Contents

Topic 1 Topic 2 Topic 3 Topic 4 Topic 5 Topic 6 Topic 7 Topic 8 Topic 9 Topic 10

Globalisation: What and how but for whom? Why are there different explanations of the economic cycle? What is the distinction between short-run and long-run economic growth? Is Inflation targeting a good thing? Why has the availability of credit caused a housing bubble? Will the Quantitative Easing experiment work? Who is the winner in the Euro debate? Are fiscal rules only fiscal folly? Is deflation a false threat? Why does the world economy need to re-balance?

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Crisis Economics: The Cutting Edge
Head of Economics and Business Studies, St. Catherine’s School

Nigel Watson

ISBN: 978-1-905504-57-2

Published by Anforme Ltd., Stocksfield Hall, Stocksfield, Northuberland NE43 7TN. Tel: 01661 844000 Fax: 01661 844111 email: info@anforme.co.uk www.anforme.com

Topic 1 Globalisation: What and how but for whom?
Globalisation
Globalisation is a broad term that means many things to different people. Therefore, it is a difficult term to define. Globalisation could be seen as the trend towards closer economic, political and cultural ties between nation states. Globalisation has created a more integrated world economy. The closer interconnectedness and interdependence between economies and societies created by globalisation has been achieved as the geographical, financial, trade and information barriers that surround countries gradually recede. In many ways the trend towards globalisation has reduced the sovereignty, and perhaps the importance, of nation states.

The characteristics of globalisation
In many ways, globalisation is not a new trend. The Romans living in Britain 2,000 years ago ate bread made from wheat grown in North Africa and drank wine produced in Spain. However, in the last thirty years free trade agreements have accelerated the pace of globalisation. It could be argued that there are four key aspects of globalisation to consider: freedom of movement of • goods; • people; • capital; • information, ideas and values.

1. Freedom of movement of goods and services
An important aspect of globalisation has been the surge in the volume of trade that has occurred between sovereign states. For example, world trade has grown 14-fold since 1950, and in the last decade, exports from the UK to the EU have nearly doubled. The bulk of the world’s trade takes place between rich economically developed countries. The richest 20% of the world’s population account for 82% of the world’s trade. Economists that believe in the merits of free trade believe that it is advantageous for countries to trade goods with each other in order to specialise, rather than being selfsufficient. According to David Ricardo countries should not aim to produce everything that they wish to consume because it would be inefficient to do so. For example, it is possible (just) to grow bananas in the UK, but only with the help of a very expensive heated greenhouse. However, it would be bananas to try to cultivate bananas in the UK because the productivity of the factors of production used in this activity would be very low. Instead, the UK should import the bananas that it wants to consume from a country that can grow this crop more efficiently. The factors of production that previously used to be used to grow bananas in the UK can then be transferred to another industry where productivity is far higher. If factors of production are transferred from industries where productivity is low, to industries where productivity is high, national output will increase, even if the country’s factor endowment remains unchanged. The increase in world output created by international specialisation has the potential to lift living standards. This is a powerful argument in favour of globalisation and the freedom of movement of goods and services.
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Figure 1: The world’s major exporters of manufactures, 2000 - 2008

Source: World Trade Organisation 2009

Figure 1 shows the increase in the volume of manufactured goods exported from 2000 to 2008. During this period the volume of goods exported soared. For example, China’s exports rose from just over $200bn to over $1,300bn per year, an increase of 550% in less than a decade. Germany’s export performance has also been impressive too. Germany is the world’s No.2 exporter of manufactured goods. Access to globalised markets has helped companies such as BMW and Siemens to grow. Some economists blame the 1930s depression on America’s decision to impose protectionist trade barriers. America’s trading partners retaliated and the result was a world-wide collapse in trade. As a result countries were forced into becoming more self-sufficient again, and the productivity and output gains previously enjoyed were lost. The credit crunch of 2008 also created an alarming reduction in world trade. Fortunately, policy makers resisted the urge to impose protectionist trade barriers against each other. Trade volumes are now recovering again despite the fact that demand in heavily-indebted countries like Britain and America remains subdued. The demand growth needed to engineer this recovery in world trade has come from consumers in South America and Asia. In July 2010, China became the third largest export market for BMW cars.

2. Freedom of movement of people
In today’s globalised world people find it easier to move across national frontiers in search of work or a new way of life. Economists believe that individuals are motivated by self-interest. Therefore, it should not surprise anyone that people living in poor countries wish to emigrate to live in countries where they can expect to earn more and live longer. Each year people living in Senegal risk their lives trying to sail to the Canary Islands in over-crowded wooden boats, to begin a new life in Spain. This behaviour is easy to explain: according to the World Bank, life expectancy in Senegal is just 56 years, compared to nearly 80 years in Spain. And income per capita in Spain is $21,600, whilst the equivalent figure in Senegal is just $600 per year. Like Spain in recent years the UK has also attracted economic migrants from poorer countries. In 2004 ten new countries joined the European Union. The British government allowed citizens from these countries to come and live and work in Britain without the need to apply for a work permit.
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It was predicted by the Labour government that fewer than 15,000 people each year would come to the UK from the ex-communist countries that became EU members in May 2004. Instead, an estimated 600,000 migrants came in two years - 62% of them from Poland. Global inequality has always existed; some countries have always been able to offer a higher quality of life for their citizens than others. However, in the past people living in poor countries found it difficult to emigrate due to the immigration policies adopted by richer countries. During the last decade migrants from poorer countries have found it easier to fulfill their ambitions to emigrate because some governments in the rich, developed world have decided to adopt a more relaxed approach towards immigration. In the current political climate people from poorer countries will carry on arriving in Britain as long as British wages and employment opportunities are preferable to those encountered in their home countries. In 2010 there were 63m people living in the UK. The government anticipates that by 2028 immigration will have lifted the UK’s population to 70m. However, in Poland, the government is concerned about the economic effects of de-population caused by emigration to Western Europe. Demographers estimate that Poland’s population will fall by 2.2m by 2035. The economic effect of this change could be considerable because the population of Poland in 2010 was just 38m.

3. Freedom of movement of capital
Globalisation has allowed multinationals to move their capital to wherever labour is cheapest. Free trade has enabled multinationals to operate wherever they like. For example, in the past Nike used to make their clothes and shoes in the USA. Today, this is no longer true. Companies like Nike have decided to close down their factories in high-wage, high-cost locations and re-open them in countries that offer lower wages and taxes. Most of the products are produced by multinationals operating from low-cost locations in the developing world and then exported back to be bought by customers in the rich developed world. According to the American Bureau of Labour Statistics, in 2006 Chinese manufacturing workers received less than 3% of the pay earned by manufacturing workers in America. In the circumstances it is easy to understand why Apple, an American company, has decided to manufacture all its products in China, despite the fact that the company has to export most of its output from China thousands of miles back to the USA and Europe. Figure 2: Hourly compensation costs in U.S dollars for all employees in manufacturing, 1998-2007

Source: http://www.bls.gov/fls/#compensation Crisis Economics: The Cutting Edge Topic 1 3

Figure 2, produced by the American Bureau of Labour Statistics, shows that hourly wages in manufacturing are highest in the euro area. In countries like Germany manufacturers overcome the competitive disadvantage of high wage rates by investing heavily in capital, which increases productivity and hence lowers unit labour costs. In addition, firms like BMW and Mercedes do not rely on low costs and low prices for their competitive advantage. Firms like Mercedes sell highly differentiated products that have a price inelastic demand.

4. Freedom of movement of information, ideas and culture
Globalisation has created a less diverse world. Multinational corporations have harnessed advances in IT and satellite technology to create a homogenised global (American) culture. Increasingly, consumers in different parts of the globe consume the same brands, watch the same TV programmes and listen to the same music. Some argue that this trend is undesirable because consumers benefit from choice and variety. On the other hand, it could be argued that people all over the world have benefitted from the opportunity to consume famous brands like Coca-Cola,McDonald’s and Nike. Globalisation does not force consumers in the developing world to buy these brands in preference to domestic alternatives. These famous global brands will only succeed if they offer sovereign consumers products that represent good value for money.

Arbitrage and the law of one price
The law of one price states that in the long run geographical price differences for goods, services and factors of production will not persist. Geographical price differences will be eroded via a process called arbitrage. Arbitrage is driven by entrepreneurs who are able to make profit from geographical price differences. For example, according to the law of one price, in the long-run, the price of a two year old BMW Mini should not vary from region to region across the UK. For example, if the price of a two year old Mini in London was £2,000 higher than Newcastle second-hand car dealers would be able to profit from this situation. The dealer could buy cars in Newcastle, where they are cheap, and then sell the cars on for a profit in London, where they can be sold for a higher price, pocketing the difference as profit. However, in the long run one would expect this behaviour to drive up car prices in Newcastle (where demand has risen) and push down prices in London (where supply has risen). Car dealers will only stop this process when the geographical price difference has been eroded as there is no longer any profit from this trade – hence the law of one price. Labour, just like any other commodity is subject to the law of one price. Multinationals have benefitted from playing the wage arbitrage game, exploiting differences in international wage rates to lower their wage bills, boosting profits. International wage arbitrage is a very important aspect of globalisation.

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Figure 3: Global wage differentials

In Figure 3, the equilibrium wage in the developed world is initially w1 because at this wage level the supply of labour in the developed world matches the current demand for labour, which is represented by the demand curve DL1. However, in the developing world the equilibrium wage rate is only Wa because the demand for labour is only D1. The price of labour in the developed world is far higher than the price of labour in the developing world. In search of cost savings multinationals have been closing down factories in the developed world, where wages are high, and re-opening them in the developing world, where wages are far lower. This very important aspect of globalisation has led to a narrowing of the wage differential which exists between the developed and the developing world. Factory closures have reduced the demand for industrial workers in countries such as Britain. According to basic microeconomic theory the fall in demand for labour in the developed world from DL1 to DL2 will lead to a fall in the wage rate in the developed world. Manufacturing workers in the developed world will suffer from a wage cut of w1 to w2. The numbers employed in manufacturing in the developed world will also fall from e1 to e2 as a result of this decrease in the demand for labour. At the same time, the decision to transfer production to the developing world will increase the demand for labour in this part of the world from D1 to D2. In the developing world, arbitrage will cause the equilibrium wage to rise from Wa to Wb. The level of employment will also increase from E1 to E2. Theory predicts that the income gap between the developed and the developing world should narrow over time. In the above example arbitrage has reduced the wage differential between the developed and the developing world from (w1–Wa) to (w2Wb). The law of one price predicts that arbitrage will continue until wage rates in the developed and the developing world have equalised. International wage arbitrage will narrow the gap in living standards that exists between the developed and the developing world. There is strong evidence to suggest that this process has already begun.

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Figure 4: Change in real hourly wages for men by wage percentile, 1973-2007

Source:Lawrence M, Bernstein J, and Shierholz H, The State of Working America, 2008/2009. An Economic Policy Institute Book, Ithaca, N.Y: ILR Press, an imprint of Cornell University Press, 2009

Figure 4 shows that real wages for Americans earning less than the median average wage have fallen since 1973. Many of these workers that earn less than the median average wage have faced growing international competition for their labour. US companies like Nike and Apple have profited from the arbitrage made possible by globalisation. In the past both companies produced their products in US factories. Today, this is no longer true. Both companies now produce in China where wages are a fraction of those paid to US workers. International wage arbitrage has also contributed to the growth of household debt in the developed world. Households in the USA and most of Europe have tried to preserve their living standards in the face of falling real wages by taking on extra debt. Asset bubbles, most noticeably in housing, gave households the confidence to take on the extra debt required to maintain aggregate demand in the USA and Europe.

What are the factors that have contributed towards globalisation?
Countries have always traded with each other. And people have always moved from one country to another in search of a better life. However, in the last 30 years the pace of globalisation has increased. The main factors that have contributed to this trend are as follows:

1. Free trade
The World Trade Organisation and trading blocs such as the EU and NAFTA have promoted globalisation. Removing protectionist trade barriers such as tariffs and quotas has encouraged countries to specialise and trade with each other.

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Figure 5: The growth in world trade

Source: IMF and Colin Ellis

Figure 5 shows how the volume of world trade soared prior to the credit crunch. The growth in world trade has been assisted by politicians who have signed free trade agreements with each other. International organisations like the World Trade Organisation have also worked hard to abolish tariffs and quotas that encourage selfsufficiency, rather than international specialisation. Free trade enabled multinationals to profit from international wage arbitrage. In the last 30 years countries like the US and Britain have exported thousands of manufacturing jobs to countries such as China and India.

2. Falling communication costs
Figure 6: Internet connection costs

Source: www.economist.com/research/articlesBySubject/displaystory. cfm?subjectid=7933596&story_id=10797453 and www.guardian.co.uk/technology/blog/2008/ oct/07/internet.telecoms Crisis Economics: The Cutting Edge Topic 1 7

The bar chart shows how the price of a broadband internet connection has fallen in recent times. Satellite time is also far cheaper to buy. Cheaper communication has helped to spread ideas, information and a global culture. Cheaper communication costs have enabled multinationals to target new markets for their services. Manchester United Football Club is a good example. In 2005 it was estimated that the club had a global fan base of 75m people, which is more than the population of the UK! The American owners of Manchester United, the Glazer family, have tapped into this enormous customer base by selling TV rights and replica football shirts and other merchandising to fans all over the world. In 2009 the club announced a record turnover of over £300m. Much of this turnover would not have been possible without the technological advances needed to screen live games to fans living abroad.

3. Falling Transport Costs
Technological advances and economies of scale in freight transport have reduced the cost of transporting manufactured goods around the globe. Marks and Spencer’s shirts sold in the UK are assembled in Turkey, using cotton grown in the USA. This type of globalisation would not be economical without very low transport costs. Figure 7 shows trade cost indices for France, Britain and the USA from 1950 to 2000. During this period, trade costs fell in each of the countries. In Britain, transport costs fell by approximately 10%. In recent times transport costs have started to rise. The most likely reason for this trend is the rising price of crude oil. Figure 7: Falling Transport Costs

Source: www.economistsview.typepad.com/economistsview/2008/08/globalisation-a.html

Globalisation: the winners and the losers
Globalisation has affected the lives of millions of people living in both the developed and developing world. In the rich developed world, globalisation has tended to favour the wealthy, and has contributed to the growing gap between the rich and poor in countries such as Britain and the USA. On the other hand it could be argued that globalisation, via international wage arbitrage, will narrow the global gap between rich and poor; living standards for the average family living in India and China have improved rapidly over the last decade.
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In the future more occupations will face competition from low-cost foreign labour. For example, in the past university educated lawyers in Britain and the USA were immune to the threat of outsourcing. However, this is starting to change. According to the New York Times in June 2010, “Cash-conscious Wall Street banks, mining giants, insurance firms and industrial conglomerates are hiring lawyers in India for document review, due diligence, contract management and more”1. Globalisation: the winners 1. Workers in the developing world have benefitted from international wage arbitrage and outsourcing. Employment levels and real wages in countries such as China and India have increased, lifting the material standard of living. 2. Consumers in the developed world. Globalisation has filled Britain’s shops with low-priced imported food, clothing and electrical goods. For those still in work, earning an income, globalisation has increased the material standard of living. Those most likely to stay in work are those that perform jobs that have not been outsourced yet. Globalisation: the losers 1. Low-skilled workers in the developed world. Outsourcing has reduced the number of jobs available for UK school leavers. The decrease in the demand for labour created by outsourcing has also limited wage increases. 2. Small businesses in the developing world that lack the economies of scale required to compete against much larger multinationals in a free trading situation.

3. The environment. Globalisation has boosted consumption by keeping prices lower than they otherwise would have been. Lower prices have increased the volume of goods consumed and, 3. Shareholders in companies that have therefore, produced, creating, in boosted their profits via outsourcing. many cases, negative externalities. Globalisation has increased the power of Transporting goods half way around a handful of multinational corporations. the world, rather than producing locally produced goods, also contributes to global warming.

Globalisation and democracy: A New World Order?
Globalisation is important to economists because it is an important aspect of economic development: democracy adds to the quality of life. According to the economist, Michael Todaro, democracy enhances the quality of life because it empowers people, freeing them from servitude. Democratically-elected politicians are supposed to make decisions that conform to the wishes of the people. In a democracy the people have the power to vote out politicians that fail to represent their views and desires. In the last thirty years globalisation has enhanced the power and size of multinational corporations. Many of these multinationals are now larger than whole nation states. For example, Coca-Cola, McDonald’s and Wal-Mart all have a larger annual turnover than the GDP of Botswana. Some economists believe that globalisation has damaged democracy because many democratically-elected politicians now represent the interest of the all-powerful multinational corporations, rather than the views of the people that elected them. In countries like Britain and the USA political parties are funded by donations from big businesses. These businesses are likely to want something in return for their donations.
1 http://www.nytimes.com/2010/08/05/business/global/05legal.html?_r=1 Crisis Economics: The Cutting Edge Topic 1 9

Many of these big businesses routinely employ politicians once their political careers have ended. For example, ex-Prime Minister Tony Blair is paid £2.5m each year by the investment bank JP Morgan. What does Blair know about banking that is worth £2.5m a year to JP Morgan? During Blair’s period of office as P.M. was the government’s decision-making unduly influenced by the needs and wishes of big business? Do politicians serve the interests of the people who elect them, or the multinationals who pay/bribe/corrupt them?

Globalisation has enabled multinational corporations to profit from wage arbitrage. In search of higher profits companies have closed down factories in high wage countries like the USA and Britain. Production has been transferred to economies such as China, which have lower wage rates. Wage arbitrage has caused unemployment to rise in the developed world, especially amongst the semi-skilled. The fall in the demand for labour created by outsourcing has created stagnant real wages. Many UK households have tried to maintain their living standards by borrowing and become more indebted. On the other hand, in China and India the opposite is true. In these countries employment and real wages are increasing. Globalisation has narrowed the gap in living standards between the developed and the developing world. However, within the developed world globalisation has increased the gap between the haves and the have not’s. Economic development is enhanced by democracy. However some economists argue that globalisation has handed the multinational corporations too much power and influence over democratically elected politicians.

Topic 1 Summary Topic 1 Questions

1. The EU has helped to create closer economic, political and cultural links between European countries. As such it could be argued that the EU is an agent of globalisation. Explain three benefits of EU membership for British citizens. 2. “Globalisation is not a new trend”. To what extent do you agree or disagree with this statement? 3. Discuss whether it was a mistake for the developed world to allow China to join the World Trade Organisation in 2001. 4. Should politicians be allowed to take up highly-paid positions with businesses whilst in office, or when they retire? 5. What actions should society take in order to minimise corruption?

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Topic 2 Why are there different explanations of the economic cycle?
Introduction
Historically, economies tend to grow in the long-run due to technological advances that increase factor productivity. However, in the short-run the level of economic activity is usually more volatile. Economists refer to these short-run oscillations in the rates of economic growth, inflation and unemployment as the economic cycle. The economic cycle can be sub-divided into four phases: 1. Boom: during boom periods the rate of economic growth is positive and above its long-run average. The level of aggregate demand tends to be quite high and the economy might be showing signs of overheating. As a result, demand-pull inflationary pressure might be building. 2. Slowdown: this phase of the economic cycle is characterised by a slowing in the rate of economic growth. As the economy stalls, employment peaks and inflationary pressure within the economy recedes. 3. Recession: the economy enters recession when GDP falls for two consecutive quarters. As the economy contracts, unemployment rises. 4. Recovery: recessions end when the economy stops shrinking. During the recovery phase of the economic cycle GDP growth tends to be below the long-term trend rate of economic growth. Unemployment tends to be a lagging indicator. Therefore, unemployment might continue to rise during the early stages of recovery.

The UK’s economic cycle 1990-2009
Figure 1 shows how the UK’s rate of economic growth has fluctuated over the last two decades. In the early 1990s the economy went into a recession but entered the recovery phase of the economic cycle by 1993. A long period of relative stability followed as the economy enjoyed a boom during the period from 1994 to 2006. The credit crunch caused the economy to slow down in 2007. By 2008 the UK was back in recession. Figure 1 clearly shows that the recession of 2008-2009 was more severe than the recession of the early 1990s. Figure 1: GDP growth, quarter on previous quarter

Source: ONS Crisis Economics: The Cutting Edge Topic 2 11

Keynesian explanations of the economic cycle
Keynesians believe that the economy is inherently unstable because the economy is not self-regulating. Keynesians put forward two theories that explain why the economic cycle occurs.

