good news is that to stabilise debt, government doesn't need to run a surplus. It doesn't even need to balance the budget; it only has to hold the deficit to 3.6% for a (longish) period of time. (Compare that with the Maastricht Treaty rule that deficits should be below 3%).
If we want to get back to the old debt rule of 40% GDP, then the deficit needs to fall to 1.8% and the magic of a little bit of growth and a little bit of inflation will do the rest. (In practice the government would not keep the deficit constant; it should make the deficit smaller when growth is good and larger when growth is low.)
So far I have taken y= 4.5%. (You could work on 5% to make the calculations easier, but 4.5% is consistent with 2% inflation and 2.5% real growth.) What happens if nominal growth is say -1%? That could happen with low growth and deflation, the Japanese scenario.
Say the debt is at 70%:
d= -1% x 70% = -0.7%
So the government would need to run a surplus of 0.7% of GDP just to avoid adding to the debt ratio.
Even with slightly positive growth, say 0.5%, the figures are bad. To bring the debt level down from 70% , the Tories would need to cut the deficit below d= 0.5% x 70% = 0.35% of GDP, almost a balanced buget.
The conclusion is obvious: fix the economy first and then a little bit of growth and a little bit of inflation will make fixing the debt a whole lot easier.
24 September 2009
David Blanchflower says:
The time for cutting public spending is not now, not next year and not the year after.
Two years ago the Bank of England was raising interest rates out of fear that rising oil and food prices would spark demands for higher wages leading to persistent inflation. I thought they were wrong, the US was already in recession and we were at risk. I discovered that there was a lone voice on the monetary policy committee arguing against rate rises, David Blanchflower. He was proved right.
I think he is right again.
Could it be that the fight against early cuts in spending is gaining momentum?
23 September 2009
"The big error of the present economic discussion is to treat national budgets as on a par with the budgets of individuals or firms, which need to balance except for narrowly defined investment projects. Even if you also favour a balanced budget at the national level, it is at most a second order rule to give way if it impedes the achievement of broader economic objectives.
"In fact the public sector balance has an entirely different function: that of offsetting gross disequilibria in the national and international economy. If attempted savings exceed investment opportunities, public sector deficits are needed for as long as necessary to fill the gap - a job which will otherwise be done by stagnation and unemployment. When economic recovery has reached a certain stage, the time may come to roll back public sector borrowing. But we have certainly not reached that stage yet and it is far too early to rule out a second or even third leg of the recession."
He points out that the national debt has been far higher in the recent past and it came down without dramatic upheaval. (Well, 1956 when debt was 150% of GDP seems recent to me.) In the aftermath of the Napoleonic wars and WWII debt was approaching 200% of GDP.
"Of one thing I am sure. If we had the misfortune to engage in a major war we would have far higher deficits and debts than anything now in prospect, and few except some pacifists would worry. Why should it be more alarming for governments to get into debt to put people into useful work satisfying human needs, than to borrow for guns and tanks whose only aim is to kill other human beings?"
Who is pushing this good old Keynesian line? Samuel Brittan, not someone I ever expected to agree with.
22 September 2009
The pound has fallen to its lowest level since April against the euro after a warning that UK public debt levels may not be sustainable.
Except, it didn't happen. The pound has fallen against the euro, but the warning about debt levels didn't happen. This is the "warning" as it appears on the BBC News website:
"In its quarterly bulletin, the Bank of England noted that the UK had run current account deficits for more than a decade - sustainable as long as the deficit was offset by foreign investors' purchases of UK financial assets.
" 'But the financial crisis may have led overseas investors to reassess their willingness or ability to purchase sterling assets and thereby finance the UK trade deficit,' the Bank of England said."
So the warning is about financing the trade deficit, not the government deficit and not the accumulated government debt.
There is a link between government deficit and the trade deficit. Government debt, in the form of gilt edged bonds, is one type of "sterling asset" foreign investors can buy. So too are corporate bonds, commercial paper, shares, property and currency.
Government debt is the "story du jour", and linking the fall in the value of the pound to public debt makes for a better article, according to the values of modern churnalism. By trying to fit the real news (a fall in sterling) to the popular narrative (frightening levels of public debt) the BBC has gone off the rails.
Actually, it gets worse if you read the Bank of England bulletin from which the quote is taken. Chapter 3 is a study looking at the causes of recent changes in the exchange rate. The attractiveness of sterling assets to foreign investors is only one of a number of factors which the study says affect the exchange rate. It concludes: "there is substantial uncertainty about the precise role of each factor"
Finally, I am not sure that sterling has fallen. It seems to me that the euro has risen; it is up against the dollar as well. Fog in the channel; continent cut off.
16 September 2009
- The finance sector has yet to reform itself or be reformed.
- Stimulus packages begin to run out, from January in case of the UK.
- Trade imbalances remain.