1. The multiplier / accelerator interaction
The accelerator theory asserts that the level of investment in the economy depends upon the rate of economic growth. Firms invest for two reasons, firstly, to replace worn out capital, and secondly, to expand capacity to meet additional demand. The accelerator theory focuses on the latter reason for investing. If GDP increases, firms will need to invest to create the extra capacity needed to meet demand. However, the quantity of investment needed will depend upon the rate of economic growth. If the rate of economic growth is constant firms will need to increase output by the same amount as last year, therefore, the level of investment will remain constant. On the other hand, if the rate of economic growth is accelerating, firms will need to create a bigger increase in output than that achieved the previous year. To create a bigger output increase than the previous year firms will need to raise their levels of investment. If the rate of economic growth declines output will still need to be increased. However, the output increase required this year will be less than the previous year. Consequently, investment levels will fall when the rate of economic growth declines. The multiplier effect describes how and why an initial injection into the economy creates a final change in aggregate demand and, therefore, GDP that is many times higher than the value of the initial injection. The multiplier effect takes place because the initial injection is re-spent. For example, the government might decide to inject £1bn into the economy by increasing teachers’ salaries. It is highly likely that most of this additional income will be spent, which will create additional incomes for the firms that have benefitted from the extra demand made possible by the rise in teacher pay. A proportion of the additional incomes received by firms will also be spent benefitting other firms in the economy. The power of the multiplier effect is determined by the amount that is leaked out of the circular flow by saving, taxation and import expenditure. During the early stages of the boom phase of the economic cycle the rate of economic growth tends to increase. According to the accelerator theory, accelerating economic growth will lead to an increase in the level of investment in the economy. An increase in investment will create an injection into the circular flow of income. The injection created by the increase in investment will create a multiplier effect, which will provide a second boost to aggregate demand and GDP. If the rate of GDP growth increases, investment will rise again, creating another multiplier effect. According to Keynesians booms create a momentum of their own because of the multiplier / accelerator interaction. The increase in investment created by the accelerator effect will create a positive multiplier effect, which in turn will boost the rate of GDP, creating even more investment and so on. At the tail end of a boom, when the economy is nearing full capacity, the rate of economic growth will tend to slow. According to the accelerator effect, as a result of a fall in the rate of economic growth, firms will react by decreasing investment expenditure. A fall in the level of investment will reduce the level of aggregate demand. The fall in the level of aggregate demand creates a negative multiplier effect, which pushes GDP down. The economy is now in recession; the rate of economic growth is now negative. multiplier interaction should create a sharp re-bound out of recession once the floor in economic activity has been reached.
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During this phase of the economic cycle the level of investment crashes because firms no longer need to invest in order to add to capacity. This second fall in the level of investment created by the accelerator will create a second negative multiplier effect. As a result the economy spirals down into a deeper and deeper recession. Economists that believe in the accelerator / multiplier interaction argue that recessions end when firms start investing again to replace worn out machinery. During recession when GDP growth is negative firms will not invest in order to build additional capacity because this extra capacity is not needed. However, it is important to realise that firms also invest to replace worn out machinery. This is the ‘floor’ level to economic activity. Eventually, even in the depths of recession there will be firms somewhere in the economy that will have to invest to replace a machine that has just broken. When this happens the level of investment in the economy will increase. According to the multiplier theory, an increase in investment will create a final increase in GDP that is many times higher than the value of the initial injection. The increase in national output created by this initial investment injection will increase the rate of economic growth. An increase in the rate of economic growth will create further increases in investment due to the accelerator effect. In addition, secondary increases in investment will also create positive multiplier effects too. According to Keynesians, the accelerator / multiplier interaction should create a sharp re-bound out of recession once the floor in economic activity has been reached.

Criticisms of the multiplier / accelerator model
During a recession most firms will have spare capacity created by investment during the boom times. Therefore, during the recovery phase of the economic cycle, firms may not need to invest to cope with an increase in demand. In addition, some firms may choose to delay replacement investment, therefore, the floor of economic activity might be much lower than economists expect. When the economy hits the floor level of economic activity investment will increase, as firms replace worn out machinery. However, if the economy concerned has a very high MPS, MPT and MPM the multiplier effects created by this investment will be very disappointing. As a result GDP might struggle to recovery in any meaningful way.

2. Fluctuations in the level of stock held
A major weakness of the accelerator /multiplier model is that it does not take into account the role played by business confidence in creating turning points in the economic cycle. Some Keynesians argue that the most important factor that explains fluctuations in the level of economic activity is fluctuations in the level of stock held by firms. Stock is accumulated by firms when current production exceeds current sales. Firms hold stocks of finished products just in case demand suddenly picks up. If stock was not held firms might struggle to meet demand from current production. Not being able to meet customer demand matters because the firms affected will lose revenue and profit. The amount of stock held by firms is affected by the level of business confidence. During boom periods, when business confidence is high, firms expect sales to grow in the future. As a result, during a boom, firms are more likely to increase production in order to increase their stockholdings. The increase in production created by the decision to increase stockholdings will increase output and employment across the economy. The boom will continue.

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Recessions are prompted by deterioration in the level of business confidence. If confidence falls, firms will expect falling sales in the future. Firms are likely to respond to this expectation by reducing the amount of stock that they hold. To reduce stock holdings firms cut production. For a period, customer demand can be met by running down stocks. The fall in production created by de-stocking, causes employment and output to fall; the economy is likely to slip into recession if firms across the economy react to deteriorating business confidence by cutting production. Robert Peston, the BBC’s business editor, was blamed by some people for creating de-stocking, and ultimately, the recession in 20081. According to his critics, Peston’s negative reporting damaged business confidence, which led to a wave of de-stocking across the economy. Negative news on the economy also affected the levels of investment too. Firms will tend to postpone investments that add to their capacity if they expect sales in the future to fall. However, few believe that Robert Peston and the rest of the UK media ‘talked the economy into recession’. Fluctuations in the level of business and consumer confidence probably do have some influence on the level of economic activity. However, Austrian economists argue that the underlying cause of the UK’s recent recession was a contraction of credit. These economists reject the arguments put forward by Keynesians, instead they believe in monetary explanations of the economic cycle.

3. Monetary explanations of the economic cycle
The Austrian School view on the economic cycle is linked to the existence of fiat money (see Topic 6). Fiat money is a type of currency that is backed by government decree, rather than by precious metals, such as gold and silver. Today, all of the world’s major currencies are fiat currencies. As a result, central banks are free to print as much money as they best see fit. In the past, under the gold standard, when countries operated commodity money, this was not possible. Under the gold standard, if a central bank wanted to print additional banknotes, additional gold would have to be acquired first to back the extra money that the central bank wanted to create. The decision to abandon the gold standard, and adopt fiat currency, meant that governments and central banks were free to inject as much liquidity into the banking system as they desired. Economists that believe in monetary explanations of the economic cycle also stress the role played by fractional reserve banking. Fractional reserve banking occurs when commercial banks hold only a fraction of the deposits made with them by savers. The remainder is lent out to households and firms. Commercial banks have the power to increase the supply of credit, and hence the broad money supply, if they choose to lend out a higher proportion of their savers’ deposits. Economic booms are created by a combination of government-induced increases in the money supply and by an expansion of credit. Governments increase the money supply by running fiscal deficits. Commercial banks can increase the availability of credit if they relax their lending standards and hold back a smaller proportion of their deposits as cash. The expansion of the money supply and credit creates an economic boom because it increases aggregate demand, which leads to a rise in output and employment. The increased availability of credit created by relaxed bank lending also drives up the demand for assets like houses, which are typically bought using credit.
1 http://www.bbc.co.uk/blogs/thereporters/robertpeston/2007/09/banks_scary_auction. html#comments Crisis Economics: The Cutting Edge Topic 2 14

The increase in demand for assets raises their price, creating a positive wealth effect for the households that own these assets. Feeling richer, households might feel that there is now less need for them to save, creating a further boost to consumption, which lifts economic activity again. Unfortunately, economic booms created by monetary and credit expansions are not sustainable in the long-run. Governments cannot keep on artificially stimulating the economy via fiscal deficits forever because the bond market will eventually question the solvency of the government that wants to permanently live beyond its means. When governments struggle to find buyers for their sovereign debt the boom will be over. To pay down its national debt the government will have to run fiscal surpluses, which remove spending power from the economy, creating a slowdown. Credit expansion in the private sector can also contribute towards a boom. This boom ends when the Minsky moment arrives. According to the American economist, Hyman Minsky, a period of credit expansion ends when households can no longer afford to service their existing debts because they are too high relative to household income2. When the Minsky moment arrives, households begin to default on their debts. At this point commercial banks start to make losses; the amount owed by households that default has to be written off as a bad loss against the banks’ profits. It is no longer possible for households to take on more debt (to finance new purchases of either asset purchases or consumer goods) because households are already struggling to service the debts that they already have; spending drops and the economy enters the slowdown phase of the economic cycle. The government might try to prolong the boom by delaying the Minsky moment by lowering interest rates. At lower rates of interest a greater stock of debt can be serviced from the same income. (See Topic 10 for further discussion of the Minsky moment). Figure 2: UK interest rates since 1951

Source: Bank of England

Figure 2 shows that UK interest rates have exhibited a downward trend since the 1980s. Falling interest rates have enabled UK households to take on the additional debt needed to sustain UK aggregate demand in the face of falling UK real wages. Interest rates in Britain now stand at just 0.5%. This means that the Bank of England is no longer able to stimulate the economy by interest rate cuts because rates are as low as they can go.
2 www.gsb.stanford.edu/jacksonlibrary/articles/hottopics/business_cycles.html Crisis Economics: The Cutting Edge Topic 2 15

Figure 3: Total Household Debt - 1990 to 2009 (millions of pounds)

Source: The Spectator http://www.spectator.co.uk/coffeehouse/5536583/the-perfect-storm.thtml

Figure 3 shows the effect that falling interest rates had on UK household debt. Over the last ten years total household debt tripled. The expansion of debt enabled households to purchase goods and services that they could not really afford to buy. The extra demand created by credit fuelled New Labour’s economic boom. Unfortunately, many UK households are struggling to service their debts because the amount households owe is very high relative to their incomes. According to figures produced by Credit Action in July 2010 the average UK household owes £58,000. This amount of debt is problematic because the median wage in the UK is just £22,000, meaning that households owe far more than they earn in a year. Interest rates in the UK are as low as they can go. However, despite this £185m is spent every day on interest payments by UK households. The Minsky moment can no longer be delayed in the UK. Households are struggling with the debts that they already have. And interest rates are already as low as they can go. The long period of UK credit expansion has almost certainly ended, and with it, high levels of consumer spending (See Topic 5 for further discussion of this concern). According to the Austrian School the recession phase of the economic cycle is caused by a credit contraction. The fall in both the demand and supply of credit leads to a fall in consumer spending, which leads to a fall in aggregate demand and GDP.

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Why does the demand for credit fall?
The demand for credit falls when households reassess their attitude towards credit and debt. During the boom most households are borrowing excessively to buy over-priced assets or to finance consumption; it is the thing to do. However, when the Minsky moment is reached, and defaults become more common, attitudes begin to change. There is a collective awakening: households regard their high levels of indebtedness as being a disadvantage. For the first time most begin to notice that a very high percentage of household income is devoted to paying interest. Households realise that it is not possible, or desirable, to borrow any more. As the recession deepens households cut back on their spending again as they start to repay existing debts. This is called de-leveraging. De-leveraging leads to further drops in consumption, aggregate demand and GDP. Attitudes towards credit and debt also affect asset prices, especially houses. High house prices can only be maintained if new buyers are willing to take on high mortgages. If first time buyers refuse to take out these mortgages the effective demand for housing will fall, leading to falling house prices. House price deflation creates a negative wealth effect; homeowners feel poorer as their equity evaporates. In response these households might feel more inclined to save. Figure 4: Japanese House Prices Index

Source: Bank of Japan

House prices in Japan rocketed during the 1980s due to a period of credit expansion. Japan’s property bubble burst in 1992 when credit dried up. House prices in Japan fell for 15 consecutive years. During this time household wealth in Japan also crashed. Households responded by trying to re-build their wealth via saving. A rise in the savings ratio led to a fall in domestic consumption, and in turn, sluggish rates of economic growth.

Why does the supply of credit fall?
The supply of credit decreases when the amount of debt owed grows to unaffordable levels. When households default on their debts the lender picks up the loss. If the banks make losses they will have less cash on deposit to lend out to prospective borrowers. Bank losses, created by bad debts, lead to a credit crunch, which is a decrease in the supply of credit.
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During credit crunches banks reassess their attitude towards risk. In the past, during the boom, commercial banks, chasing market share, may have underestimated risk, making loans to marginal or sub-prime customers. The losses generated from these failing loans begin to crystallise during the recession as a growing number of households default (declare themselves bankrupt). Banks respond by raising the price of debt, so that interest rates rise. Without government intervention many banks that have made bad loans will fail. Those that are able to survive will have to recapitalise. To attract the cash needed commercial banks will be forced into raising interest rates in order to attract new funds from savers. The banking bailouts of 2008 – 2009 ensured the survival of banks that had made losses on loans that had defaulted. However, the supply of credit is still restricted because the banks have chosen to hoard most of the bailout cash that they have received. This is probably because the banks realise that most households are already struggling with the debts that they already have. Therefore, in the circumstances, lending more to these households will probably lead to more bad losses at a later date when households subsequently default on these new loans. The banks also realise that interest rates cannot go any lower. In the future, if interest rates rise, the banks could be hit by a fresh wave of losses because higher interest rates will increase the cost of servicing the stock of debt that households already have. Many UK households are already struggling to cope with their debts, even though interest rates are at an all time low. In January 2010 the charity, Shelter, reported that in the last year over 1m UK households had resorted to using their credit card to pay the mortgage or their rent. How will these households cope when interest rates rise? In addition, the banks are also aware of the government’s finances and the need for fiscal consolidation. To reduce the rate of growth of the national debt the government will be forced, by the bond market, to raise taxes. Tax increases will reduce the amount of income that UK households have to service their debts. As a result, tax increases are likely to push more UK households over the edge, leading to more personal insolvencies and more bad debts for the banks. In the circumstances, the decision on the part of the UK banks to hoard cash looks to be fairly sensible. Figure 5: Individual insolvencies in England & Wales (thousands, not seasonally adjusted)

Source: Insolvency Service - total individual insolvencies for Q2 2009 onwards include Debt Relief Orders, which came into force on 6 April 2009 Crisis Economics: The Cutting Edge Topic 2 18

Figure 5 shows personal insolvency has soared in the UK since 2000. This has happened because household debt has grown at a much faster rate than household income. As a result many individuals do not earn enough to service the debts that they have built up. In Britain there are three types of personal insolvency: bankruptcy, Individual Voluntary Arrangement (IVA) and Debt Relief Order (DRO). Bankruptcy requires a debtor to sell all of his/her assets to repay the money owed to creditors, such as banks. Any debts that cannot be re-paid are written off. An IVA is an agreement between the debtor and the creditor that enables the debtor to re-schedule their debt repayments. The creditor may also agree to writing-off a part of the debt owed by the debtor. A DRO allows an individual with less than £15,000 of debt and minimal assets to write-off their debts without having been declared bankrupt.

The recovery phase of the economic cycle
Recovery begins once households have repaired their balance sheets; household debts have been paid off and have been replaced by a healthy stock of savings. The banks have also repaired their balance sheets too. The money lost through bank loans has been replaced by new deposits made by savers. Both households and banks are cash rich again. Slowly attitudes towards credit change all over again: households no longer fear being in debt. Instead, they see the attraction of being able to borrow in order to buy things today that they might have saved up for in the past. Households can easily cope with more debt at this stage because their existing debt levels are very low relative to their incomes. Attitudes amongst bankers slowly change too. The previous generation of managers that made loans to sub-prime borrowers has probably retired now. The new generation of bankers view the huge amounts of cash that they have on deposit as an opportunity. The bank should be lending a greater proportion of their deposits out to borrowers; by doing so the bank will be able to make more revenue (interest income) and profit. A new wave of credit expansion begins, which increases consumption, AD and GDP.

Conclusions
According to monetary explanations of the economic cycle, booms are created by periods of credit expansion. On the other hand, recessions are caused by credit contractions. Unlike Keynesians, Austrian economists that believe in monetary explanations of the economic cycle argue that credit expansions and, therefore, booms can go on for decades. Recessions tend to be equally as long because it will take decades for households and banks to deleverage and repair their balance sheets. Consumer credit is destructive because it destabilises consumer spending. An expansion of credit might lift consumer spending, and hence aggregate demand, for a period. However, spending and economic activity will fall in the period after because the debt taken out during the boom has to be paid back with interest. Consumer credit does not create a permanent increase in economic activity. Instead, credit simply pulls forward spending that would otherwise have occurred in the future. Consumer credit creates debt that can only be repaid by reducing discretionary expenditure in the future. Unlike a commercial investment, borrowing in order to consume does not create an income-bearing asset. For example, a consumer that uses credit to buy a £2,000 flat screen TV can enjoy a product today that they otherwise might not be able to afford. Unlike a firm that borrows to buy a new machine this type of debt will not pay for itself. The TV bought on credit will not create an income stream which will help to pay the interest on the £2,000 credit card bill.
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By spending some of tomorrow’s money today, spending tomorrow falls. When debts are re-paid, spending falls, and the economy slips into recession. Hence Austrian economists argue that it is really the boom that is the problem, not the recession. To prevent recessions the government should avoid fiscal deficits and regulate the banking system to prevent the credit expansions that create the booms. Economies will not suffer from recessions caused by credit contractions if the government acts to prevent booms caused by credit expansions. Governments that try to avoid the consequences of credit contractions by printing money to prop up insolvent banks run the risk of creating hyperinflation. The following quote from Ludwig von Mises neatly sums up the Austrian School’s position, “There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved.”3

3 http://mises.org/humanaction/chap20sec8.asp Crisis Economics: The Cutting Edge Topic 2 20

The economic cycle describes the fluctuations in economic activity that occurs in all economies in the short to medium term. Economic activity picks up during booms when unemployment falls and economic growth accelerates. During recessions economies contract leading to higher levels of unemployment. Keynesians argue that the economic cycle is best explained by changes in business confidence, which affect the amount of stock held by firms. In addition Keynesians believe that the accelerator-multiplier interaction also contributes to the economic cycle. Austrian economists reject the Keynesian explanations of the economic cycle. They hold the view that economic booms are created by an expansion of credit, whilst recessions are caused by credit contractions. Over the last decade central banks and governments have responded to the threat of recession by using slack monetary policy and expansionary fiscal policy in order to reflate the economy. Austrian economists are critical of this approach. They hold that governments should not intervene to prevent recessions because recessions cleanse the economy of inefficient firms. The factors of production released by firms that have gone into liquidation can then be taken up by more successful firms that would like to expand. In the long-run recessions improve the allocation of resources. Consumer credit destabilises economies. Unlike borrowing to invest, borrowing to consume is not sustainable.

Topic 2 Summary Topic 2 Questions

1. Economists have various theories that seek to explain the economic cycle. Which of these theories best explains the 2008-2009 UK recession? 2. UK household debt has exploded since 1990. Explain the role played by debt in creating UK economic growth during the NICE decade. 3. What is the Minsky moment and why is it important? Explain the actions taken by the Bank of England to delay the onset of the Minsky moment. 4. Explain why borrowing to invest is sustainable, whilst borrowing to consume is not. 5. Austrian economists argue that it is the boom that is the problem, not the bust. Explain this view. 6. In 1997 Gordon Brown promised to establish a “new economic framework to secure long-term economic stability and put an end to the damaging cycle of boom and bust”. Discuss whether it really is possible for policy makers to put and end to boom and bust. To what extent is economic stability desirable?

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Topic 3 What is the distinction between short-run and long-run economic growth?
Introduction
Economists measure a country’s economic growth rate by calculating the percentage change in real GDP from one year to the next. Economic growth is important to policymakers because growth has the capacity to lift the standard of living within a country, creating economic development. In recent times the economic growth rates of countries in the developed world, like the UK and the USA, have been well below the growth rates achieved by developing countries such as India and China. As a result, in terms of output, the gap between the developing and the developed world has been closing. Figure 1: China’s rapid growth - real change in gross domestic product (GDP) since 1990, in percent

Source: http://www.spiegel.de/international/world/0,1518,660432,00.html

Figure 1 shows that the economy of China has been growing at a far faster rate than the American economy. National output in China grew by 536% during the period from 1990 to 2009. In the same period the US economy only achieved growth of 61%. China’s economy is still far smaller than the American economy. However, if China continues to achieve faster rates of economic growth than America the result will be that China will overtake the US economy in terms of its size. China’s economy is already larger than the UK, French and German economies. According to the World Bank the world’s largest economies in 2009 were:1. USA: 2. Japan: 3. China: 4. Germany: 5. France: 6. UK: 7. Italy $14,256,300 million $5,067,530 million $4,984,730 million $3,346,700 million $2,649,390 million $2,174,530 million $2,112,780 million

Source: http://data.worldbank.org/indicator/NY.GDP.MKTP.CD Crisis Economics: The Cutting Edge Topic 3 22

To understand why countries like India and China have been achieving higher rates of economic growth than countries like the UK and the USA it is necessary to first of all understand the distinction between short-run and long-run economic growth.

Short-run economic growth
Short-run economic growth arises when real GDP rises because an economy is now making fuller use of its existing capacity. The most common cause of short-run economic growth is an increase in aggregate demand. According to Keynesian theory, provided that there is spare capacity, firms will respond to an increase in aggregate demand by raising output. The increase in output prompted by the rise in aggregate demand boosts GDP by taking the economy closer to its full employment output level. In the developed world, central banks and governments focus their attentions on trying to boost GDP in their countries. This normally involves using expansionary fiscal policy and slack monetary policy to boost the level of aggregate demand. Figure 2 shows an economy operating in equilibrium producing a real GDP of NY1 because the level of aggregate demand is stable at AD1. The current level of GDP is below the full employment level of GDP (Y/Fe). As a result the economy is currently suffering from a negative output gap: a situation where current output is below the economy’s full capacity output level. To create short-run economic growth policymakers opt to increase aggregate demand from AD1 to AD2 by cutting interest rates and by running a fiscal deficit. Firms react to this increase in demand by raising output, and not by raising price because spare capacity exists. The equilibrium level of real GDP rises from NY1 to NY2, creating short-run economic growth of the same amount. The shortrun economic growth created by government intervention has reduced the economy’s negative output gap from (NY1 to Y/Fe) to (NY2 to Y/Fe). Figure 2: A negative ouput gap

There are two key problems created by this over-reliance on trying to create growth by shrinking negative output gaps. The first problem is relatively easy to identify: the policy is not economically sustainable. It is not possible to keep on creating economic growth by boosting aggregate demand because eventually the economy will run out of spare capacity. For example, in Figure 2 if the economy is already operating at full employment further increase in aggregate demand will create inflation, rather than short-run economic growth. For example, suppose that the economy is operating in equilibrium producing an output level of Y/Fe because aggregate demand is stable at AD3. If the government carries on injecting spending into the economy via continued fiscal deficits and/or further interest rate cuts the increase in aggregate demand created of AD3 to AD4 will only succeed in creating demand-pull inflation of AP2 to AP3.
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Increasing demand when the economy is already operating at full capacity will not create short-run economic growth because there is not a negative output gap to close. The second problem created by the desire to chase short-run economic growth is a growing current account deficit. If the economy is already operating at, or close, to full employment additional spending power injected into the economy by the government will suck in imports. Countries like Britain that have lived with current account deficits end up becoming progressively poorer over time. To finance a current account deficit countries have to sell off income-generating assets and/or take on debt from overseas creditors. Britain’s huge external debts can be traced back in part to the government’s and the Bank of England’s decision to pursue short-run economic growth to the exclusion of all else. The government’s response to the credit crunch induced recession of 2008-2009 said it all. Apparently the solution to all our problems was more reflationary demand-side policies designed to set the supermarket tills ringing again. Deeper, supply-side issues, such as low levels of investment and productivity in the UK were largely ignored.

Long-run economic growth
Long-run economic growth is caused by supply-side factors that lift the economy’s full employment output level. To create long-run economic growth virtually all economists now advise governments to use supply-side policies. These policies are designed to shift the long-run aggregate supply curve to the right. Figure 3 shows that it is possible to achieve economic growth even if the level of aggregate demand remains constant. Initially, the economy is operating in equilibrium producing an output level of NY1 because the levels of aggregate demand and aggregate supply are both stable at AD1 and LRAS1 respectively. If the government manages to increase the level of aggregate supply from LRAS1 to LRAS2, via supply-side policies, the result will be economic growth of NY1 to NY2. The average price level drops from AP1 to AP2. The fall in the average price level enables the same level of aggregate demand (AD1) to buy up a larger volume of goods and services. Economists refer to this situation as benign or harmless deflation (See Topic 9 for discussion of deflation). To maximise the rise in GDP made possible by the increase in aggregate supply, the government could also allow aggregate demand to grow. If aggregate demand is allowed to rise from AD1 to AD2, real GDP will increase again from NY2 to NY3. However, the government should avoid any temptation to increase aggregate demand beyond AD3 because the economy would start to overheat. Figure 3: Supply side growth

It is often said that China and India have relied heavily on an export-led approach towards creating economic growth. This is partially true; per capita incomes in both countries remain very low.
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This lack of domestic household demand has been compensated for by exporting output to countries in the economically developed world that have the higher incomes needed to pay profitable prices. However, this is only half the story. Unlike America and Britain, China and India have not relied solely on aggregate demand growth to create short-run economic growth. Instead, both countries have very high levels of saving and investment, which have boosted aggregate supply as aggregate demand has grown, making long-run, noninflationary, economic growth possible. So far both countries have been able to maintain very impressive rates of economic growth because policy makers in both countries have managed to match increased aggregate demand growth with increases in aggregate supply. As a result, the symptoms of overheating, namely demand-pull inflation and growing current account deficits have largely been avoided.

The Harrod-Domar model: the importance of saving
The Harrod-Domar model was developed by two Keynesian economists in the 1940s. The model puts forward the view that the rate of economic growth is a function of two variables: the savings ratio (S) and the marginal efficiency of capital (k). The savings ratio is the proportion of total income that is saved. The capital-output ratio measures the productivity of capital: the number of units of capital needed to produce an extra unit of output. The lower the capital-output ratio the higher the productivity of capital. According to the basic circular flow of income model, the level of national output will stabilise at the level where saving equals investment. The model also assumes a closed economy. In a closed economy there is only one injection, which is investment, (I), and one withdrawal, which is saving, (S). It therefore follows that the economy will reach equilibrium at the national income level where saving equals investment. In other words the Harrod-Domar model assumes that in the long-run saving will always equal investment. Therefore, if the level of saving in the economy increases, the level of investment will also increase too, and by the same margin. The Harrod-Domar model also points out that the rate of economic growth is also affected by the productivity of capital. Other things being equal, if the capital-output ratio falls, the rate of economic growth will increase. The Harrod-Domar formula: Economic growth Savings ratio Capital-output ratio For example, a country that saves 5% of its GDP will also be able to invest 5% of its GDP each year because saving equals investment. If the same county’s capital output ratio is 2, the country will require two units of capital to create an extra unit of output. This combination of an investment level of 5% and a capital-output ratio of 2 will produce an economic growth rate of 2.5% (5% / 2 = 2.5%). However, if the country can reduce its capital-output ratio to 1, the same level of investment will create a 5% rate of economic growth. Countries can reduce their capital-output ratios by investing in appropriate technology that they can operate and maintain successfully. Countries can also increase their economic growth rates by increasing the proportion of income saved. Countries that struggle to save also struggle to achieve meaningful rates of economic growth. Loan capital is an important source of finance for firms that are looking to purchase capital. Commercial banks obtain the funds needed to finance these loans from savers. In the 1970s economists argued that economic growth rates in the developing world were being held back by a shortage of loanable funds.
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=

The logic behind this view was simple: banks cannot make loans to their customers if they have no cash in their vaults to lend out! A shortage of loanable funds therefore restricts investment because without saving there cannot be investment. Economists that believed in the Harrod-Domar model argued that in very poor developing countries households might be too poor to save. Low per capita incomes meant that in order to meet basic subsistence needs, nearly every $1 of income earned would have to be spent on life sustaining goods, such as food, water and shelter. The resulting lack of saving in these economies constrained investment, which in turn condemned these countries to a very slow rate of economic growth. Furthermore these poor developing countries faced a classic poverty trap: to lift living standards faster rates of economic growth were required. However, to create faster rates of economic growth the population had to accept the need to save a greater proportion of their income. But, the decision to save more also meant that households would have to sacrifice some of their current consumption. The opportunity cost of a decision to create a faster rate of economic growth would be a fall in consumption in the short-run, leading to a rise in absolute poverty. At that time economists wrote about the dilemma facing developing countries: should developing countries sacrifice their living standards in the short-run, by adopting policies designed to lift the savings ratio, in order to create faster rates of economic growth in the long-run?

A Developing Country’s Dilemma
To create long-run economic growth investment is required. However, investment requires saving, which in turn requires households to forgo consumption. Figure 4 shows a Production Possibilities Curve (PPC) for a developing country that can use its factors of production to produce either food or capital goods. At present society has chosen to operate at point A on the PPC. All factors of production are devoted to food production. As a result, the output of capital goods is zero, i.e. there is no investment taking place. The output of food is F1, which is below the poverty line. F2 is the amount of food needed by the country to adequately feed its population. To overcome this situation the country needs to create economic growth that will push the production possibilities curve from PPC1 to PPC2. Economic growth of this amount would make a position such as point C attainable. At this point the output of food is above F2. However, in order to create this economic growth a very important sacrifice needs to be made in the short-run. To create the investment needed to stimulate growth, factors of production must be transferred from food production in order to allow capital good production to begin. The decision to move from point A to point B on the frontier enables i1 capital goods to be produced. The opportunity cost of this decision is that food production will fall from F1 to F0. Falling food production in the short-run will add to absolute poverty. Figure 4: The growth dilemma

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Economic growth in Britain has been held back by a lack of saving
To create meaningful rates of long-term economic growth, countries like Britain must also save to accumulate the loanable funds needed to finance productive investment. In the last decade both the UK and the USA have not saved or invested enough, explaining why both countries have achieved relatively modest rates of economic growth. In both countries there has been a general unwillingness on the part of both government and society to sacrifice current consumption in return for faster rates of long-term economic growth. Table 1 shows that the savings ratio in the UK fell quite dramatically over the last two decades. Since 2007 the savings ratio has turned positive again. Unfortunately, this rise in saving is unlikely to feed through to higher levels of UK investment, and hence long-run economic growth. The reason: households in Britain are saving to re-pay debt. Table 1: The UK savings ratio
Year 1992 1995 2000 2007 % of GDP 13.5 10 4 -1

Source: http://www.statistics.gov.uk/CCi/nscl.asp?ID=5927

There are several reasons that could be advanced to explain Britain’s low savings ratio: • Very low interest rates set by the Bank of England have reduced the financial incentive to save. Savers in the UK face negative real interest rates; the nominal rate of interest is less than the rate of inflation. Those willing to save and postpone consumption are penalised in Britain. Over time, the purchasing power of cash held on deposit in British banks falls over time. In Britain the government taxes interest income generated from savings. The only exception being interest generated from cash held in ISAs (Individual Savings Accounts). To encourage UK households to save more the government could stop taxing all interest income. In Britain the state offers a range of transfer payments, including: job seekers allowance, incapacity benefit and the state pension. These benefits reduce the incentive to save for precautionary reasons. In countries like China the government does not provide a comprehensive ‘cradle to the grave’ welfare state. Instead, individuals are expected to look after themselves. As a result, households in China are forced into saving more of their income. In the UK the benefits system actually discourages saving. For example, those with substantial savings might not qualify for a free care home, creating a moral hazard. For many UK households, nominal income growth has failed to keep pace with the rising cost of living. Falling real wages make it harder for households to generate the surpluses needed to save. House price inflation in the UK has also soared out of control, leading to higher monthly mortgage repayments. Many people in Britain do not save for a pension because they do not earn enough once housing costs are taken into account.
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Sadly, many British people have confused mortgage debt with wealth. In countries such as Germany that have managed to avoid property bubbles saving remains high because mortgage debt is lower. Lower rents and mortgage repayments in Germany enable the Germans to save more than the indebted British.

High levels of saving in China have created rapid rates of economic growth
The BRIC countries (Brazil, Russia, India and China) have achieved much faster rates of economic growth than either Britain or America. The reason is simple: unlike Britain and the USA, the BRIC economies do not suffer from a lack of saving and investment. In these countries the government and the people have been willing to sacrifice current consumption to finance saving and investment. High levels of saving have fuelled high levels of investment in the BRIC economies. In turn, these high levels of investment have created spectacular rates of economic growth. Over the last decade households in China have consistently saved 40% of their incomes. Unsurprisingly, China has consistently achieved similarly high levels of investment. Over the same period economic growth in China has averaged 10% per annum, which implies, according to the Harrod-Domar model, that the capital-output ratio in China must be approximately four. 40% (savings ratio) = 10% economic growth 4 (capital-output ratio) Figure 5: Chinese saving and investment, as a % of Chinese GDP

Source: constructed by the US economic think-tank, The Council on Foreign Relations, http://blogs.cfr.org/setser/2009/06/30/the-savings-glut-controversy-guaranteed/

Figure 5, shows the positive correlation between China’s savings ratio and its level of investment. When the savings ratio rises, the level of investment rises too. According to the Harrod-Domar model saving should equal investment. This is not quite true in China; during the period from 2004 until 2007 saving in China grew, however, the level of investment in China did not. The reason for this discrepancy was that at this time, China was exporting some of its surplus pool of saving to banks and governments in Europe and the USA. The inflow of liquidity into these countries expanded bank lending, creating asset bubbles and rising levels of debt in Europe and the USA.
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China’s decision to export some of its savings to the developed world enabled China to pursue a policy of export-led economic growth. Without access to China’s savings households in the USA and Europe would not have had access to the credit needed to buy Chinese imports. Figure 6: Growth rates in three countries

Source: http://www.google.com/publicdata/home

Figure 6 compares the rates of economic growth achieved by Britain, the USA and China over the last two decades. China has regularly achieved rates of economic growth in excess of 10%. Sadly, both the US and the UK economies appear to have struggled, achieving growth of less than 5%. Britain and the USA have struggled to grow because they have not saved enough. Low levels of saving mean low levels of investment. This is important because the main factor that creates economic growth in the long-run is investment. Investment boosts GDP by lifting the productivity of a country’s land and labour.

Conclusions
In relative terms the UK looks set to continue its decline against the rapidly-emerging BRIC countries. This decline will only cease when the UK is able to match the rates of economic growth being achieved by these countries. To catch up Britain needs to devote a greater proportion of its GDP to investment. Unfortunately, as a nation we seem to be unwilling to sacrifice current consumption. We remain extremely reluctant to save. But without saving there can be no investment. And without investment, economic growth will remain low. We seem unwilling to give up jam today, for more jam tomorrow. Misguided decisions made by central bankers and governments on both sides of the Atlantic have condemned the USA and the UK to anaemic rates of economic growth. In both countries short-term economic growth has been prioritised over long-term economic growth. British and US policymakers seem to be overly influenced by the Keynesian paradox of thrift. According to Keynes, saving, whilst being an individual virtue, is bad for the economy as a whole.
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According to Keynesians, saving should be discouraged because saving reduces consumption. If consumption falls, aggregate demand will also fall too. Falling levels of aggregate demand will cause national output to fall, creating a recession. The problem with the paradox of thrift is that it fails to acknowledge the vital role that saving plays in creating long-run economic growth. The UK and the USA will not grow properly again until they rediscover the need to save. To encourage saving the Federal Reserve and the Bank of England will need to raise interest rates. Whilst there are negative real interest rates on offer for savers, the incentive to save will remain low. Policymakers in Britain and the USA should learn from China: saving and investment create economic growth, not consumption. Finally, much of the investment that did take place in Britain and the USA prior to the credit crunch was wasteful and speculative, and not really worthy of the name investment. In both countries households were allowed to borrow huge sums of money in order to place speculative bets on the price of housing. Sadly, much of this money was wasted, a classic example of what Austrian economists refer to as malinvestment (This is discussed in Topic 5 ).

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Economists distinguish between short-run and long-run economic growth. Short-run economic growth arises when GDP increases because the economy is now making fuller use of its existing capacity. The most common cause of short-run economic growth is an increase in aggregate demand. On the other hand, long-run economic growth is driven by supply-side factors that increase an economy’s full employment output level. A good way of creating long-run economic growth is via investment, which increases factor productivity, boosting the economy’s capacity. In the last decade policy makers in Britain and the USA, obsessed by the paradox of thrift, have underplayed the importance of long-term economic growth, favouring short-run economic growth instead. Interest rates in the UK and the USA have been set too low, which has discouraged saving and encouraged consumption. This policy has helped to boost aggregate demand, creating short-run economic growth. However, low levels of saving have limited the loanable funds available for investment, which has compromised long-run economic growth. On the other hand, in China, where rates of economic growth are much higher, households do save. As a result, banks in China have the finance needed to grant loans to firms that wish to invest. Ironically, given the political system, the Chinese have quite rightly recognised that it is impossible to have capitalism without capital. To create meaningful economic growth countries must save in order to invest. To catch up with the rates of economic growth being achieved by China and India, the USA and Britain must rediscover the merits of saving. However, in order to save more British and US households will have to consume less.

Topic 3 Summary Topic 3 Questions

1. Compare and contrast short-run economic growth with long-run economic growth. 2. Explain why the pursuit of long-run economic growth invariably requires a fall in living standards in the short-run. 3. Policy makers in Britain and the USA reacted to the credit crunch by loosening monetary policy. Discuss the possible short-run and long-run impacts of near zero interest rates on the rate of economic growth.

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Topic 4 Is inflation targeting a good thing?
Monetary policy involves changing either the money supply or the rate of interest in order to influence either: the level of aggregate demand and the general level of economic activity; the rate of inflation; and/or the exchange rate. Monetary policy is carried out by central banks, such as the Bank of England.

The Objectives of Monetary Policy 1. Monetary (Price) stability
Central banks achieve monetary stability when inflation is low and stable. High rates of inflation are to be avoided because they make economies inefficient. For example, inflation will disrupt the workings of the invisible hand of the market if consumers are no longer able to track relative price movements. Inflation also creates a moral hazard because it unfairly penalises prudent savers at the expense of the profligate. The most important function of a central bank is to set monetary policy in order to preserve both the internal and external value of money. Central banks achieve this goal by adjusting interest rates and the money supply to prevent high rates of inflation and collapses in the exchange rate.

2. Financial stability
Financial stability is achieved when commercial banks and other financial institutions are deemed to be reliable and trustworthy. In the past central banks have been responsible for passing banking and other financial regulations that were designed to prevent bank failures. Financial stability is important because banks perform a vital role as financial intermediaries, i.e. they link savers with firms that wish to borrow for investment purposes. In 2007 UK financial stability was compromised by a bank run, culminating in the collapse of Northern Rock. At that time some households responded to UK financial instability by withdrawing their savings, preferring to keep their savings in cash at home instead. This loss of trust in the banks compromised their liquidity, which contributed towards the credit crunch. The Bank of England’s duties no longer extend to maintaining financial stability. In 1997, the then Chancellor, Gordon Brown, set up the Financial Services Authority (FSA) whose role was to regulate the financial sector.

The Monetary Transmission Mechanism
The monetary transmission mechanism describes how changes to the rate of interest affect the component parts, and the overall level, of aggregate demand in the economy, which in turn influences the rate of inflation. The interest rate is the price of money. Interest rate changes are a very powerful economic tool because the price of money affects three out of the four components of aggregate demand.

1. Private sector consumption
There are four reasons why lower interest rates lead to high levels of private sector consumption. The first relates to how interest rates affect the desire on the part of households to save. Lower interest rates reduce the average propensity to save within the economy.
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If interest rates fall the unearned income received from cash held on deposit falls. If the savings ratio falls, consumption must rise, because income can only be saved or spent. On the other hand, a fall in interest rates might encourage some households to live beyond their means. Borrowing to consume using personal loans, credit cards and overdrafts becomes cheaper and, therefore, more attractive when the interest rate falls. Lower interest rates will also reduce the cost of servicing existing loans too. The biggest debt that most UK households have is their mortgage. During the period from December 2007 to March 2009 the Bank of England slashed interest rates from 5.5% to 0.5%, which amounted to a 91% fall in the cost of borrowing! Households that had borrowed at variable mortgage rates had their monthly repayments reduced by hundreds of pounds. The additional disposable income created by falling monthly mortgage repayments helped to boost household consumption. Finally, lower interest rates boost consumption because lower interest rates tend to lead to higher asset prices. A good example is the price of housing. Lower interest rates make it cheaper to borrow to buy a house. The additional effective demand made possible by lower interest rates forces house prices up. Higher house prices create a positive real wealth effect for households. Households feel wealthier if their main asset, their home, has become more valuable. Rising house prices add to consumer confidence. House price inflation gave many households the opportunity to go out and borrow more against their appreciating asset. Many UK households gave up saving altogether – they viewed their house as their savings.

2. Private sector investment
Firms invest when they purchase capital. Investment can be for replacement purposes, for example, a piece of equipment may have worn out or become obsolete. In addition to replacement investment, firms also purchase capital to increase their productive capacity. Investment tends to be expensive. As a result most investment is financed via borrowed money. If the rate of interest increases, the profitability of investing decreases. However, the reverse will be true if the cost of capital falls. For example, an investment that is expected to yield a return of 5% will only go ahead if interest rates are less than this.

3. Net expenditure on exports (X-M)
The last component of aggregate demand is net expenditure on exports, or (X-M). The addition to domestic aggregate demand created by foreign trade is calculated by subtracting import expenditure from export income. For countries that run a current account surplus, the foreign trade sector will add to domestic aggregate demand. On the other hand, for countries like the UK that run current account deficits, the (X-M) component of aggregate demand will be negative. Monetary policy can affect this last component of aggregate demand because monetary policy has the power to influence the exchange rate, which in turn affects a country’s export income and import expenditure. For example, a fall in interest rates usually causes net expenditure on exports to rise. This is because monetary slackening creates hot money outflows from a currency, leading to a fall in the exchange rate. A lower exchange rate causes export prices to fall. If the demand for exports is price elastic, a fall in export prices will lead to a rise in export income. A weaker currency also pushes up import prices. If the demand for imports is price elastic, a rise in import prices will lead to a fall in import expenditure. If export income rises, and at the same time, import expenditure falls, the result will be a rise in net expenditure on exports and, other things being equal, a rise in aggregate demand.
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Monetary Policy Based on Inflation Targeting
Monetary policy based on inflation targeting is a relatively recent innovation. In the past policymakers considered a wide range of economic variables when making interest rate decisions. The idea behind the inflation targeting philosophy is that policymakers should only consider one variable when making monetary policy decisions: the rate of inflation. In Britain interest rates used to be set by democratically elected politicians. Politicians considered inflation as well as other economic variables, such as the value of sterling, debt and asset prices when making their monetary policy decisions. Gordon Brown gave away the government’s sovereignty over monetary policy in 1997 by making the Bank of England independent. At the same time Brown also asked the Bank’s Monetary Policy Committee (MPC) to set interest rates in order to achieve an inflation target set by the Treasury.

Inflation Targeting is Proactive, not Reactive
Central Banks such as the Bank of England and the ECB stress that interest rate decisions are not based on the current rate of inflation. Instead, interest rate policy is driven by the desire to achieve the Bank’s inflation target in 12 to 18 months time. The Bank of England’s proactive approach towards monetary policy can be explained due to time lags. The full impact of a change in the base rate of interest on the economy will not be immediately felt. For example, cutting interest rates will boost consumption amongst homeowners because lower mortgage repayments will boost disposable incomes. However, the short run increase in consumption created by this change will tend to be less than the long-run increase. For example, in the short-run households that have borrowed at fixed rates will not see their disposable incomes rise. But, in the longer term these households will be able to take advantage of lower rates by re-mortgaging once their existing fixed rate deal has expired. As a result, the full impact of an interest rate cut on consumption will take time to emerge. Central banks do not make monetary policy decisions on the basis of the current rate of inflation because interest rate changes made today will not affect the present rate of inflation. Instead, due to time lags, interest rate changes made now will affect the rate of inflation in the future. The MPC acknowledges the existence of time lags and adopts a proactive, rather than a reactive approach towards rate setting. For example, during most of 2008 UK inflation remained above the Bank’s target. However, despite this, the MPC refused to tighten monetary policy on the grounds that the Bank’s inflation forecast showed that inflation was expected to be below target in 12 to 18 months time. Therefore, raising interest rates at that time would have been the wrong thing to do. The interest rate rise would have further decreased aggregate demand, pushing inflation further below its target rate.