- Houses and shares are seriously overpriced.
27 August 2009
One good index of how overvalued house prices are is to compare prices to average earnings. Nationwide provides a useful time series of house prices going all the way back to 1983. They also calculate the ratio of prices paid by first time buyers to average earnings. I have put these figures on the chart below.
The first observation is that the ratio is still higher than at the peak of the 1980s bubble.
A second point is that during the last downswing there were occasions when the ratio ticked up - eg Q2 1991 and Q4 1994.
The average ratio is 3.3. First time buyers pay 3.3 times the average earnings, on average. Currently the ratio is 4.2. If the ratio is to return to its historic level then prices have another 21% to fall relative to earnings. Of course, if wages rise quickly then prices need not fall so far.
Another look at the chart shows that after the last housing bust, the ratio overshot the average and fell to a low of 2.1. In Q4 1995 first time buyers were only shelling out about twice average earnings. To fall back to that level, prices would need to fall by half or wages double.
What does this mean for the economy. Falling house prices have a "wealth effect". People feel poorer and decide to save more, postponing consumption and so reducing demand. At present government spending is lifting demand but the stimulus packages will begin to run down next year. The household spending which will be needed to keep the recovery going may not materialise.
23 August 2009
First lets see how the three part economic crisis looks according to my traffic lights.
Banking Crisis: I measure this crisis using the spread between the policy rate and the LIBOR, which is down to 25pb. Another 5bp and it could go amber. But for now we are still on red.
Debt/Demand Crisis: The Economist poll of polls forecast for 2010 has slipped back to 1% GDP growth. To be fair, this figure came before the Q2 GDP figures were published and so next month could see the forecast rise. For now it is as red as ever.
20 August 2009
How do we know that a recession is over? We know what a recession looks like - unemployment rising , falling orders, short time working, businesses closing down, GDP falling, tax receipts down, etc. How will we spot when it turns the corner?
GDP is an obvious indicator. When GDP is falling there is a recession and when growth returns it is finished. Sadly it is not so simple.
The chart shows quarterly growth for the UK from 1990. The economy shrank for five quarters beginning in the third quarter of 1990. GDP then grew slightly for two quarters before shrinking again. You might have thought that the recession was over by the end of 1991, but you would have been wrong. It didn't end at least until mid 1992. So one quarter (or even two) of GDP growth does not guarantee the end of the slump.
An alternative might be to look at the level of at GDP rather then the change. The UK economy grew to a peak in early 2008, since when is has been contracting. Is the recession over only when GDP again reaches the level it was in Q1 2008? If so then we have a long way to go. GDP has fallen by 5.7%. If growth returned to a normal rate (about 2.5% a year) it will take more than two years to get back to the pre-recession level.
Perhaps that is too strict a test. It might reflect reality if unemployment is our main concern, but then why not just use the unemployment figures.
The alternative which appeals to me for calling the end of the recession is when the annual growth rate turns positive, ie the growth over the last four quarters is positive. In the 1990s it is clear that this condition was not met until Q3 1992. Another criterion could be for quarterly growth to return to (or exceed) the trend rate (about 2.5% annually for the UK, or over 0.6% a quarter). On this condition the earlier recession ended in Q4 1992.
So, it is too early to be sure that either France or Germany has exited from recession. I will wait until one of these two conditions have been met.
18 August 2009
This is the Bank of England's projection for economic growth taken from the August Inflation Report published last week. At first sight it would appear to be good news. It shows a strong recovery from recession. Here we have a V shaped and not a U shaped or W shaped or even an L shaped recession. So what is the problem?
The first problem is that in the press conference, Mervyn King , the bank's governor, warned of a fragile recovery, "The pace of recovery over the next few years is highly uncertain." (See the BBC) The fan chart, on the other hand sees growth back to normal levels next year.
The next problem is interpreting the chart. This shows the annual growth rate, or more accurately, the 4 quarter growth rate. So when the central projection crosses the zero, as it does early in 2010, then the growth rate over the last four quarters is zero; ie the economy is the same size as it was in early 2009.
(Another difficulty is that it looks like the ONS data is only available up to the first quarter of 2009, but from the shape it is obvious that the latest data (Q2 2009) is included. See here) Reading off from the chart, annual GDP reaches about 1% at the end of Q1 2010.
This is where it gets interesting. GDP fell by 0.8% in the second quarter of 2009. So to get to 1% in March next year, the economy must grow by over 1.8% over the next three quarters, equivalent to an annual growth rate of 2.4%. So either the economy grows at its trend rate from now on, or it grows faster than its trend rate in the early months of 2010.
I know that the monetary policy committee is stuffed with people who know more about economics than I ever will. But I can't see how this projection is possible.
If there is a choice between an optimistic chart and a pessimistic governor, I'm with the governor.