Symmetrical versus Asymmetrical Inflation Rates
A symmetrical inflation target is one that requires policy makers to set interest rates to ensure that inflation does not stray too far away from a central rate. Policy makers are granted an equal margin of error on each side of the central target rate. A good example of a symmetrical inflation target is the one set by the UK government. According to this target the Bank of England set interest rates to achieve an inflation target of 2%.
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The margin of error on each side of this central rate is 1%; implying that the Bank must not allow inflation to fall below 1%, or rise above 3%. This is shown in Figure 1. Figure 1: The Bank of England’s Symmetrical Inflation Target

The Bank of England’s symmetrical inflation target implies that the UK government believes that the risks and the associated problems of inflation and deflation are equal. If inflation is expected to rise above 3% the Bank of England is supposed to intervene by raising interest rates now in order to prevent inflation from rising above the ceiling rate. On the other hand, if the Bank of England believes that there is a risk that inflation could fall below the floor level of 1% they should reduce interest rates now to minimise the risk that this could happen. Keynesians believe that low inflation is a threat to the economy. Inflationary pressure, according to the Keynesians recedes when the level of aggregate demand grows slowly. The level of aggregate demand determines the level of output and employment. Sluggish demand growth therefore restrains inflationary pressure at the expense of economic growth. Furthermore, Keynesians also argue that low inflation has a tendency to morph into deflation. An asymmetric inflation target is one that forces policymakers to keep inflation below a certain level set by politicians. Unlike, a symmetrical inflation target there is no lower limit to an asymmetric target. A good example of an asymmetrical inflation target is the European Central Bank’s target to, “keep inflation close to, but below 2%”. This target implies that the ECB will respond to the threat of inflation breeching its 2% target. However, unlike the Bank of England, the ECB is under no obligation to react to the threat of low inflation, or even deflation, by cutting interest rates. Figure 2 illustrates the ECB inflation target. Figure 2: The ECB’s Asymmetric Inflation Target

The ECB must keep inflation close to, but below 2%. It could be argued that the ECB’s inflation target is asymmetric because unlike the Bank of England the ECB’s inflation target does not include a floor rate of inflation.
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Some Keynesians have put forward the view that the ECB’s asymmetric inflation target indicates that this central bank conducts its monetary policy with a deflationary bias. In other words, the ECB is obsessed with keeping inflation low. To maintain low inflation, the ECB will have to set high rates of interest, which will damage economic growth prospects in the Eurozone. This view can be criticised on several grounds. Firstly, the Keynesians have failed to fully comprehend the meaning of the ECB’s inflation target: “Keeping inflation close to, but below 2%”, is not the same as “keeping inflation below 2%”. In practice, during the first wave of the financial crisis, the ECB did respond to low rates of inflation of less than 1% by cutting interest rates. Secondly, as Table 1 illustrates, in practice the ECB operates with an inflationary, rather than a deflationary, bias.

The ECB’s Inflationary bias
Table 1 shows how inflation tolerated by the ECB has reduced the purchasing power of the euro over the last decade. Most households are unaware of this loss of value because the annual rate of inflation has never exceeded 3%. However, due to the effects of compounding, the impact in the long-term has nonetheless been dramatic. The inflation index series shows that over the period the ECB has allowed the internal value of money in the Eurozone to fall by about 25%! Table 1: The purchasing power of the euro Year 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Eurozone CPI inflation index 87 86 90 93 95 98 100 101 105 108 107 110 ECB’s interest rate 2.5% 4% 4.5% 3.25% 2% 2% 2% 2.5% 4% 4% 2.5% 1%

Source: http://sdw.ecb.europa.eu/quickview.do?SERIES_KEY=122.ICP.M.U2.N.000000.4.INX

The Bank of England’s Inflation Forecasting Record has been very poor!
Every quarter the Bank of England produces an inflation report, which includes an inflation forecast for the next two years. The inflation forecast is presented as a fan chart. The fan chart approach acknowledges that it is impossible to predict the future rate of inflation with utter certainty. The predicted outcomes shown in darker blue are more likely to occur than the predicted outcomes shown in the lighter shades. An example of a fan chart, taken from the May 2010 Inflation Report, is shown below. At that time inflation was above its target rate. However, the Bank of England justified its decision to keep interest rates low on the grounds that its fan chart predicted inflation to fall below its target rate within the next two years.

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Figure 3: The Bank of England fan chart

Source: Bank of England

Figure 3 shows that in May 2010 the Bank of England believed that the most likely outcome is that rate of inflation would fall sharply, but remain above its central target rate of 2% for the remainder of 2010. The Bank also predicted that the most likely outcome is in 2011 the rate of inflation will be below 2%. The fan chart also indicates that the Bank of England believed that there was an outside risk that there could be some modest deflation during 2011 and 2012. However, on the up-side there was also a perceived risk that inflation could rise above 3% during the same period. In the last decade the Bank of England’s inflation forecasting record has been as inaccurate as the Met Office’s long-range weather forecasts! However, unlike the Met Office, arguably the Bank of England’s forecasting errors have been asymmetric. The Bank of England’s fan charts have consistently overstated the risk of deflation, whilst consistently underestimating the risks of above target inflation. So why has the Bank of England been so bad at forecasting inflation? There are only two possibilities: The first is incompetence: the Bank of England’s inflation forecasting models could be wrong. The second reason could be that the Bank of England has made forecasting errors on purpose. In the past the Bank of England, by deliberately underestimating the future risk of inflation, has been able to keep interest rates lower than they otherwise would have been. Keeping interest rates artificially low provided a much needed to boost to UK households and firms that had borrowed heavily during the boom period. It could be argued that, when setting interest rates, the Bank of England has demonstrated an inflationary bias. If this situation persists the international community will start to doubt the inflation fighting credentials of the Bank of England. Just how committed is the Bank of England to its inflation target? In practice does the Bank of England make its interest rate decisions on the basis of its inflation forecasts, or does the Bank simply construct its inflation fan chats to justify interest rate decisions that it has already made?
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Figure 4: UK inflation and February forecasts (Annual % change in CPI)

Source: Goldman Sachs May 2010

The solid red line in Figure 4 shows the actual rate of inflation in the UK. The dotted lines show the inflation forecasts made by the Bank of England at specific points in the past. The chart shows that the Bank of England’s inflation forecasts have consistently underestimated inflation. For example, the inflation forecast made in 2007 predicted that by mid-2008 UK inflation would be just below 2%. This forecast proved to be laughably wrong. In the middle of 2008 inflation was well over 4%.

The Advantages of Inflation Targeting
Setting interest rates to achieve an inflationary target has the potential to create the following four advantages:

1. Transparency and accountability
In countries that operate an inflation targeting regime the goal of monetary policy is transparent, i.e. clear for all to see. In the UK households and firms know that the Bank of England will use interest rates to keep inflation below 3%, but above 1%. The Bank of England is also held accountable for its performance. If inflation rises above or below its target rate the governor of the Bank of England is obliged to write a letter of explanation to the Chancellor of the Exchequer. In an inflation targeting monetary policy regime it is possible to objectively assess the success or failure of the central bank’s monetary policy.

2. Economic stability
Economic stability occurs when the economy’s level of activity stays fairly constant over time. To achieve economic stability, policy makers intervene to moderate both the up and the down swings in the economic cycle. According to Keynesians, inflation targeting increases the chance that central banks will make the interest rate decisions needed to create economic stability.

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For example, if central banks are asked to set monetary policy to achieve an inflation target, the economy should never overheat. Keynesians believe that economic booms are caused by rising levels of aggregate demand. When the economy starts to run out of spare capacity demand-pull inflation picks up. In the past central bankers allowed the boom phase of the economic cycle to get out of control, creating instability. Today, this instability is less likely to occur. Inflation targets force central banks into raising rates well before booms get out of control. At the same time, the inflation targeting approach also reduces the risk of economic instability created by deep and prolonged recessions. Symmetrical inflation targets force central banks into cutting interest rates at a very early stage in the downswing phase of the economic cycle as soon as inflation falls below its target rate. Keynesians believe that an early slackening of monetary policy will reduce the length and the severity of any recession, contributing to greater economic stability. Economic stability makes it easier for firms to predict the future with greater certainty. As a result business confidence tends to improve during periods of stability, which stimulates investment, leading to higher rates of economic growth.

3. Low inflationary expectations
The phrase ‘inflationary expectations’ refers to the views formed by both households and firms regarding the likely rate of inflation in the future. Central banks believe that an important part of their role is to anchor inflationary expectations at a low level. Inflationary expectations are important because inflationary expectations can affect inflationary realities. If economic agents expect low inflation they will be more likely to behave in a way that makes low inflation more likely in the future. For example, if households believe that central banks will keep inflation low and stable they will be less likely to demand large nominal wage increases that could spark off a wage-price inflationary spiral. On the other hand, if trade unions expect inflation to accelerate in the future they will tend to make higher nominal wage claims. Higher nominal wage increases will lead to greater cost-push and demand-pull inflationary pressure. If households and firms believe that central banks are committed to achieving their inflation targets they will expect low inflation. If inflationary expectations can be anchored at a low level the central bank will have a better chance of being able to achieve its inflation target. Low rates of inflation that are maintained help to create economic stability. However, it is important to realise that inflation targeting will only deliver low inflationary expectations and economic stability if firms and households believe that the central bank is genuinely committed to setting policy to achieve the inflation target. During the period from 2007 to 2010, the Bank of England consistently underestimated inflation and ran negative real interest rates. If economic agents begin to question the integrity of central banks and their commitment to their targets, inflationary expectations will start to rise.

4. Flexibility
Inflation targets help central banks to achieve the very important goal of price stability. However, in addition, symmetrical inflation targets also enable central banks to make cuts in interest rates in response to the risk of a deflationary recession. Therefore, it could be argued that a symmetrical inflation offers policy makers a degree of flexibility when determining monetary policy.
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The Disadvantages of Inflation Targeting
There are however some problems involving inflation targets.

1. Selecting the right inflation target to pursue
Inflation targeting has the potential to deliver economic stability, but only if the right inflation target is set. The Bank of England’s inflation target is based on (CPI) Consumer Price Inflation, which is a very narrow measure of inflation. The CPI excludes housing, shares and other asset prices from the recorded inflation number. During the boom period the Bank of England kept interest rates too low for too long because consumer price inflation stayed below 3%. This prolonged period of inflation led to the build up of debt and asset price bubbles, which subsequently destabilised the UK economy. These problems could have been avoided by higher interest rates. Higher interest rates would have made debt more expensive to take on and service. In addition, higher interest rates would have reduced the speculative demand for housing, which created an unsustainable bubble in this market. In many ways the origins of the UK’s financial crisis can be traced back to a decision made by Gordon Brown’s in 2003, which asked the Bank of England to set interest rates to achieve an inflation target that completely ignored the price of housing, or any of its associated costs. Some economists have argued that the government should revise the Bank of England’s inflation target. These economists believe that the current inflation target is too strict. If a higher upper limit is set the Bank of England will be able to tolerate higher rates of consumer price inflation without being forced into raising interest rates. These economists hope to use inflation to erode the real value of the UK’s debts to foreign creditors. Unfortunately, any move on the part of the government to change the Bank of England’s inflation target could backfire. A decision to upwardly revise the inflation target will lift inflationary expectations within the economy. If inflationary expectations rise, the government will probably have to raise the nominal rates of return offered on UK government bonds, which will increase the cost of servicing the UK’s national debt. Higher rates of inflation created by rising inflationary expectations will also damage the UK’s international competitiveness too.

2. Should interest rates be set solely with regard to inflation?
Interest rates are a very powerful policy instrument because changes to the price of money tend to have a profound effect on the level of aggregate demand, and hence the real economy. However, should interest rates be set purely on the basis of achieving an inflation target? It could be argued that many of the problems of the last decade could have been avoided had the Bank of England been asked to consider other economic variables apart from inflation, when setting interest rates. The combination of immigration from Eastern Europe and cheap exports from China enabled the Bank of England to meet its inflation target during the boom years. With the benefit now of hindsight the Bank of England should have raised interest rates in 2005, not cut them. Higher interest rates would have taken some of the air out of the speculative bubble forming in property. In addition, tighter monetary policy would have reduced the demand for imports, improving the UK’s problematic current account balance. Finally, higher interest rates would have encouraged UK households to save more and to take on less debt.
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It could be argued that inflation targeting created three adverse unintended consequences for the UK economy: 1. A destructive speculative bubble in the housing market: cheap and plentiful credit drove up the effective demand for housing, increasing its price (See Topic 5
for further discussion).

2. Rising household debt: house price inflation forced first time buyers into taking on ever higher levels of mortgage debt. Rising household debt reduces long-term living standards because higher interest payments created by larger debts will reduce future disposable incomes (See Topic 5). 3. A huge current account deficit: house price inflation created a positive wealth effect for homeowners. At the time UK banks allowed homeowners to take out second mortgages on their properties. The equity withdrawn was used to purchase (mostly) imported manufactured goods. Rising UK import expenditure pushed the UK’s current account balance further into deficit. Borrowing to consume imported goods from abroad created a second layer of UK household debt. At the height of the housing boom in 2007 mortgage equity withdrawal contributed over £12bn to UK aggregate demand. There is evidence to suggest that the Bank of England spotted many of the problems outlined above. For example, in 2004 the Governor of the Bank of England, Mervyn King, warned that UK house prices were, “well above what most people would regard as sustainable in the longer term”1. Unfortunately, the Bank of England was powerless to act. The Bank could not raise interest rates to prevent this bubble from inflation because at that time CPI inflation was still within its target range and expected to remain there (See Topic 10 for futher discussion).

How Might UK Monetary Policy be reformed?
The most obvious policy change would be to abandon the failed inflation targeting experiment. Instead, when setting interest rates, central banks could be asked to adopt a more holistic approach. When making monetary policy decisions, central banks should be asked to consider a range of variables. In addition to the expected rate of inflation these factors might include: 1. Levels of private sector debt: It could be argued that the Bank of England should consider the affordability of the debts taken on by both UK households and firms when setting interest rates. The risk of default increases when debt increases relative to income. In the future it might be wise to monitor household debt as a percentage of GDP. When debt rises too high, interest rates should be increased to discourage any further accumulation of debt. 2. The current account balance: Central banks should be aware of persistent current account deficits, especially if the deficit has been created by borrowing to finance consumption. Over a prolonged period, persistent current account deficits increase a country’s external debt, which increases the risk of national bankruptcy. To avoid this situation, central banks could raise interest rates to deflate aggregate demand. The fall in import sales that results will push the current account towards equilibrium.
1 http://news.bbc.co.uk/1/hi/business/3806961.stm Crisis Economics: The Cutting Edge Topic 4 41

1.

2. 3. The level of unemployment: If central banks anticipate rising unemployment they could respond by boosting aggregate demand by slackening monetary policy. Keynesian economists argue that slack monetary policy should be used in conjunction with expansionary fiscal policy in order to fight off the threat of recession and rising unemployment. 4. Asset prices: Inflation occurs when the purchasing power of money falls. At present the government’s preferred measure of inflation completely ignores the effects that inflation has on the affordability of assets such as housing. If interest rates are to be set according to an inflation target, the target cannot be consumer price inflation. Instead, the new inflation target must be based on a broader measure of inflation that includes asset price inflation. The RPI includes house prices within its average basket of goods. However, it might be argued that the RPI is still too narrow as an inflation measure because there are other assets apart from housing. For example, a new broader measure of inflation that could be used for inflation targeting purposes would have to include the price of other assets, such as shares, land and possibly bonds.

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Monetary policy concerns adjusting the rate of interest and the money supply in order to affect the real economy and the rate of inflation. In recent times most central banks, the Bank of England included, have set interest rates in order to achieve an inflation target. Inflation targeting is designed to create macroeconomic stability. Central bankers will be forced into raising interest rates during a boom if inflation looks like it could exceed its target. The rise in interest rates will help to cool the economy, ensuring that booms are never left to get out of control. Setting inflation targets will also help to manage down inflationary expectations within the economy. This is important because inflationary expectations affect wage negotiations, which in turn affect both demand-pull and cost-push inflation. The Bank of England’s inflation target is symmetrical, i.e. to keep CPI inflation to within 1% of a 2% central target. Supporters of this type of inflation target argue that deflation and inflation are equally problematic. If CPI looks likely to fall below 1% the Bank of England is obliged to act by cutting interest rates in order to prevent the risk of deflation. The European Central Bank’s inflation target is to keep CPI inflation close to, but below 2%. Some economists argue that this type of asymmetric inflation target represents a deflationary bias in policy making. In practice, central bankers on both sides of the Atlantic set interest rates with an inflationary bias: deflation is extremely rare. Furthermore, low positive rates of inflation achieved by central banks quickly erode the internal purchasing power of money due to compounding effects. Critics of inflation targeting argue that central bankers should take other variables into account when setting interest rates other than the anticipated rate of inflation. During the boom years a combination of immigration and China’s rapid industrialisation kept inflation artificially low. As a result, in countries like Britain and the USA interest rates stayed too low for too long. These low interest rates created malinvestment, most noticeably in property, where speculative bubbles formed. Cheap money also encouraged households to borrow and spend, contributing to balance of payments problems. It could be argued that central banks should take into account other variables apart from inflation when setting interest rates. These other variables could include: household debt, asset prices, the exchange rate and the current account balance.

Topic 4 Summary

Topic 4 Questions

1. The Bank of England has two goals: to maintain both price and financial stability. Explain the possible conflicts that the Bank might face when trying to achieve these goals simultaneously. 2. Distinguish between an asymmetric and a symmetrical inflation target. 3. Discuss whether the European Central Bank conducts monetary policy with a deflationary bias. 4. Some economists have argued that the inflation targeting approach to monetary policy was instrumental in creating a property bubble and an unstable UK economy crippled by debt. To what extent do you agree with this view?

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Topic 5 Why has the availability of credit caused a housing bubble?
UK House Price Inflation
Rising house prices have had a dramatic impact on the UK economy. According to data collected by the Lloyds Banking Group, the average price of a UK home in 1983 was just £30,898. However, by 2007 this figure had risen to £196,478. In percentage terms this amounts to an increase of 636%.

Housing is a cyclical market
House prices in the UK have not increased at a constant rate. Instead, the market goes through periodic booms, and slumps. Booms tend not to be followed by soft landings. Instead, when booms end the market has a nasty tendency to crash. During the crash house prices fall as dramatically as they rose during the preceding boom. Figure 1 shows the cyclical nature of the UK housing market. The figures are shown in real terms, i.e. once the effects of general inflation have been taken into account. The red line on the chart shows that the general trend in inflation adjusted house prices has been upward; indicating that over the period shown the rate of house price inflation has exceeded the general rate of inflation in the economy as a whole. The chart shows the 15 year super-boom in house prices, from 1995 until 2007. The chart also shows the crash of the early 1990s, and more recently the crash of 2008-2009. Figure 1: Real House Prices

Source: http://www.housepricecrash.co.uk/graphs-average-house-price.php

The housing market attracts more amateur analysis from would-be economists than any other. The nation’s media has definitely contributed to the UK’s property bubble. Channel 4 led the way, commissioning a plethora of property-related T.V. programmes such as: Location, Location, Location; A Place in the Sun, Home or Away; and, Property Ladder. Even the BBC felt compelled to join in the property-ramping action, running shows such as Homes under the Hammer, and To Buy or Not to Buy. These television programmes have been extremely influential in shaping British attitudes towards property. The main message being that the road to riches was to borrow heavily from the bank in order to buy property. Then, after applying a couple of coats of magnolia, sit back and watch the price of the asset rise, before selling on for a profit at a later date!
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Television news bulletins have also been afflicted by property propaganda. Those with vested interests, including: estate agents, mortgage providers and professional organisations, like the Royal Society of Chartered Surveyors, are usually chosen to appear on news programmes to offer their expert view on the likely direction of UK house prices. Arguably these ‘experts’ tend to be habitual optimists, forecasting rising house prices for the foreseeable future. They rightly point out that house prices are a function of the relative strength of the supply and demand for housing, and that house prices in Britain have risen because the demand for housing has grown at a faster rate than its supply. The consensus view amongst the general public is that the main factor that has driven UK housing demand is immigration: if more people come to live and work in Britain, the demand for housing must go up! This consensus view is incorrect. Housing demand has increased, but most of this increase is not immigration related; the basic flaw being an inability to distinguish between potential and effective demand. Potential demand is an idle want; a desire that is not backed up by an ability to pay. Potential demand does not affect market price. Only effective demand has the power to influence market price. Effective demand is demand that is backed up by hard cash. The vast majority of immigrants that arrive in Britain come with very little cash. They also tend to do low paid jobs. As a result, their ability to influence house prices is extremely limited. The demand for housing amongst immigrants tends to be potential, not effective. This explains why most immigrants in the UK end up living in rented housing. Figure 2: The UK housing market

The supply of housing in the UK tends to be price inelastic. Builders would like to respond to rising house prices by building more houses. However, their ability to do so is limited by the UK’s restrictive planning laws. As a result, even small changes in demand create an exaggerated effect on market price. Figure 2 illustrates that during the recent housing boom the demand for housing increased, say from D1 to D2, which forced the price of housing up from P1 to P2. Vested interests, such as mortgage lenders and estate agents, argue that the main factor that drove demand up was immigration. This is incorrect because the demand for housing, like any other good or service is determined by effective, not potential, demand. The real reason for the increase in demand relates to changes in the price and the availability of credit.
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What caused the UK’s 15 year-long house price boom?
UK house price inflation was caused by an increase in the effective demand for property. The most important factors that increased the demand for UK housing were as follows: 1. The increased availability of credit which arose from high lending multiples, high loan-to-value ratios, interest only mortgages, self-certification of mortgages and loans for buy-to-let property purchase 2. The falling price of credit 3. Speculative demand 4. Government intervention We now consider each of these factors increasing the demand for housing in turn.

1. The increased availability of credit which arose from high lending multiples, high loan-to-value ratios, interest only mortgages, selfcertification of mortgages and loans for buy-to-let property purchase
Most houses are bought with borrowed money. Therefore, the most important factor that affects the demand for housing is the availability of credit. If credit becomes easier to obtain, the demand for housing will increase. During the boom years the demand for housing increased because banks gradually, over time, increased the amount that they were prepared to lend to prospective house buyers. Twenty years ago banks were quite prudent in their mortgage lending. Typically, single buyers were allowed to borrow up to three times their salary, whilst married couples could only borrow 2.5 times their joint income. In addition, buyers were also expected to contribute a deposit. Figure 3: BBA Mortgage Value - Average value of loan for house purchase

Source: British Bankers’ Association - http://www.bba.org.uk/

Figure 3 shows that the average value of a mortgage granted for a house purchase increased by over 150% during the period from 1997 to 2007. This increase in the availability of credit provided prospective buyers with the hard cash needed to pay higher house prices. Unsurprisingly, over the same period, the average price of a house in the UK rose from £68,504 to £196,478, an increase of 186%. Without the extra credit supplied by Britain’s banks, house price inflation on the magnitude seen would have been impossible. Credit enabled households to pay higher prices.
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To maintain house price inflation during the boom, banks had to feed ever higher levels of credit into the housing market. Examples, of reckless UK sub-prime mortgage lending included: • High lending multiples: in the late 1990s banks relaxed the old rule that a borrower’s mortgage should not be more than three times higher than their annual salary. Over time lending multiples increased. At the height of the property boom it was possible to find lenders willing to provide mortgages seven or eight times higher than the borrowers’ income! Lending at high multiples of salary is risky because it increases the size of the borrower’s debt relative to their ability to service the debt. At the time the banks defended their lending decisions by making reference to low interest rates. At lower interest rates households could load up on more debt and still be able to make the repayments. Figure 4: First time buyer house price to earnings ratio

Source: University of Salford: http://live.scri.salford.ac.uk/?p=782

During the boom years from 1997 to 2007 UK house prices soared. An important cause of this inflation was rising lending multiples. Figure 4 shows that in 1997 UK banks were on average only willing to lend first time buyers 2.5 times their salary. At the height of the boom in 2007 this multiple had risen to 5.5 times income. The relaxation of bank lending increased the amount buyers were willing and able to pay, increasing the effective demand for housing. • High Loan-to-Value (LTV) ratios: before the property boom, lenders required potential home buyers to contribute a deposit towards their purchase. For example, thirty years ago a couple that might have wanted to buy a house for £25,000 might have been asked by the bank to contribute a deposit of 10%, i.e. £2,500. In this case the LTV ratio would have been 90%. The requirement for the borrower to contribute a deposit was justified on the grounds of prudence. From the lenders point of view asking a potential borrower to save a deposit indicated that the borrower was a reasonable risk. Lending to those who lacked the self-discipline to save up a deposit was asking for trouble. In addition deposits would also provide a cushion for the lender just in the case house prices fell.
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During the boom years UK mortgage lenders gradually relaxed their requirement for prospective buyers to contribute a deposit. As a result UK LTVs rose. Most lenders provided 100% LTV mortgages for first time buyers. Northern Rock went one step further offering potential buyers 125% mortgages. For example, a first time buyer that wanted to buy a house for £200,000 was allowed to borrow £250,000! High LTV lending by banks added extra spending power into the market, forcing up prices even higher. Unfortunately, granting mortgages with a LTV ratio of above 100% creates negative equity. Negative equity is a situation where the mortgage debt exceeds the market value of the house. Negative equity creates a problem for the lender: if the house has to be re-possessed, because the borrower loses their job, the bank stands to make a loss, because the cash generated from the sale of the repossessed house will not be enough to pay off the outstanding mortgage debt. • Interest only mortgages: this type of mortgage reduces the monthly cost of borrowing because the borrower has opted to just pay the interest due on their debt. Alarmingly, in 2010, of the 11.4m mortgages in Britain currently outstanding, 41% are interest only! Most of these borrowers are not even aware that their monthly payments are not paying off their mortgages. In effect these homeowners have chosen to rent their homes from their mortgage lender. Interest only mortgages forced the demand for housing up because it enabled prospective buyers to borrow more in order to pay high house prices. Self-certificate mortgages (‘liar loans’): a self-certificate mortgage enables a prospective house buyer to borrow without having to provide documentary proof of their income to their lender. In the past, when banks were prudent, lenders insisted that borrowers had to provide wage slips and bank statements in order to prove to the bank that they were capable of repaying their debt. During the boom years banks gradually relaxed this requirement. In some cases banks actually encouraged borrowers to lie and overstate their income. By doing so the borrower could obtain the additional debt needed to pay higher house prices. Halifax Bank of Scotland (HBOS) was the UK’s champion of this form of sub-prime lending. According to former HBOS manager, Michael Bolton, “HBOS had five brands, all offering products without proof of income. It was offering a lot of self-cert, a lot of buy-to-let that needed no proof of income and a lot of Halifax’s mortgages were ‘non-verified income’ loans, which was essentially fast track. Before the credit crunch, as much as 80% of HBOS’ loans were going through without full proof of income.” 1 Unsurprisingly, many of these borrowers subsequently defaulted on their lie-to-buy loans because their debts were too big relative to their actual incomes. The defaults led to huge losses for HBOS, which had to be rescued via a combination of a secret £25.4bn loan supplied by the Bank of England and by the subsequent takeover of HBOS by Lloyds-TSB. In 2004 the BBC carried out undercover research into the UK mortgage market. The Money Programme discovered that banks were creating house price inflation by inviting their own customers to defraud them! The film “Mortgage Madness” caught bank employees and mortgage brokers advising their clients to lie about how much they earned in order to purchase property that they really could not afford. Prospective buyers were informed that in order to get the cash they needed to purchase their dream home it would be necessary to go down the self-certificate route.
1 http://www.glitec.co.uk/2009/07/no-income-check-with-80-percent-of-hbos-loans/ Crisis Economics: The Cutting Edge Topic 5 48

For example, a prospective buyer seeking a mortgage from a lender willing to lend at 6 times salary needing a mortgage of £600 000 would be advised to self-certify their income as £100,000 per year, even though their real income was well below this level. Self-certificate mortgages were initially targeted at the self-employed who found it hard to provide payslips to prove their income. Today, many industry insiders recognise the misuse of self-certification, using the phrase ‘lie-to-buy’ to describe this type of mortgage. • Buy-to-Let: buy-to-let mortgages are taken out by people that want to borrow to buy a home that they do not wish to live in. Buy-to-Let mortgages are used by property investors who hope to profit from the rental income that they receive and from the hope that rising house prices in the future will provide a capital gain. House prices in the UK are very high relative to rents. Therefore, the yields achieved by property investors are not attractive. Despite this Buy-to-Let is still popular. The main reason being that banks are willing to advance huge loans to those that are willing to speculate on continued house price inflation. From the speculators perspective this proposition is attractive. In the past many of these speculators were able to make their bets without using any of their own money at all. During the boom years of reckless lending banks were willing to advance 100% LTV loans to potential Buy-to-Let investors. Lenders that did require a deposit were helped by builders that specialised in constructing inner city flats. These companies helped their clients by providing cash-back deals. The cash being used to pay any deposit required by the Buy-to-Let mortgage lender. The great depression of the 1930s was caused by ordinary Americans being able to borrow huge sums in order to speculate on rising US share prices. During the roaring 20s the US stock market boomed due to the extra demand for shares created by the wall of borrowed money hitting the market, made possible by reckless bank lending. When the stock market bubble burst, asset prices fell like a stone, however, the debt built up by ordinary Americans remained, and a deflationary depression ensued. The US government reacted by regulating the banks, preventing banks from granting loans to people that wanted to borrow in order to speculate on share prices. Unfortunately, the broader lesson appears not to have been learned. How can it be right for banks to advance huge sums of money to ‘investors’ that wish to speculate on rising share prices? There is nothing wrong with property speculation, provided that the speculator uses his or her own money, rather than the bank’s money. Buy-to-Let mortgages financed over 1.1m property purchases in the UK. The impact that this type of lending had on the UK property market should not be underestimated because it created a new type of demand for housing, which was largely speculative.

2. The falling price of credit
In addition to the availability of credit, the price of credit also affects the demand for housing. The price of credit is the rate of interest. Over the last decade central bankers in both America and Britain reacted to events such as the bursting of the dot.com bubble and 9/11 by cutting interest rates. Lower interest rates reduce the monthly cost of servicing a mortgage debt. Therefore, lower interest rates increase the effective demand for housing because they enable prospective buyers to obtain bigger mortgages.

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Figure 5 shows the trend in UK real interest rates over the last 25 years. The real interest rate is calculated by subtracting the rate of inflation from the nominal rate of interest. For example, if a bank is prepared to offer its savers a nominal rate of interest of 1.5% at a time when inflation is 5.3%, the real rate of interest on offer for savers will be equal to -3.8%. The decision by the Bank of England to slash nominal interest rates to 0.5% created negative real rates of interest. Negative real rates of interest were designed to boost asset prices and to help the economy move out of recession. To an extent the policy has worked. Poor rates of returns on cash drove money back into property and shares, boosting the prices of these assets. Negative real interest rates also discouraged saving and encouraged a final round of debt driven consumption, which helped the economy out of recession. Figure 5: Real Interest Rates, UK

Source: www.greenenergyinvestors.com/

It could be argued that the inflation targeting approach towards monetary policy also contributed to asset price bubbles. Central banks kept interest rates too low for too long because CPI inflation remained within its target range. During the boom years inflation in the UK remained low due to two factors that were beyond the control of the central banks. The first factor that created low CPI inflation was immigration into Britain from Eastern Europe. The resulting increase in the supply of labour in the UK helped to reduce UK wage inflation. Low rates of wage inflation restrained both demand-pull and cost-push inflationary pressure in Britain. The second factor is ‘the China effect’. Rapid industrialisation in China and in the other BRIC countries created a surge in the supply of consumer goods. This increase in world supply helped to keep the lid on prices. China’s ability to fill the world with low cost products played a crucial role in keeping UK CPI inflation within its target range because many of the products that were included within the UK’s CPI basket were made abroad in places like China, rather than in Britain.

3. Speculative demand
The desire to buy housing as an investment has also contributed to UK house price inflation. The belief that house prices always go up has become ingrained in the nation’s collective psyche. The expectation of future price rises created a self-fulfilling prophecy. Property speculators bought housing in anticipation of a capital gain. The extra demand brought to the market by these speculators created the house price inflation that was anticipated. Ever higher levels of speculative demand were made possible by the relaxation of bank lending. The result was the formation of a speculative bubble in the housing market.
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4. Government intervention
The tax system has helped to boost the demand for housing. Capital gains tax is paid when an asset is sold for more than it was bought for. The rate of capital gains tax affects the speculative element of the demand for housing. Gordon Brown’s decision to reduce the rate of capital gains tax to 18% benefited property speculators because it meant that they kept a greater proportion of their profits. In addition, the income tax system also benefitted Buy-to-Let property speculators. Property investors are obliged to pay income tax on their rents. However, in the UK, mortgage interest is classified as a tax deductable expense. For example, a landlord that bought a house that rents for £2,000 per month, who pays mortgage interest of £1,500 per month, will only pay income tax on the net monthly income of £500. The UK benefits system has also stimulated the demand for Buy-to-Let property. A good example is housing benefit, which is paid by the government to low income households, who would otherwise struggle to pay the rents charged by private landlords. During the Labour government, expenditure on housing benefit soared. Landlords benefited from the extra demand created by housing benefit payments by raising rents. Higher rents increased the yield on property. As a result the demand for housing from investors increased, which contributed to house price inflation. In June 2010 the new government decided to place a cap of £400 per week on housing benefit payments. This change will reduce the effective demand for rented housing. In the future rents are likely to fall, leading to lower yields.

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Table 1: The UK Property Roller Coaster
Year Average UK Annual rate of house price house price inflation 7.2% 9.1% 11% 15.4% 23.3% 20.8% 0.0% -1.2% 5.5% 2.9% 0.5% -1.7% 4.5% 6.3% 5.4% 7.2% 9.8% 8.5% 17.4% 22.4% 18.3% 5.7% 8.3% 9.4% -7.9% -10.5% 3.38% House price index 100 107.2 117 129.9 149.9 184.8 223.1 223.2 220.5 208.1 202.1 203.1 199.6 208.6 221.7 233.7 250.5 275.1 298.6 350.6 429.1 507.6 536.6 581.3 635.9 585.9 524.6 542.33

1983 £30 898 1984 £33 117 1985 £36 145 1986 £40 126 1987 £46 315 1988 £57 087 1989 £68 946 1990 £68 950 1991 £68 130 1992 £64 309 1993 £62 455 1994 £62 750 1995 £61 666 1996 £64 441 1997 £68 504 1998 £72 196 1999 £77 405 2000 £85 005 2001 £92 256 2002 £108 342 2003 £132 589 2004 £156 831 2005 £165 807 2006 £179 601 2007 £196 478 2008 £181 032 2009 £162 085 2010 £167 570 (May)

In the late 1980s the UK economy boomed. The demand for housing increased due to the relaxation of bank lending standards. Wage inflation also contributed to house price inflation too. House prices in the early 1990s fell due to a combination of high interest rates and a severe recession which led to thousands of homes being re-possessed. House prices rose rapidly as a result of interest rate cuts that followed the bursting of ‘the dot com bubble’ and the 9/11 attacks. Prices carried on rising as lending standards were relaxed. The credit crunch reduced the availability of credit, which led to falling house prices during 2008 and 2009. A combination of the banking bailouts and £200bn of quantitative easing provided UK mortgage lenders with the liquidity required to resume mortgage lending. As a result of this intervention the UK government was able to re-start house price inflation.

Source: http://www.nationwide.co.uk/hpi/historical.htm

The impacts of house price inflation on the UK Economy House price inflation has had a variety of effects on society and the UK economy. Some of these effects have been positive. On the other hand rising house prices have created a range of issues that have reduced the UK’s standard of living and have led to economic instability. We can identify six issues: • Higher levels of aggregate demand, creating short-run economic growth • Higher taxation revenue • Increase in the balance of trade deficit • Raising the level of household debt • Increasing the indebtedness of the banks • Heightening wealth and income inequality • Diverting investment from the productive capacity of the economy We consider these issues in turn.
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1. Higher levels of aggregate demand, creating short-run economic growth
During the boom years when house price inflation was accelerating many UK households felt better off because the value of their asset was appreciating relative to the amount that they owed, which remained constant. The additional equity created by house price inflation increased the net worth of households that had mortgages. Households responded to the perceived increase in their wealth by spending most of it. Households reasoned that a £5,000 credit card debt built up to pay for a foreign holiday or a new car did not really matter because their homes were rising in value at a much faster rate than their debts. UK banks made it even easier for households to spend the equity locked up in their houses by granting homeowners second mortgages, which could be spent on anything the homeowner wished. The technical term for this type of lending is mortgage equity withdrawal. Figure 6: Housing Equity Withdrawal

Source: The Bank of England: http://www.bankofengland.co.uk/statistics/hew/current/index.htm

The role that mortgage equity withdrawal played in supporting UK consumption cannot be under-estimated. Wage inflation in the UK has been held in check during the last decade by globalisation. At the same time, the cost of living has increased at a steady rate. As a result, real wages in the UK have fallen, particularly amongst the low skilled whose jobs are easy to outsource. In the face of falling real wages, UK households opted to maintain their lifestyles by taking on debt. Figure 6 shows that during the boom years mortgage equity withdrawal was regularly contributing billions of pounds to UK aggregate demand. For example, in 2003 nearly 9% of UK household income was borrowed via mortgage equity release. The credit crunch led to a dramatic fall in consumer spending. The chart shows that by 2008 UK households were beginning to reduce their mortgage debt. The boost to consumption created by rising house prices enabled the UK economy to achieve short-run economic growth. This type of growth arises when GDP increases because the economy is now making fuller use of its existing capacity.

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Figure 7: House prices and economic growth

House price inflation gave households the confidence to take on additional debt which was used to finance consumption. The increase in consumption created an increase in UK aggregate demand. The increase in aggregate demand from AD1 to AD2 shown in Figure 7 lifted the equilibrium level of national income from NY1 to NY2, which created short-run economic growth of the same amount. During the boom years the extra demand made possible by mortgage equity withdrawal and other forms of debt helped to create jobs in retailing, restaurants, health clubs etc that soaked up the additional discretionary consumer spending.

2. Higher taxation revenue
House price inflation boosted the government’s tax revenues. A good example is stamp duty, which is paid by house buyers. Rising house prices enabled the government to collect more stamp duty. For example, at a rate of 1% the government would receive tax income of £2,000 per transaction if the average price of a house was £200,000. However, if the average price of a house increased to £250,000 the government would receive an additional £500 in stamp duty on each house sold. During the period from 2002 to 2007, stamp duty income increased by 140%. The property boom also enabled the government to collect more VAT. The combination of rising house prices and relaxed credit enabled UK households to go on a spending binge. The growth of the Buy-to-let sector also contributed to rising indirect tax revenues. Small time property investors spent billions of pounds on home improvements, which benefited UK retailers selling kitchens, sofas, flat screen TVs and other fixtures and fittings needed to re-fit houses. The UK’s banks also did well out of house price inflation because rising house prices gave many UK households the confidence to take on more debt. Higher levels of debt enabled the UK’s banks to generate additional interest income, which increased their profits. The banking sector generates over 25% of the UK’s corporation tax. According to the British Bankers Association, the UK’s financial sector employs over 1.1m people. Therefore, the sector also pays huge sums of tax to the government via national insurance.

3. Higher balance of trade deficits
A country runs a trade deficit when its income from selling goods abroad is less than its expenditure on imported goods. During the boom years the UK ran a trade deficit. It could be argued that rising UK house prices were partially responsible for this situation. House price inflation encouraged UK households to borrow and spend. Unfortunately, a high proportion of this extra spending went on buying imported goods.
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The Buy-to-Let property bubble indirectly fuelled the UK’s demand for imported Italian kitchens, Japanese flat screen HD TVs and Swedish furniture. All of these goods were bought by property developers to renovate their investments.

4. Higher levels of household debt
The vast majority of houses bought in the UK are financed via mortgages. Cheap and easy credit supplied by banks forced up UK house prices. Unsurprisingly, as house prices rose, the stock of debt owed by UK households rose too. Banking practices such as mortgage equity withdrawal added to the stock of debt owed by households. In addition, it could also be argued that the wealth effect created by rising house prices might be partially to blame for the rise in UK credit card debt. According to figures published in July 2010 by the charity Credit Action, the average amount of unsecured personal debt owed by UK households that have this type of debt was a staggering £18,159, and this figure does not even include mortgage debt! Figure 8: UK household debt

Source: ONS

Total UK personal debt currently stands at £1,460bn. This is a monumentally large figure, which is well in excess of the entire country’s annual GDP. During the boom years UK aggregate demand was bolstered by the willingness of UK households to take on new lines of credit. In practice aggregate demand cannot be permanently supported by UK households borrowing in order to undertake spending because, eventually, the stock of debt owed grows too large for the debtor to service from their current income. There is strong evidence to suggest that this turning point has already been reached. Record numbers of UK households are defaulting on their debts because they cannot pay them, even at very low rates of interest. The problem with debt is that it has to be paid back, and with interest added on top. Unfortunately, the level of private sector consumption is likely to be crushed in the future. Banks that have been badly burned by their own reckless lending are likely to withdraw credit from households that would like to live beyond their means. Attitudes towards debt are likely to change too. If households begin to re-pay their debts, households will have chosen to spend a lower proportion of their incomes. High levels of UK household debt will make it harder for the UK economy to recover. High levels of personal debt are a reflection of high UK property prices.
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5. Insolvent banks
Banks make profit by charging borrowers higher rates of interest than they pay to savers. In the short-run an increase in household debt enabled banks to generate more interest income and, therefore, profit. The bigger the amount owed, the greater the interest income received by the bank, provided that the borrower does not default. The banking crisis started in 2007 when the numbers of households defaulting on their mortgages and credit card debts increased. When a customer fails to repay a debt, the amount owed has to written off against profit. Figure 9: Individual Insolvency in England & Wales, 1987-2009

Source: Insolvency Service

Figure 9 shows the number of people being forced into bankruptcy. Individual Voluntary Agreements and Debt Relief Orders grew from 2001 onwards. The surge in the number of bad debts resulted in huge losses for the banks that threatened their very survival. To save Britain’s commercial banks Gordon Brown spent billions of pounds of taxpayers’ money injecting new capital into the banks via share purchases. In addition, the policy of quantitative easing also improved the liquidity of the UK’s banks. By the middle of 2009, the extra lending made possible by these polices re-started UK house price inflation. House price inflation benefits mortgage lenders because it reduces the possibility that a re-possessed house will fail to generate the revenue needed to cover the outstanding debt. Despite the government’s best efforts, banks are still suffering from bad losses caused by loans defaulting. According to figures produced by Credit Action in July 2010, UK banks are, on average, writing off over £23m every day in bad loans. Taxpayers’ in the UK may need to save the UK banking system for a second time because the banks, spurred on by government, are still making loans to people who may not be in a position to pay them back.