15 July 2009
Banking crisis: The index (the spread of 3 month sterling LIBOR over the policy rate) is down to 54bp from 76bp last month. The target is 10bp. The banking crisis is far from over.
Debt/demand crisis: The index (economic growth forecast for 2010) is 1.1% up from 0.6% last month. To be on track for recovery it should be upwards of 2%. The recovery is still some way off.
Trade crisis: My trade index is 5.9% down from 6.3%. (The index sums the deficits and surpluses of four major trading economies and divides by their combined GDP.) Looking up, but the recession is cutting the level of trade. We need to watch what happens when the recovery begins.
For more information on the indices see the small print here.
14 July 2009
SproutWatch is my occasional blog looking for signs of the "green shoots" of recovery. If I see any sprouting of green shoots, I will mark the occasion with with a green light, but until then we will make do with red and occasionally amber.
Banking crisis: The index is at 0.70% down from 0.77% last week. (See the small print below for an explanation.) A recovery from the banking crisis would mean a number in single figures. So for now we are still on red.
Debt/demand crisis: The Economist forecast for growth in 2010 is 0.6% up from 0.3% last month . If the economy was to recover next year then we should see growth over 2%. So the prospect for recovery soon is a big red sprout from Brussels.
Trade crisis: The trade imbalance is unchanged at 6.3%.
Notice that two of the indicators have improved. They still signal that the downturn will continue, but they are better than last time. This partly explains why some commentators see green shoots and why they are wrong. In maths, this is called the second derivative. Basically the indicators are saying the economy is shrinking, but not as fast as before.
Here is an example from this weeks Economist:"The rich world’s manufacturing slump may be coming to an end." That sounds good. "In America, the Institute for Supply Management’s activity index rose from 40.1 to 42.8 in May..." Good, the index is going up.Then in brackets, "(a reading above 50 indicates industry is expanding)" So a reading of 42.8 means industry is contracting.
The banking crisis is measured by the risk premium banks demand when they lend to each other. The index is the difference between the interest rate for inter-bank lending (3 month sterling LIBOR) and the policy rate set by the Bank of England.
The debt/demand indicator is the forecast published by the Economist newspaper, based on the forecast of a dozen or so institutions.
The trade crisis indicator is the sum of the trade deficits of the US and UK plus the trade surpluses of China and Germany (on the basis of the latest 12 months for which figures have been published) expressed as a percentage of their combined GDP.
13 July 2009
It seems to me that behind the economic slump is not just one crisis but, at least, three:
- a banking crisis;
- a debt /demand crisis; and
- a trade crisis.
Of course they are linked - each impacting on the other – but dealing with the slump means responding to all three crises at the same time. My argument is that fixing all three simultaneously will not be easy.
The banking crisis is the most talked about. Banks have “assets” which no-one wants to buy and so the true value, if they have any, is unknown. Consequently the solvency of the banks is in doubt, and so interbank lending froze up two years ago and banks remain stuck.
The solution is to get the doubtful assets off the banks balance sheets. Recapitalising and offering insurance on bad loans might work, but the only sure way is too strip out the bad stuff and lodge it in a “bad bank”. If nationalisation is the only way to clean up the banks then so be it.
The debt crisis is more interesting. I keep reading - usually accompanied by expressions of shock – that total UK debt had reached 300% of GDP. But debt amounting to 3 times annual income is not that strange. If you have ever had a mortgage then you were probably allowed to borrow three times your income. The real crisis is that the appetite for risk has gone. Businesses and households want to hold cash rather than make risky investments. So there is a huge switch from lots of debt and credit to everyone trying to reduce their debts and increase saving.
This is the classic Keynesian crisis and the solution begins by expanding the money supply. But, partly because the banks aren’t doing their job and partly because people are holding on to cash, it isn’t working. The Bank of England is expanding the money supply as much as it can but broad measures of money are barely growing.
The other solution is for the government to borrow and spend – fiscal stimulus. The government is on the case, but I think it needs to do more.
The trade crisis has been developing for some years. Britain, the US and some other countries have been running large current account deficits, while others – like China and other Asian countries – have been running current account surpluses. The other side of the coin is that while trade flows go one way financial flows go the other. The surplus countries in effect lend their money back.
The solution to this one is for Britain, the US etc to save more and for China, etc to consume more. That may not be obvious, but as a matter of economic arithmetic, domestic savings less investment is equal to the trade balance; so more savings means less of a trade deficit.
Now I can see a difficulty here. Can the government deal with the second crisis and the third crisis at the same time? If government borrows enough to keep the economy going then it simply replaces the borrowing which firms and households no longer undertake, and the trade position will not improve.
The real answer to the trade imbalance is for the surplus countries to save less or borrow more (which is the same thing). So China’s fiscal stimulus and Germany’s fiscal stimulus are more important to the recovery than our own.