6. Wealth and income inequality.
During the boom years house price inflation increased the value of assets of homeowners, boosting their wealth. The average price of a house in the UK in 1983 was just £30,898. By 2007 the owner of the same house was sitting on an asset worth £196,478. In this example, over a 24 year period, the homeowner’s wealth increased by 536%. Those unable or unwilling to load up with debt in order to get on the property ladder did not experience anything like this increase in their personal wealth.
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House price inflation created a divided nation of property have’s and property have not’s. According to Martin Weale, chief economist at the National Institute of Economic and Social Research, house price inflation has compromised inter-generational equity: “If land prices increase to a permanently higher level, then the cohort which happens to own the land at the time enjoys a windfall which it can realise by selling its land to younger cohorts, reducing the need to accumulate other forms of capital to fund retirement,” 2

7. Malinvestment
Malinvestment is a term used by Austrian economists to describe wasteful investment that does not add to the productive capacity of the economy. The UK’s property bubble is a classic example of malinvestment. During the boom years UK banks focused their lending on the property sector. Bank loans made to property speculators have not increased the productive capacity of the economy. Instead of making loans to property speculators, UK banks should have been making loans to UK manufacturing firms that wanted to borrow in order to expand or to modernise. If the UK is to achieve a sustainable recovery the economy must be re-balanced in favour of production. Bank lending should support production, not wasteful speculation.

Conclusions
Booming property prices created a positive wealth effect which encouraged households to borrow in order to finance consumption. The increase in aggregate demand that followed helped the UK economy to achieve short-run economic growth. The economic costs of this period of an unsustainable form of economic growth have now been acknowledged. Rampant house price inflation led to soaring levels of household debt, which almost brought down the entire financial system. However, the social effects of the housing bubble have yet to be fully acknowledged by the British media. Take family life, forty years ago it was possible for those earning an average income to buy a respectable house on one income without having to take on too much debt. In the 1980s and 1990s the number of dual income households rose. The growth in the number of dual income households led to higher house prices because house buyers with two incomes can afford to pay higher monthly mortgage payments than single income households. Today, in the majority of households both parents work. However, in many cases, virtually all of the income earned by one of the parents goes towards servicing the super-sized mortgage debts created by house price inflation. The move towards dual income households has definitely helped the banks; bigger mortgages have boosted incomes of Britain’s banks. Unfortunately, the main casualty created by this trend has been family life. British workers endure the longest working hours in Europe. Long working hours reduce utility because less time is available for leisure. Long working hours have not even increased the material standard of living for most UK households because a very high proportion of the extra income generated from dual incomes and longer working hours flows straight to the banks via interest payments charged on mortgage debt! In 2007 the Children’s charity UNICEF reported that British children were the least happy in the developed world3. According to the survey many British children felt neglected by their parents. Might some of this neglect stem from the UK’s long working hours? And what created this long hours culture? Could it have been created, in part, by house price inflation? House price inflation has turned Britain into a nation of debt slaves.
2 http://www.niesr.ac.uk/pubs/searchdetail.php?PublicationID=2654 3 http://news.bbc.co.uk/1/hi/6359363.stm Crisis Economics: The Cutting Edge Topic 5 57

• •

The housing market is cyclical. In practice house prices do not always go up! House price booms tend to be followed by house price crashes. House prices are determined by the relative strength of the supply and demand for housing. The most important factor that affects the price of housing is the price and the availability of credit because this is the most important factor that affects housing demand. House prices will only increase if lenders and borrowers are willing to accept mortgages that are higher than the mortgages granted to the previous buyer. House price inflation encouraged the UK to live beyond their means. Many homeowners used their houses as cash machines by taking out second mortgages, which were then spent on goods and services, creating short-run economic growth.

Topic 5 Summary Topic 5 Questions

1. Potential demand is an idle want, unlike effective demand, which is backed up by an ability to pay. Explain why immigration from relatively poor Eastern European countries, such as Poland, might add little to the effective demand for UK housing. 2. “The most important factor that affects UK house prices is the availability of credit”. To what extent do you agree with this statement? 3. Should the UK government intervene more actively to regulate the UK mortgage market? 4. Over the last 15 years UK house prices have soared. Has house price inflation added to, or compromised, the quality of life in the UK?

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Topic 6 Will the Quantitative Easing experiment work?
What is Quantitative Easing?
Quantitative easing is an ‘unconventional’ monetary policy measure that occurs when a central bank prints money to purchase financial assets such as government or corporate bonds. In the UK most of the money printed by the Bank of England was spent buying up government bonds. The government did not allow the Bank of England to buy newly issued government bonds directly from the Treasury. Instead, the Bank of England was only allowed to purchase second-hand government bonds from financial institutions that had previously bought them from the Treasury.

Examples of QE 1. Zimbabwe in 2006: QE to directly monetise a fiscal deficit
In the past some governments have allowed their central banks to print money which has then been used to purchase newly-issued government bonds. This is called monetising a fiscal deficit. History indicates that if a government tries to finance its fiscal deficits via the printing press the result is invariably inflation, and lots of it! A good example is Zimbabwe. In 2006 the Reserve Bank of Zimbabwe printed over 60 trillion Zimbabwean dollars. The cash was used to buy up the government bonds needed to finance a huge fiscal deficit. The fiscal deficit was caused by a collapse of tax revenues (Zimbabwe’s agricultural sector declined sharply following President Mugabe’s decision to confiscate land from white farmers). In addition, at the same time, to shore up his power-base Mugabe granted the army and the police force a 300% pay rise. At the same time the output of the country was falling. The combination of a rapidly-growing money supply and a rapidly-shrinking economy led to hyperinflation. It also seems likely that the government of Zimbabwe used quantitative easing to create the inflation needed to reduce the burden of the country’s huge external debts. Like all other currencies, the Zimbabwean dollar is an example of a fiat currency. The governments of countries that run fiat currencies are free to print their own currencies. Unfortunately, printing money does not make a country rich. In fact the reverse is true. Quantitative easing in reduced the purchasing power of Zimbabwean dollar to almost zero. In May 2010 the ECB allowed themselves to buy Greek government bonds directly from the Greek government to prevent the Greek government from defaulting on its national debt. At the time the ECB argued that this policy would not be inflationary. There would be no net increase in the euro money supply because the ECB promised that they would sterilise their bond purchases. For every euro of Greek government debt bought, the ECB would sell a euro of high quality German government debt. In the absence of quantitative easing, governments have to find genuine buyers for their government debt. At the time of writing in June 2010, due to the growing risk of sovereign default, these buyers are in increasingly short supply.
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This has forced governments into tax increases and public spending cuts. If electorates refuse fiscal consolidation governments might be forced into more quantitative easing. Gold offers excellent insurance against the risk of inflation because unlike fiat currency it cannot be printed. In recent years the price of gold has soared. Many investors clearly expect politicians to deal with the challenges posed by high levels of debt by choosing quantitative easing over fiscal austerity. They expect governments to pursue policies designed to inflate debt away.

2. The UK from March 2009 until February 2010: QE to indirectly monetise a fiscal deficit
In some countries liquidity (cash) injected into the economy via quantitative easing has been used by central banks to purchase second-hand government bonds from private institutions, such as banks and insurance companies. In the UK in 2009 the Bank of England created £200bn. In theory the cash could have been spent on buying up corporate bonds, such as newly-issued mortgage backed securities. In practice well over 90% of the new cash created was spent on government bonds. However, unlike the example of Zimbabwe, the Bank of England insisted that they would not use QE cash to buy newly-issued government bonds. The Bank of England would not help the UK government to directly monetise its fiscal deficit. Instead, the £200bn could only be spent on purchasing second-hand government bonds held by private institutions. This type of quantitative easing undertaken in the UK increased the liquidity of commercial banks, insurance companies and pension funds that might have bought government bonds in the past. Quantitative easing enabled these financial institutions to swap any government bonds that they might have on their balance sheets for newly created cash. The financial institutions now had the cash needed to finance new loans to households and firms. At the time, the UK economy was suffering from a credit crunch induced recession. Keynesians argued that the economy required new lines of credit to get the economy moving again. However, it could be argued that the UK’s policy of quantitative easing indirectly monetised the UK government’s fiscal deficit because the policy made it easier for the government to sell its new debt. In 2009 the government had to find buyers for over £150bn of debt. The £200bn of liquidity injected by the central bank certainly helped the Treasury; during that year the Bank of England was the only net buyer of UK government bonds! As a result of the UK’s QE programme the Bank of England is now the proud owner of UK government bonds that total more than 30% of the UK’s national debt. Figure 1 shows how the Bank of England spent the cash created by the quantitative easing programme. When the policy was announced it was expected that the Bank of England would spend most of the new cash created on corporate bonds. Figure 1 shows that this was not the case. Month after month the Bank of England bought more and more government bonds, adding weight to the argument that the Bank of England was indirectly monetising the government’s fiscal deficit. This is why the amount spent on corporate bonds and commercial paper is barely visible in Figure 1. The last of the £200bn of cash created was not spent until spring 2010, explaining why the bars on the chart that only run until September 2009 do not reach £200bn.

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Figure 1: QE in the UK during 2009

Source: Bank of England

Figure 2: Who owns gilts?

Source: Office for National Statistics

Governments finance fiscal deficits by selling government bonds. In the UK these bonds are referred to as gilts. The deterioration of the government’s finances has meant that the government has had to sell more of its gilts. Fortunately, the policy of quantitative easing made this easier. In a very short period of time the Bank of England has become a very important buyer and holder of UK government debt. Supporters of quantitative easing argue that quantitative easing has helped to keep interest rates low. If the government had to find genuine buyers for its gilts, higher rates of return would be required.

3. The US from 2008 onwards: QE used to buy corporate bonds and US government debt
In the USA the American government also used cash created by quantitative easing to buy US government bonds held by American banks. However, unlike the Bank of England, the American central bank, the Federal Reserve, spent a gigantic sum of money buying up bonds issued by American companies.
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For example, the Federal Reserve spent $1.25 trillion buying up American mortgage backed securities. The Federal Reserve also used QE cash to buy other types of securitised private sector debt, including car and student loans!

Why quantitative easing might be necessary: liquidity traps and all that
According to Keynesians, recessions are caused by a lack of aggregate demand in the economy. To counter recession, Keynesians favour demand-side policies, such as expansionary fiscal policy and slack monetary policy. Unfortunately, in the depths of a recession, conventional monetary loosening may prove to be ineffective in terms of boosting aggregate demand and employment. There are two reasons why monetary policy can lose its traction:1. In a severe recession the economy might find itself stuck in a liquidity trap. A liquidity trap is a situation where interest rate cuts fail to stimulate aggregate demand in the conventional way. When the economy is stuck in a liquidity trap the monetary transmission mechanism breaks down. For example, usually interest rate cuts will increase private sector consumption. Unfortunately, if consumer confidence has been shattered by a long-lasting and deep recession consumers may decide to save any increase in their disposable income created by a fall in interest rates that reduces their monthly mortgage repayments. Furthermore, cuts in interest rates might make credit cheaper. However, the increase in debt-fuelled consumption expected might not occur if households have reassessed their attitude towards personal debt and are now in the process of deleveraging. The same principle also applies to private sector investment; cuts in interest rates might not cause the increase in investment normally expected. Firms will not borrow to invest, even if borrowed money is cheap, if entrepreneurs are pessimistic about the future. Investing to add capacity will not take place if entrepreneurs believe that sales in the future are likely to remain flat, at best. If the economy is in a liquidity trap, cuts in interest rates will not help to boost the level of aggregate demand. Economists liken this situation as trying to push on a string. 2. The central bank might no longer be able to cut interest rates because nominal interest rates might already be close to zero. For example, the Bank of England and the Federal Reserve started the recession with rates of interest that were already low by historical standards (approximately 5%). Furthermore, both central banks cut interest rates sharply thereafter. The Bank of England shot off all its monetary policy bullets in its arsenal very quickly. Once interest rates approached zero there was nothing further that the central banks could do. In practice interest rates cannot be reduced to below 0%, because if commercial banks start charging interest on savers’ deposits cash will be quickly withdrawn from the banking system and hoarded at home.

The specific benefits of quantitative easing
As the credit crunch and the recession deepened Keynesian economists, like Professor Danny Blanchflower, argued that there was a clear need for QE. Conventional policy had failed to produce the desired results. Interest rates had been cut close to zero, and the economy was still struggling to recover. To overcome the liquidity trap problem, the government and the Bank of England embarked upon quantitative easing.

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1. Improved liquidity for UK banks
The credit crunch began in Britain when UK banks experienced defaults. Some of the losses made by UK banks were due to losses originating from the American property market. However, it would be a mistake to claim that all of the losses suffered by British banks came as result of the American sub-prime problem. British banks, such as HBOS and Northern Rock also made suicidal sub-prime loans to borrowers that were always going to struggle to repay what they owed. For example, Northern Rock’s best selling mortgage enabled borrowers to take out a mortgage equal to 125% of their property’s value. HBOS was arguably “the self-certificate, lie-to-buy, specialist” (See Topic 5 for further discussion of this issue). The losses created by UK defaults reduced the capacity of Britain’s banks to lend to British households and firms. Over 70% of UK aggregate demand is made up of private sector consumption. The Bank of England wanted Britain’s commercial banks to resume their lending to Britain’s households. If consumer credit could be restored there would be a bounce-back in private sector consumption, and the economy would recover. Quantitative easing would help to restart the flow of consumer credit. Commercial banks would be allowed to sell UK government bonds that they held in exchange for newly printed cash. The commercial banks would then have the necessary cash required to make new loans to UK households and firms. Quantitative easing was supposed to lead to higher levels of consumption and investment, creating higher levels of aggregate demand, which would help to close the UK’s negative output gap. In practice Britain’s commercial banks responded to the offer of quantitative easing by selling government bonds to the Bank of England, in the manner expected. However, the commercial banks hoarded some of the additional liquidity added by quantitative easing. The commercial banks used quantitative easing cash to finance new mortgage loans, which stabilised UK property prices. The stabilization of UK property prices was important because it helped to give consumer confidence a much needed boost. However, the commercial banks were more reluctant to use quantitative easing cash to extend credit facilities for small firms.

2. Lower commercial rates of interest
The base rate of interest is the rate of interest that commercial banks pay when they borrow from the Bank of England on a short-term basis. Households and firms are not allowed to borrow from the central bank. When households and firms need cash they have to borrow from commercial banks, paying commercial rates of interest. During the credit crunch commercial rates of interest increased even though the bank of England cut the base rate of interest. The commercial rate of interest is determined by the supply and demand for loanable funds. During the credit crunch the supply of loanable funds dried up because banks became more risk adverse, making them less willing to grant new loans. Over time, the spread between the Bank of England’s base rate and commercial interest rates increased. The Bank of England’s plan was to use quantitative easing to reduce the yields on offer for holding UK government bonds. The decision to print money to buy government bonds would increase the demand for UK government bonds, forcing their price up. Higher bond prices would then bring down yields on UK government bonds. The following example explains the inverse relationship between bond prices and bond yields.
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Suppose that the UK government issues a bond with a face value of £10,000 which might offer investors an annual coupon payment of £1,000. At the time the bond was issued the bond offered the investor that bought it a 10% return. Bonds are bought and sold in bond markets. The price of a bond can vary significantly according to the relative strength of demand and supply for that type of bond. The central banks decision to use quantitative easing to buy up UK government bonds might mean that the bond that offers a £1,000 coupon might now sell for £11,000. If this happens the bond now only offers investors a return of £1,000 / £11,000 * 100 = 9.1% Quantitative easing was designed to reduce commercial interest rates by lowering the yields on offer for holding government bonds. To compete, commercial banks will have to cut their interest rates too, leading to lower commercial rates of interest. Lower commercial rates of interest would help the economy to recover. Some economists estimate the quantitative easing reduced commercial rates of interest in the UK by approximately 1%.

3. Weaker currency, promoting an export-led recovery
Central bankers like Ben Bernanke were happy to tap into the markets fear that quantitative easing would lead to inflation at some point in the future. Economists predicting this inflationary outcome tended to be monetarists who believed in the quantity theory of money. Monetarists believe that inflation is always and everywhere a monetary phenomenon. Inflation is created when the money supply grows at a faster rate than the economy. Helicopter drops of quantitative-easing cash were expected to be highly inflationary because this policy will increase the rate of growth of the money supply. The implied promise of higher inflation was designed to spook investors. Higher rates of UK inflation would reduce the real rates of return on offer for holding sterling and sterling denominated assets. The Bank of England, and other central bankers using quantitative easing, hoped that investors would react to the fear of inflation, and therefore, lower real rates of return, by liquidating sterling and sterling denominated assets. The resulting currency outflow from sterling would increase the supply of sterling on FOREX markets, leading to a lower exchange rate. A lower exchange rate would hopefully create an export-led recovery. Central Bankers like Trichet, Bernanke and King promised to keep interest rates low for the foreseeable future. Low interest rates and the promise of low interest rates in the future helped to keep hot money out of the euro, dollar and sterling. The decision to keep interest rates low, even at a time when inflation was above target, added further weight to the belief that the central banks of Europe and America were no longer as committed to maintaining low inflation. In short, central bankers tried to talk down their own currencies in order to maximize the chance of an export-led recovery.

4. Reducing the savings ratio
Quantitative easing was designed to reduce commercial rates of interest for both savers and borrowers. If commercial rates of interest fall the incentive for households to save also falls too because a given stock of cash held on deposit will generate less unearned income for the saver. During recessions central banks try to reduce interest rates in an attempt to reduce the savings ratio.
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If the savings ratio can be decreased, the level of consumption within the economy will rise, even if incomes remain flat. In practice it is very difficult to reduce nominal rates of interest to below zero because households will respond to bank charges by withdrawing their cash from savings accounts in order to keep it at home instead, to avoid the charge. However, inflation allows the central banker to create a negative real rate of interest. For example a savings account that pays 1% interest will offer the saver a negative real rate of return of -2% if the rate of inflation is 3%. Deflation is to be avoided at all costs because even a nominal interest rate of 0% will create a positive real rate of interest for savers. Quantitative easing reduced both nominal and real rates of interest, providing UK savers with a powerful incentive to spend rather than to save. Furthermore, many people in Britain also believed that quantitative easing would eventually lead to higher rates of UK inflation and a weaker currency (these people have been proved to be correct). The expectation of higher rates of inflation and a weaker currency encouraged savers to withdraw their sterling savings in order to spend them before they lost value. If policy makers can create a convincing threat of inflation savers will respond by withdrawing their savings and spending them, which will stimulate aggregate demand, pushing the economy towards recovery.

5. Indirectly monetising fiscal deficits
In the UK the government prevented the Bank of England from directly monetising the fiscal deficit by forbidding the Bank of England from purchasing newly-issued government bonds from the Treasury. Instead, the Bank of England was allowed to buy UK government bonds from banks and other financial institutions. It could be argued that this policy helped the Treasury to create the room and the liquidity in the bond market required to sell new issues of UK government debt – indirectly monetising the UK’s fiscal deficit. If quantitative easing was not used the government would have found it harder to sell the bonds needed to finance the 2009 fiscal deficit, without the need to raise interest rates. So in effect the decision to use quantitative easing to indirectly monetise the UK’s fiscal deficit enabled the government to run larger fiscal deficits, without the need to raise interest rates. Keynesians would argue that the economy needed the combination of a huge £170bn + deficit and low interest rates to counter the threat of a deflationary spiral.

Evaluation
The effectiveness of quantitative easing was limited by the behaviour of UK banks. In practice commercial banks hoarded the QE cash they received from the government. For Keynesians the reluctance of the commercial banks to extend credit made the UK’s recession longer. Quantitative easing created a moral hazard. The British and US economies fell apart in 2008 because policy makers had kept interest rates too low for too long. Low interest rates had created a mountain of debt in both countries. Borrowing to consume can create short-run economic growth. However, this strategy does not create a sustainable form of economic growth. A crisis caused by debt cannot be solved by

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more debt. Both economies will need to go through a period of deleveraging before a sustainable form of economic growth becomes a possibility. Quantitative easing creates a moral hazard because it sends out the wrong set of incentives. Long-term economic growth is created by investment. To fund high levels of investment, high levels of saving are required. Using quantitative easing to lower real interest rates discourages saving. Banks rely on savers for their loanable funds. If banks cannot attract savers they will not be able to finance many business loans for investment purposes. Britain and the US needs to follow the Chinese approach. In China the savings ratio is 40%, which means that the average household saves 40% of their income. There is no shortage of loanable funds in China. In China investment equals 40% of the country’s GDP. It should come as no surprise to anyone that China has been able to achieve economic growth rates of 10%. Meanwhile in Britain and the US our economies struggle, even in a good year, to achieve growth rates of 3%. The citizens of both countries must be encouraged to save again because without saving there can be no investment, and without investment there can be no economic growth. In Britain and the USA predominately Keynesian policymakers, obsessed with the paradox of thrift, focus solely on achieving short-run economic growth by adopting policies like QE which are designed to boost aggregate demand. Unfortunately, the opportunity cost of these policies is much slower rates of long-term economic growth. QE enables the Treasury to run larger fiscal deficits without the need to raise interest rates. Running fiscal deficits might boost short-run economic growth. However, in the long-term if governments run fiscal deficits year after year the national debt will increase. Servicing this debt will crowd out private sector activity. The Bank of England’s attempt to indirectly monetise the UK government’s fiscal deficit by printing cash has increased the UK’s narrow money supply. Monetarists believe that quantitative easing can be highly inflationary and destabilising.

Does quantitative easing create inflation? The Keynesian view
Keynesian economists like Paul Krugman and Danny Blanchflower supported the policy of quantitative easing in both Britain and the USA. As Keynesians, they blamed the recession brewing in both countries on falling aggregate demand. Quantitative easing would create the increase in aggregate demand needed to get out of recession. They also dismissed the view that quantitative easing would lead to higher rates of inflation. Keynesians believe that inflation is synonymous with an overheating economy that is suffering from a positive output gap. In other words inflation arises when aggregate demand is growing from a starting point where the economy is operating in equilibrium at, or close to, full employment.

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Figure 3: Inflation and the level of aggregate demand

In 2009 the US and British economies were both in recession operating at an equilibrium level of GDP of NY1 because aggregate demand was low and stable at AD1. Keynesians hoped that quantitative easing, along with zero interest rates and a fiscal stimulus, would increase the level of aggregate demand from AD1 to AD2. Firms would respond to the extra spending by raising output and not by raising price because they have spare capacity. As a result, the policy creates economic growth of NY1 to NY2, without any inflation, the average price level remains at its old level of AP1. Quantitative easing will not create demand-pull inflation until the economy begins to run out of spare capacity. Keynesians would acknowledge that it would be a mistake to use quantitative easing if the economy was starting from an equilibrium such as Y/Fe. The economy is producing its full employment output level because the level of aggregate demand is high and stable at AD3. In this situation it would be a mistake to use quantitative easing or any other policy designed to boost the level of aggregate demand because the result will be inflation. Firms cannot respond to the increase in aggregate demand from AD3 to AD4 by increasing output because they are already producing as much as they are able to. Instead, firms will respond by raising their prices, pushing up the average price level from AP2 to AP3. In 2008 and 2009 Keynesians argued that quantitative easing would not create demandpull inflation. They believed that the economy had huge amounts of spare capacity, which would be able to soak up the extra spending power created by quantitative easing. According to the Keynesian paradigm, demand-pull inflation will not occur whilst the economy has a negative output gap. A negative output gap occurs when the economy’s output level is below its full employment output level.

The New Classical view on inflation
According to the ‘father of monetarism’, Milton Freidman, inflation “is always and everywhere a monetary phenomenon”. Monetarists believe that inflation is caused by an over-rapid growth of the money supply. There are several measures of the money supply. The narrow money supply is equal to the total value of all notes and coins in circulation. Broader measures of the money supply also include access to consumer credit. Irving Fisher formalised monetarism in the equation of exchange. Fisher’s equation is really an identity: something which must be true by definition.
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Fisher’s equation of exchange: MV = PT
Where: • M = the % growth of the money supply • V = the velocity of circulation of the money supply. The velocity of circulation is the speed at which money is spent and re-spent as it moves around the circular flow of income from households to firms, and then back again. • P = the average price level • T = the % growth in the number of transactions (volume of goods bought and sold) M*V = total expenditure made by consumers P*T = total receipts received by sellers Logically, total expenditure must equal total receipts. The total amount of money spent by consumers must be the same as the total received by producers. Therefore, MV must always equal PT, explaining why the equation of exchange is really an identity.

Monetarists assume:
• • That the value of V is constant in the short-run. In other words, in the short-run the speed at which money is circulated around the economy is fairly stable. That T, the total volume of goods and services produced in the economy in a year, will also be fairly stable in the short-run. From one year to the next the value of T will tend to increase in line with the economy’s rate of economic growth. For example, if the economy grows by 2% this year, the volume of goods produced during the same year will also increase by 2%. In this case the value of T for the year will be 2%.

Monetarism in practice
Monetarists argue that because V is a constant in the short-run, inflation can only come about as a result of a situation where the money supply, M, has grown faster than the rate of growth of the economy, T. For example, if the government or central bank allows the money supply to grow by 4% the value of MV (total expenditure) will also increase by 4% too because monetarists assume that the value of V is constant in the short-run. By definition, if the value of expenditure rises by 4% the value of receipts must also rise by 4% too. At the same time the economy has grown by 1%, therefore, the value of T is 1%. In this situation, according to the equation of exchange, there can only be one outcome. The value of PT must rise by 4%. However, if the T component of PT has only risen by 1%, the average price level must increase by 3%. In summary a 4% growth of the money supply combined with a stable velocity of circulation and an economy that has grown by 1% produces a 3% increase in the average price level. It is important to appreciate that monetarism can also explain deflationary episodes. During the great depression of the 1930s, the US economy suffered from deflation because the money supply contracted faster than national output. The value of P fell because M decreased faster than T.

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In the 1980s the UK government adopted monetarist policies to reduce inflation. The government reduced the UK’s rate of inflation by using monetary policy to control the rate of growth of the money supply to ensure that the money supply never grew faster than the economy. The government set money supply targets as part of what was known as the Medium Term Financial Strategy. If monetarism is to work governments must be able to accurately predict the value of T (economic growth) in the future. Secondly, the government must then be able to control the growth of the money supply so that it never grows faster than the economy. For example, if the government predicts that the economy will grow by 2% next year the government should not allow the money supply to grow any faster than 2% because the result will be inflation, i.e. an increase in the value of P.

Could quantitative easing cause hyperinflation?
Hyperinflation occurs when a central bank loses control over the average price level. Inflation will be rising rapidly, measured in thousands of percent per annum. In 2009 and 2010 several economists, including Marc Faber, Jim Rodgers, Nouriel Roubini, Peter Schiff and Liam Hallighan have warned that quantitative easing could create a serious inflation problem for the countries that have printed their currencies. Quantitative easing has increased the narrow money supply in both the US and the UK at a time when national output has been contracting, or struggling to achieve only modest rates of economic growth. Figure 4 shows the dramatic effects that the quantitative easing carried out by the Federal Reserve had on the US monetary base. The monetary base is a very narrow measure of the money supply that only takes into account notes and coins in circulation. Figure 4: The Monetary Base in the USA, 2006-2010

Source: St. Louis Fed

According to Fisher’s equation of exchange, one might have expected a sharp acceleration in American inflation following the Federal Reserve’s decision in 2009 to increase the narrow money supply by 100%. By mid-2010 the inflation anticipated had not arrived. Does the absence of serious inflation in the USA, following a rapid monetary expansion, undermine the theory of monetarism? Other economists argue that the impact that quantitative easing has had on the monetary base has been partially offset by a period of credit contraction that has slowed the growth of the broad money supply.
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Broad measures of the money supply, such as M4, include cash and credit. Figure 5 illustrates that by May 2010, despite UK quantitative easing, the annualised rate of growth of M4, had fallen to 3%. Figure 5: The money supply (M4) in the UK, 2008-2010

Source: www.bankofengland.co.uk/statistics/m4/2010/may/M4SA.GIF

Why the monetarists might still be right
Some economists have argued that the rapid increase in the money supply has not caused inflation yet because the velocity of circulation in the countries that have used quantitative easing is still very low. As a result, the money created by central banks has not affected the average price level because it has not entered the real economy yet. The reason for this is that the commercial banks, that benefited from QE cash have, so far, opted to hoard the cash they received, rather than to lend it out to household and firms. If the velocity of money is close to zero, a rapid expansion of the money supply will not have any impact on the average price level. Monetarists argue that central banks can keep on pumping cash into the economy via QE with very little effect, if velocity remains low. Hyperinflations are often preceded by deflationary scares that have prompted money printing, a good example being the German Weimar hyperinflation of the 1920s. Governments fighting a deflationary recession create huge quantities of cash to prevent prices and the economy from collapsing. However, most of the money does not reach the real economy because the public is hoarding cash (or government bonds). The central bank then responds to continued weakness in the real economy by printing even more money. If economic agents hoard cash a metaphorical dam is created, preventing the gargantuan volumes of printed money from affecting prices. Unfortunately, as more money is printed the weight of water bearing down on the dam builds. When the dam breaks, the economy becomes flooded by a wall of hoarded cash that enters the economy in a flash, creating hyperinflation. There are several triggers that can cause the dam wall to break. If countries opt to repeat quantitative easing doubts over sovereign solvency could emerge. If investors question a country’s solvency cash will most likely move out of government bonds, into the real economy. The inflation created by this initial increase in velocity then sets off a destructive feedback loop between velocity and the average price level.
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Rising inflation encourages households to withdraw, and spend, any cash savings that they might have before they lose value. Incomes will also be spent faster too. This will lead to an even higher velocity of circulation and, therefore, an even higher rate of inflation. The money printing policies favoured by Mervyn King and Gordon Brown might have saved the UK economy from a conventional deflationary depression. Instead, we might now face a hyperinflationary depression similar to the one suffered by Germany in the 1920s. The full impacts of quantitative easing may take time to show through.

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Quantitative easing (QE) occurs when central banks create money in order to stimulate the economy. In the UK most of the money created via quantitative easing was used to buy UK government bonds. Many of these bonds were owned by British banks. Swapping bonds for newly-created QE cash improved liquidity, giving UK banks the opportunity to make new loans. Quantitative easing also boosted bond prices, which helped to push down commercial rates of interest. Supporters of QE argued that in addition to Zero Interest Rate Policy (ZIRP) and record fiscal deficits, the British and the US economies needed additional stimulus in order to prevent a 1930s style deflationary collapse. The extra spending power injected into the economy via QE would help the economy to recover from the effects of the credit crunch. Keynesians, who believe in output gap theory, argue that QE will not create inflation in Britain or the USA because in both countries there is plenty of spare capacity available: unemployment remains high. Critics of QE believe that printing money will not affect the real economy. Instead, QE transfers wealth from savers to borrowers via inflation. Monetarists reject the Keynesian theories on the causes of inflation. Recessions have a nasty habit of destroying capacity because once closed down factors of production quickly disperse. In practice it is not quick and easy to re-open factories that belong to firms that have gone into liquidation: production cannot be restarted. Monetarists believe that inflation is always and everywhere a monetary phenomenon. QE expands the money supply. If the money supply grows at a faster rate than the economy the result will be inflation. At the present time inflation only remains relatively low because the velocity of circulation of the money supply is very low. However, this could change quickly. Printing money in Zimbabwe eventually led to hyperinflation despite the fact that at the time the economy was suffering from very high rates of unemployment and, therefore, running a huge negative output gap.

Topic 6 Summary Topic 6 Questions

1. Explain how quantitative easing affected the UK government’s ability to finance its fiscal deficit 2. Evaluate the arguments put forward to justify the Bank of England’s £200bn quantitative easing experiment. 3. Keynesians argue that central bankers should not be overly concerned about inflation if an economy is experiencing a negative output gap. Evaluate this view. 4. According to monetarists, inflation is always and everywhere a monetary phenomenon. Quantitative easing has led to a sharp increase in the UK’s narrow money supply. From a monetarist’s perspective, explain why this increase in the money supply might not immediately lead to a sharp rise in the UK’s rate of inflation.

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Topic 7 Who is the winner in the Euro debate?
The move to create a single European currency is an example of economic integration. Economic integration arises when countries take action to reduce barriers to trade between themselves. Closer integration creates a situation where there is greater freedom of movement of people, goods and capital between the countries that wish to integrate. Some economists believe that economic integration leads to closer political ties between the countries concerned and a loss of political sovereignty. Prior to the introduction of the euro, the EU was an example of a single market. A single market is formed when countries agree to establish a free trading area where the members agree to abolish quotas, tariffs and hidden barriers to trade between themselves. The EU’s single market is protected by a common external tariff, which is levied against imports originating from outside the EU.

Qualifying criteria: the Stability and Growth Pact and the Maastricht convergence criteria
Not all members of the EU are part of the eurozone. To become eligible for membership of the single currency an applicant country must meet the rules of the Stability and Growth Pact (SGP), namely: 1. Governments must not run an annual fiscal deficit in excess of 3% of GDP 2. The government’s total stock of debt, i.e. the national debt, should not exceed 60% of GDP In addition, to qualify for membership the applicant country must also meet the Maastricht convergence criteria for at least two years before euro entry. The applicant country must meet the following conditions: 1. Have low inflation, which is below the eurozone threshold – applicant countries must not have an inflation rate that is more than 1.5% higher than the inflation rates of the three countries that have the lowest rates of inflation in the Eurozone. 2. Have relatively low interest rates on government bonds. High interest rates on government bonds are deemed to be undesirable because they indicate a lack of confidence on the part of the bond market. Governments that are perceived to be at greatest risk of defaulting on their debts are punished by the bond market. Governments in this position are forced into paying higher interest rates to compensate for the extra risk of holding these bonds, i.e. a risk premium has to be paid. The EU wants to avoid the risk of a member state defaulting on its debts because it would cause instability for the whole of the eurozone. Therefore, in order to qualify for membership long-term bond yields on government debt must be within two percentage points of the best three Eurozone countries. 3. The applicant’s currency has to be relatively stable. The applicant country has to agree to join a semi-fixed exchange rate called ERM II (Exchange Rate Mechanism two). To qualify for euro membership the applicant country must keep its exchange rate to within ±15% of a central exchange rate. The central exchange rate against the euro is determined by the government and the central bank of the applicant country. 4. Low and stable rates of interest. The interest rate set by an applicant country must not be more than 2% above the interest rate set by the ECB.
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Gordon Brown’s 5 Tests
Back in 1997, the chancellor, Gordon Brown, set out five tests for joining the euro. Brown stated that the UK should not join the Single Currency until all these tests were met. The five tests can be summarised as follows: • • • • • Are the UK and European economies converging - are they synchronised? Will one interest rate suit all? Are the economies that use the euro flexible enough to cope if things go wrong? Will joining the euro encourage companies to invest in the UK? Will joining be good for financial services? Will joining be good for jobs?

At the time Brown’s five tests were criticised on the grounds that they were deliberately vague. For example, how would one be able to know whether the UK economy was going to be good for jobs or not? Surely, the answer to this question could only be ascertained after the event, i.e. years after a decision to ditch the pound in favour of the euro. It could be argued that Brown’s five questions were purely rhetorical, i.e. asked just for effect, with no answer expected. Brown, unlike Tony Blair, was opposed to UK entry into the single currency. Brown’s five tests were deliberately vague. The ambiguity built into the tests gave the chancellor ample room to argue that that the UK could not join the euro just yet because we still had not met all of the tests yet.

The arguments in favour of joining the euro
In Britain the economic implications of possible UK eurozone participation tend to be overshadowed by political factors and other issues pertaining to national sovereignty. The thought of taking the Queen’s head off the UK’s bank notes appals most British people, and that, unfortunately, is about as far as the debate goes. Fortunately, the debate amongst economists concerning the pros and cons of the single currency tends to be more rigorous and analytical. So what are the economic benefits of joining the euro?

1. Reduced uncertainty, higher levels of investment and more foreign trade.
The main advantage of joining would be greater certainty. At present the UK operates a floating exchange rate. In a floating exchange rate regime the value of a currency is determined by the relative strength of the supply and demand for that currency on foreign currency (FOREX) markets. The demand and supply of sterling changes on an almost daily basis due to changes in trade flows and investors’ expectations. As a result, in a floating exchange rate regime, the exchange rate fluctuates too. If the UK joined the euro, UK exporters and importers would have a more stable trading environment to operate in. At present, under a floating exchange rate, currency fluctuations can affect the profitability of an export contract. A sudden rise in the value of the pound against the euro is likely to result in falling profits for UK exporters. A UK car producer looking to generate a sterling revenue of £20,000 car would have to charge their customers in the eurozone a price of €30,000 per car, assuming an exchange rate of £1: €1.50. However, if the exchange rate appreciated to £1: €1.80 the manufacturer would have to raise the price of the car in the eurozone to €36,000. The €6,000 price increase will contract the demand for the car in the eurozone. As a result, of the exchange rate change a contract that was previously profitable may now prove to be a loss maker.
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Currency fluctuations also affect UK firms that import stock or components from suppliers operating inside the eurozone. If the pound suddenly fell against the euro, the sterling cost of imported stock would rise, even if the price in euros remained constant. To maintain sterling profit margins UK firms would have to raise the prices charged to their British customers. Unfortunately, higher prices are likely to lead to falling sales volumes for the UK firms affected. On the other hand, a rising exchange rate is likely to have the opposite effect. The UK firm buying the imported goods might use the change in the exchange rate as an opportunity to cut their sterling prices, leading to higher sales volumes. Fluctuating exchange rates make it more difficult for firms to accurately predict their sales and profits. When faced with uncertainty, many firms tend to err on the side of caution when making investment decisions. Low levels of UK investment harm international competitiveness and the country’s economic growth prospects. Joining the euro would help to boost UK investment because all the uncertainties created by a fluctuating exchange rate against the euro would now be removed. For example, entrepreneurs exporting to France should have greater confidence in their sales forecasts for this market because there would no longer be an exchange rate to worry about. As a result, UK entrepreneurs should be more inclined to expand and invest, which would help the British economy. If investment can be increased the economy should grow at a faster rate, creating a higher material standard of living for UK citizens. Joining the euro should also give smaller UK firms a greater incentive to exploit the opportunities presented by the European Single Market. At present many small UK firms might be put off from exporting their product into the eurozone due to exchange rate risks. Small firms are more likely to be discouraged by exchange rate risk because they are less likely to be able to afford expensive hedging contracts (insurance against an adverse movement of the exchange rate that results in a loss of profit). If the UK joins the single currency these smaller firms might choose to begin trading with the eurozone more actively. Free trade should be encouraged because it promotes economic efficiency. Trade theory suggests that countries should be encouraged to specialise according to their comparative advantage. By doing so factors of production can be transferred from sectors where productivity is low. The factors of production freed up can then be re-deployed in other industries where productivity is much higher. The increase in productivity created by specialisation will increase GDP, creating material progress.

2. Reduced transactions costs
At present, when UK firms trade abroad with the eurozone, many have to accept payment for their goods in euros, rather than in sterling. This situation creates a problem for the firms concerned: their costs and revenues will be in different currencies. Wages, taxation and other operating costs will have to be paid in sterling. However, a proportion of the revenues received from the eurozone export market will be collected in euros. As a result, UK companies will have to pay to have their euro income converted into sterling, so that they can pay wages, taxes and other UK based expenses. If the UK joined the eurozone British firms would no longer face these Bureau de Change costs. At the margin, these transactions costs act as a disincentive to engage in foreign trade. The same point also applies to foreign companies. At present the oligopoly enjoyed by the UK’s high street banks has not been seriously challenged by foreign new entrants.
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If the UK joined the euro foreign banks might be more inclined to set up branches in the UK. Incomes and profits generated from the UK would no longer have to be converted back into euros. The UK consumer would certainly benefit from new entrants. The increase in competition by new entrants created would almost certainly lead to lower banking charges and a better all-round deal for customers. The Single European Act of 1992 was designed to sweep away hidden barriers to trade within Europe. Examples of hidden barriers to trade include: excessive bureaucracy and delays at border crossings; public sector procurement policies that are designed to favour domestic producers, rather than the tax payer; manipulating indirect tax rates to divert expenditure from imports to domestically-produced substitutes; product quality standards that block out non-conforming imports; and subsidies paid to domestic producers. By removing these hidden trade barriers the EU hoped to create greater international trade between member states. The move towards greater free trade between member states would increase competition within Europe, which would lead to greater choice and lower prices for consumers. At the time, many economists criticised the EU on the grounds that, to work well, a single European market would require a single European currency to accompany it. A single market without a single currency would be ineffective in terms of promoting greater trade because the uncertainty created by exchange rate fluctuations would matter far more than trying to abolish hidden barriers such as excessive bureaucracy at border crossings. Setting up a single European market without a common currency would fail to produce meaningful results in terms of creating further economic integration within Europe. Exchange rate fluctuations between member states making up the single market would create tremendous uncertainty for firms, which would hold back trade between member states. This can be removed by a single currency. At present the UK is theoretically part of the European Single Market. However, the decision to retain the pound sterling means that we are arguably not receiving the full economic benefits or potential offered by the Single European Market.

3. Increased price transparency
Price transparency exists when consumers can easily compare the prices of goods supplied by different firms operating within the same market. The sterling / euro exchange rate is a major obstacle to price transparency because consumers cannot make immediate price comparisons because the goods offered by UK and eurozone suppliers are priced up in different currencies. If the UK joined the euro price transparency would be created. For example, when choosing between British and French goods, consumers in Britain would be able to make immediate price comparisons because prices in Britain and France would be measured in a common unit of account. Price transparency should increase the intensity of competition within the European Single Market. If the UK joined the euro consumers in Britain would find it far easier to judge the relative value for money offered by UK suppliers. The euro would adversely affect UK firms that charge undeserved price premiums. However, euro membership would certainly benefit UK consumers because greater price transparency should lead to increased competitive pressure and, therefore, lower prices. Belonging to the eurozone should help to put an end to the profiteering ‘rip off Britain’ culture, because once inside the eurozone consumers would be more likely to notice, and do something about, price discrepancies between countries.

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4. An external discipline
At present the UK government allows the pound to float freely against the euro. In a floating exchange rate regime exchange rates tend to move automatically in the direction required to correct a current account disequilibrium. For example, if the UK economy lost some of its international competitiveness one would expect the demand for UK exports to fall, leading to a fall in the demand for sterling on FOREX markets. At the same time, worsening UK international competitiveness should lead to a rise in import expenditure, and hence an increase in the supply of sterling on FOREX markets. The combination of a fall in the demand for sterling and a rise in its supply will lead to a fall in the exchange rate. A fall in the value of sterling would make UK exports cheaper and UK imports more expensive. As a result one would expect the current account deficit to fall, provided that the Marshall-Lerner condition has been met. It could be argued that a floating exchange rate against our most important export market, the eurozone, has promoted inefficiency in Britain. Many firms in the UK have relied on a falling pound for their international competitiveness. In a floating exchange rate environment firms do not have a strong incentive to take responsibility for their own internal efficiency. Why bother to make the tough decisions needed to keep costs under control when a weakening currency will do it for you? If the UK joined the euro the option of allowing the pound to drift down against the Euro would no longer exist. Once inside the eurozone British firms would have to behave differently. With the bailout option of a currency depreciation now gone, UK firms would have to become more efficient, or face the threat of liquidation. The external discipline provide by eurozone membership would force UK firms into improving their efficiency, which would boost economic growth. The government’s decision to keep the pound has created a destructive moral hazard; why bother to make the tough decisions needed to keep costs under control when a weakening currency will do it for you?

5. Closer integration creates supply side benefits
The creation of a European single currency has created a deeper form of economic integration between the countries that opted to join the euro. Economic integration occurs when countries decide to trade barriers between themselves. The aim of economic integration is to create a situation where there is freedom of movement of people, goods and capital between the countries that wish to integrate. The euro converted what was a single market into the next stage in economic integration: an economic and monetary union. The decision to establish a single currency in Europe has increased competition within the Eurozone. In the past the uncertainty and cost created by separate currencies may have encouraged firms into contracts with other domestic firms. Inside a monetary union this will no longer be the case. For example, theoretically it should be as easy for a French firm to trade with a Finnish company, or any other company located within any of the countries that use the euro as their currency. The extra competitive options opened up by the euro should encourage firms in the Eurozone to drive down their average costs. Firms that fail to improve their efficiency stand to lose revenue and profit. In the long-run one would expect that productivity in the Eurozone would increase in response to the extra competitive pressure created by the single currency. If productivity rises, the full employment output level of the Eurozone economy should increase from Y/Fe 1 to Y/Fe 2, because a rise in productivity will increase total output, even if the Eurozone workforce stays the same. If the full employment output level of the Eurozone economy increases, the aggregate supply curve representing the Eurozone economy will also increase from LRAS1 to LRAS2.
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Figure 1: The eurozone economy

Before the euro was introduced the eurozone economy was operating in equilibrium at full employment producing a real income of Y/Fe 1 because the level of aggregate demand was stable at AD. The level of employment at Y/Fe was E1. Following the introduction of the euro productivity rose; this pushed the LRAS to the right, from LRAS1 to LRAS2. If the level of aggregate demand remains constant at AD, the increase in aggregate supply will cause a rise in the level of GDP from Y/Fe1 to NY2. The extra competition and free trade created by a single currency causes the average price level to fall from AP1 to AP2. The increase in productivity also causes the employment line to shift to the right from Employment line 1 to Employment line 2. An output level of NY2 can now be produced with only E2 employees. To prevent a rise in unemployment and deflation of AP1 to AP2, the ECB might consider slackening monetary policy in order to allow aggregate demand to increase from AD to AD1. If aggregate demand can be increased to this level the level of employment within the eurozone will not fall. The extra productivity created by the euro will have been put to good use; the increase in aggregate demand forces national output up from NY2 to Y/Fe2.

The disadvantages of the Single Currency
We can identify six key problem issues arising from possible UK membership of the Eurozone.

1. Loss of control of monetary policy
If the UK joined the euro the government would have to instruct the Bank of England to abolish the Monetary Policy Committee. The MPC would no longer set the UK’s interest rate. Instead, the UK would have to adopt the common rate of interest set by the European Central Bank, which is based in Frankfurt, Germany. This loss of sovereignty over our monetary policy could be very costly, especially if the UK economy’s economic cycle is not synchronised with the eurozone’s economic cycle. For example, if France and Germany are in recession the ECB might be forced into cutting interest rates.
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However, this policy might prove to be absolutely wrong for the UK economy, which might be enjoying a boom period at the same time. The low interest rate set by the ECB to suit France and Germany might exacerbate inflationary pressure within the UK economy. Member states of the EU have very different economies. Firstly, some countries are far richer than others. Secondly, the economic structure of the economies that make up the EU can be very different. Some member states, such as Germany, have economies with relatively large manufacturing sectors. However, in other countries the economic structure might be completely different. For example, in the UK financial services and retailing are the dominant sectors. In recent years the enlargement of the EU into Eastern Europe has exacerbated these differences. Given these circumstances it could be argued that in the future when countries like Latvia and Poland are allowed to join the euro there will be an even greater strain on a “one size fits all” monetary policy. An interest rate of 10% might be suitable for a country like Poland. However, Germany might need a much lower interest rate, say 5%. In the circumstances what should the ECB do, should they split the difference and set an interest rate of 7.5%? If so the interest rate would be “wrong” for both countries. The theory of optimum currency areas is relevant to this discussion. An optimum currency area is a geographical region that has a fairly homogenous economy that would cope with a single currency and a single interest rate. Some economists argue that the eurozone is a good example of an optimum currency area. Since the introduction of the euro the economic cycles of the economies that make up the eurozone have become more synchronized. If the economies of Italy, Germany, Ireland etc are all in a boom at the same time the interest rate set by the ECB will be more likely to meet the individual needs of each eurozone country. On the other hand, other economists argue that the eurozone is too large and diverse to be a good example of an optimum currency area. According to this group, the Eurozone will always be too diverse to cope with a one-size fits all monetary policy. According to the American economist, Robert Mundell the criteria that need to be fulfilled to create an optimum currency area are:

i. Labour market flexibility.
The geographical region under consideration for a single currency must have a flexible labour market. In particular, labour must be geographically and occupationally mobile in order for a single currency to work effectively. Structural unemployment affecting a region within an optimal currency area should be self-correcting. The supply of labour in the region affected will increase relative to the demand for labour, leading to a lower wage rate. Falling wages should attract new firms to the region because lower wages will increase the profitability of operating from this location. Over time, as new firms move in, employment should start to recover. In order to create an optimal currency area workers must be allowed to move to where there is work. The 1992 Single European Act granted European workers the legal right to live and work in any other member state. Therefore, theoretically, it could be argued that the eurozone’s labour market should be flexible. However, in practice the geographical mobility of labour in the eurozone is limited. There are two problems: first, some EU member states, such as Finland are happy to ignore EU single market law. Member states are obliged to accept each others professional qualifications. In practice this does not always happen.
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For example, an Italian doctor seeking work in Finland might find it difficult to find work in a Finnish hospital because his or her qualifications are not accepted by the Finnish authorities. The second factor that reduces the geographical mobility of labour in Europe is language. Unemployed Italian’s would find it very difficult to find work in Finland if the only language they can speak is Italian. The EU single market has a single currency, but not a single language. Even if this issue can be resolved, one further factor remains: will workers be prepared to leave their families and friends in a depressed region in search of work abroad elsewhere within the eurozone? If not regional inequalities will persist in the long-run, which will compromise the effectiveness of a common currency and a common interest rate.

ii. Capital mobility.
Capital mobility is compromised by protectionism that prevents foreign firms from setting up, or taking over, firms abroad. Can a German firm takeover an underperforming French firm? Can a German company, such as Lidl, set up a new branch in Helsinki? In the past, in some European countries, domestic competition policy has been used to block both types of expansion for protectionist reasons. Capital mobility matters because it should help depressed regions within the eurozone to recover faster because it will be easier for foreign firms to set up or buy businesses at low cost there.

iii. Wage and retail price flexibility.
In order for a geographical area to function effectively as an optimal currency area, wages and retail prices within the region will need to be flexible too. Wage rates in depressed regions within the optimal currency area will need to fall, in order to attract new employers to the region. However, if some countries have higher minimum wage rates than others this might not happen.

iv. Fiscal transfers.
From time to time pockets of poverty will tend to emerge within an optimal currency area. Unfortunately, within an optimal currency area interest rates cannot be cut. Therefore, in order to overcome the loss of monetary policy flexibility fiscal policy will need to take up the slack. To speed up the regeneration of depressed regions within the eurozone the EU uses the social fund to pay for the investments in physical and human capital needed to revitalise these regions. Politically, the social fund is a difficult ‘sell’; especially for politicians facing re-election from voters living in the richer regions of the optimal currency area who stand to pay the higher rates of tax needed to fund regional policy. It could also be argued that fiscal transfers such as the EU’s social fund are inequitable. For example, why should German tax payers finance the construction of new roads in Greece or bridges to remote Scottish islands? The opportunity cost of the EU’s social fund (higher taxes) should also be considered too. According to the Austrian School of thinking all forms of government spending should be avoided because of the risk of crowding out. Crowding out arises when an expansion of the public sector, at the expense of the private sector, backfires and leaves society worse off. The requirement to make a profit in the private sector means that productivity in this sector will always be higher than public sector productivity. Transferring factors of production from a sector where productivity is high to one where productivity is low makes no sense; average productivity across the economy will fall, leading to a smaller economy.1
1 http://www.robertmundell.net/books/main.asp?Title=A%20Theory%20of%20Optimum%20 Currency%20Areas Crisis Economics: The Cutting Edge Topic 7 80

2. Partial loss of control over fiscal policy
Countries that have adopted the euro as their currency are supposed to follow the rules of the EU’s Stability and Growth Pact (SGP). According to the rules of the pact all eurozone countries must agree to limit their annual fiscal deficits to no more than 3% of GDP. According to Keynesians recessions are caused by a lack of aggregate demand in the economy. Keynesians also believe that the macro-economy is not self-regulating. Therefore, to move the economy out of recession the government must adopt policies designed to increase the level of aggregate demand. Countries that have adopted the euro cannot unilaterally cut interest rates in order to reflate their domestic economy. Instead they must adopt the interest rate set for them by the ECB. The only other measure that policy makers could use to boost aggregate demand, apart from slack monetary policy, is expansionary fiscal policy. Unfortunately, the rules of the SGP restrict the government’s ability to use this policy. In the middle of a deep recession Keynesians might argue that a fiscal stimulus of ‘just’ 3% of GDP might not be enough to move the economy out of recession. Membership of the euro could prove to be very expensive in this situation. If the UK joined the euro the country could end up being stuck in a recession. But worse still, the government might not be able to rectify the situation because by joining the euro they have lost control over monetary policy and partial control over fiscal policy.

3. Collective responsibility
According to monetarists inflation is always and everywhere a monetary phenomenon. Inflation is caused when the rate of growth of the money supply (M) exceeds the rate of growth of national output (T). Fiscal deficits have to be financed by government borrowing. Typically this involves the government selling bonds to interested investors. Bonds are designed to act as a store of value. However, they are also relatively liquid because bonds can be sold before they mature. Therefore, it could be argued that bonds are a type of near money. Running a fiscal deficit will boost the volume of bonds in circulation, increasing the broad money supply. Over the last decade, eurozone countries such as Portugal, Greece and Italy have run large budget deficits that have exceeded the 3% limit set out in the SGP on a fairly regular basis. On the other hand, at the same time, other eurozone countries, such as Germany and Finland, have complied with the EU’s fiscal rules. Monetarists argue that in order to control inflation in the eurozone the ECB must control the rate of growth of the money supply. To control the growth of the eurozone money supply all member states will need to follow the rules of SGP. If the eurozone money supply grows at a faster rate than eurozone output the result will be inflation. The inflation created by fiscal incontinence in Italy or Greece will adversely affect producers and consumers in countries like Germany and France. To combat the inflation created by the reckless Italian and Greek governments the ECB might have to tighten monetary policy for the whole of the eurozone. It could be argued that this situation is very unfair. The Finnish and the German economies end up suffering from high inflation and high interest rates because the Italians and the Greeks refused to follow the rules of SGP! It could be argued that the UK should not join the Euro until all member states can be coerced into following the rules of the SGP.

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4. Further integration might only create a temporary increase in competition.
The creation of a single currency will create a deeper economic integration between the countries that have adopted the single currency. In the short-run the single currency will encourage firms to undertake foreign trade that they might not previously have been willing to undertake. If this happens competition will increase. However, how long will this increase in competition last for? It could be argued that in the longrun the creation of a single currency might lead to huge monopolies. During the initial competitive battle prices will be low as firms fight it out for market share. However, over time, the level and intensity of competition within most markets is likely to fall due to liquidations, and horizontal takeovers and mergers. In the long–term, prices will probably rise again once the winners of the initial competitive battle emerge. In the eurozone a single currency has led to an increase in concentration within most markets, i.e. most markets in Europe are dominated by a smaller number of larger firms. Prices will only stay low in highly concentrated markets if the market is contestable. A contestable market is one where barriers to entry and exit are low. In a contestable market the fear of competition, rather than actual competition, keeps prices low. It could be argued that in order to function effectively, a single currency requires a harmonised eurozone competition policy.

5. The ECB’s (alleged) deflationary bias
When the euro was first launched foreign currency dealers were initially sceptical about the prospects for the euro. Would the ECB be able to operate a one-size fits all monetary policy successfully? Would Eurozone countries agree to be fiscally responsible? Would the ECB be able to keep inflation in the Eurozone low and stable? Some economists argue that the ECB adopted an overly cautious approach towards monetary policy in order to gain credibility with the markets. Other economists have even gone as far to suggest that the location of the ECB, in Frankfurt in Germany, has influenced monetary policy! According to this theory Germans are still paranoid about inflation, due to the collective memory of the hyperinflation that ravaged the German economy in the 1920s. As a result, the ECB has adopted an overly hawkish attitude towards inflation. Those that believe in this hypothesis argue that the ECB has consistently set eurozone interest rates too high. They believe that by setting interest rates too high the ECB has dampened the rate of economic growth in the eurozone. High eurozone interest rates have also pushed up the value of the euro against other currencies like the dollar and the pound, creating a competitive disadvantage for eurozone exporters. In addition, high Eurozone interest rates slowed down the rate of growth of aggregate demand in the Eurozone, reducing the short-run rate of economic growth.

Did the decision to retain sterling help the UK to counter the global financial crisis?
Modern Keynesian economists like Professor Blanchflower have argued that the UK’s decision to stay out of the euro helped the economy to recover faster from the global crisis than eurozone economies such as Ireland and Spain2. According to the Keynesians, the UK’s decision to keep the pound enabled the government to engineer an export-led recovery by pursuing policies that were designed to lower the value of the pound. The logic of this argument is based on the premise that a weaker currency will enable UK firms to cut their export prices. Lower export prices will (hopefully) lead to increased export income.
2 http://www.newstatesman.com/economy/2010/03/greece-euro-germany-8364-debt Crisis Economics: The Cutting Edge Topic 7 82

At the same time, a weaker currency will also boost import prices, which will (hopefully) lead to falling UK import expenditure. The improvement in the UK’s current account balance created by a weaker currency will stimulate the last component of aggregate demand, net expenditure on exports (X-M). Figure 2: The stimulus of a weak currency

The credit crunch led to a rapid fall in the level of UK aggregate demand from AD2 to AD1. As a result, the economy found itself in recession producing an output level of just NY1. The Bank of England’s decision to slash interest rates to 0.5% and to inject £200bn into the economy via quantitative easing made sterling less attractive to buy and hold. The Bank of England’s policies created a 25% fall in the value of sterling. It was hoped that the fall in the exchange rate would improve the international competitiveness of UK firms by pricing them back into their markets both at home and abroad. The increase in net export income created by the fall in the exchange rate should shift the aggregate demand curve to the right, from AD1 to AD2, which will lift national output from NY1 to NY2. Countries such as Ireland and Spain were not able to depreciate their currency against their European neighbours to create an export-led recovery because they had opted to join the euro. Countries such as Ireland that have elected to use the euro now run what amounts to a fixed exchange rate against other eurozone economies. To recover their international competitiveness countries like Ireland will need to go through a painful period of nominal wage deflation. Wage deflation is unpopular with employees for obvious reasons therefore it tends to be resisted. As a result the Irish economy has found it far harder to recover from the credit crunch than the British economy. Membership of the euro meant giving up the automatic stabiliser effects of a floating currency on aggregate demand.

But so far a weak pound has failed to produce the anticipated export-led recovery
Theoretically, a weaker currency should boost aggregate demand, creating an exportled recovery. However, by the summer of 2010 the UK economy had failed to respond in the manner expected. Despite the fall in the exchange rate, UK export income remains disappointing, whilst at the same time, the country’s appetite for imports appears to be undiminished. Trade figures released in July 2010 showed that the UK’s trade deficit had been worsening, rather than improving. What has gone wrong? Why has a weaker currency failed to deliver the export-led recovery anticipated by the Keynesians? There are three possible reasons that could be put forward to explain why:
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1. The UK economy has not met the Marshall –Lerner condition yet
The Marshall–Lerner condition states that a weaker currency will only improve a country’s current account balance if the sum of the price elasticities of demand for imports and exports exceeds one. A weaker currency will definitely make import prices rise. However, the impact of this price rise on UK import expenditure will depend upon the price elasticity of demand for imports. If the demand for imports is price inelastic, a rise in import prices will lead to an increase in import expenditure, which will worsen the current account balance, not improve it. The same principle applies to exports. A fall in the exchange rate will definitely cause export prices to fall. However, the impact on export income will depend upon the price elasticity of demand for exports. Cutting price on a product that has a price inelastic demand will always result in a fall in total revenue. Therefore, if the price elasticity of demand for UK exports is price inelastic, a fall in export prices will lead to fall in UK export income. To benefit from a weaker currency the UK will need to have a price elastic demand for both its exports and imports. The most important factor that affects the price elasticity of demand for any product is the availability of substitutes. In general if there are few substitutes available, demand will tend to be more price inelastic than if there are many substitutes available. The low price elasticity of demand for imports in the UK has probably been caused by deindustrialisation. Deindustrialisation has reduced the number of domestically-produced substitutes available for British consumers to choose from. The UK used to produce manufactured goods like televisions, shoes and clothes. Today, manufacturing contributes less than 15% of GDP. Most of the manufactured goods that we buy are imported. If the price of these imported goods goes up, UK consumers can not respond by switching to a domestically produced alternative because there are not any. As a result, most consumers choose to carry on buying the import despite the price increase, creating a price inelastic reaction. The same principle applies to UK exports. Theoretically, UK exporters should benefit from a weaker currency. However, we can only benefit if we have goods to export! The UK economy needs to re-discover manufacturing.

2. The ratchet effect
Theoretically, a weaker currency should help to improve a country’s international competitiveness because a depreciating currency will push export prices down and import prices up. Unfortunately this approach only tends to work in the short-run due to the cost-push inflation created by a fall in the exchange rate. Economists refer to the cost-push inflation created by a falling currency as the ratchet effect. The logic behind the ratchet effect is as follows. A weaker currency will increase the price of imported raw materials and components bought by domestic producers, which drives up costs. To preserve profit margins domestic producers respond to the cost increase by raising their retail prices. The inflation created by rising import costs will push export prices back up to their previous levels. In conclusion, there seems to be little benefit in using a weaker currency to boost export sales because the fall in export prices created by a fall in the exchange rate will only tend to be short-lived. Figure 3 shows how the value of the pound crashed against the euro following the Bank of England’s decision to respond to the credit crunch via a combination of quantitative easing and interest rate cuts. The Bank of England’s decision to print £200bn and to slash interest rates from over 5% to just 0.5% in a matter of months led to panic selling of sterling. Against most currencies the value of the pound fell by at least a quarter!
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Unfortunately the fall in the value of sterling has yet to create the boost in UK export income, or fall in import expenditure, anticipated by the Keynesians who advocated policies like quantitative easing, designed to weaken sterling. Figure 3: The falling pound sterling

Source: http://uk.finance.yahoo.com/currencies/converter/#from=GBP;to=EUR;amt=1

Figure 4: Import prices (excluding fuels) and the pound sterling

Source: Bank of England, ONS and Bank calculations

Figure 4 shows how the fall in the value of the pound affected UK import prices. A weaker currency drove up the price of UK imports by over 20%. Higher import prices caused UK firms to raise their prices. The cost-push inflation created by the fall in the value of the pound quickly eroded the competitive benefits of a weaker currency. The Bank of England’s decision to cut interest rates to 0.5% and to print £200bn via quantitative easing has backfired. From 2008 onwards the Bank of England has struggled to keep inflation below target. The inflation created by artificially low interest rates and money printing has reduced the UK’s international competitiveness!
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Figure 5: UK Trade

Source: http://www.statistics.gov.uk/cci/nugget.asp?id=199

The fall in the value of sterling engineered by the Bank of England has so far failed to deliver the export-led recovery that was anticipated by the Keynesians. Figure 5 shows the UK’s trade deficit. The fall in the value of sterling has not improved the UK’s trade balance. The income generated from the sale of UK exports is still insufficient to cover the amount spent by the UK on imported goods. The data shows that a falling exchange rate has not fixed the UK’s international competitiveness problem. In addition to the handicap of high domestic inflation, many UK firms struggle to compete against their foreign rivals because they sell poor quality goods. A weak pound might, until inflation kicks in, at best help to create a temporary price advantage for UK firms. However, a weak currency will not help UK firms to overcome non-price factors that hold back the country’s international competitiveness

2. External factors
The economies that suffered most from the global financial crisis were those that had relied most on debt. During the boom years households in America, and much of Europe, used credit to boost consumption, creating short-run economic growth (see Topic 3 and Topic 5). Sadly, when credit disappeared aggregate demand in these countries crashed, leading to a sharp recession. In the circumstances it seemed unlikely that a recovery could be based around a recovery in domestic consumption; it would take households years to pay down their debts. To generate the increase in aggregate demand required to create a recovery, policy makers tried to stimulate exports. To create an export-led route out of recession central banks pursued policies that were designed to weaken their currencies. Countries that tried this approach encountered two problems. The first problem was that other countries were trying to do the same thing. The global financial crisis crunched the demand for goods and services across the developed world. As a result firms in countries such as Britain found it difficult to export because the credit crunch had decimated markets across the developed world. It is difficult to export if nobody is buying! And secondly, it was difficult for countries such as Britain to create a weaker currency because other countries were trying to do the same thing at the same time. For example, policymakers in most highly indebted countries in the developed world have also embarked upon programmes of quantitative easing, and interest rate cuts.
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Does the euro have a future, or can we expect a Greek tragedy?
During the spring and early summer of 2010 buyers of government bonds began to question the credit worthiness of governments in countries that were described as ‘the PIGS’ (Portugal, Ireland, Greece and Spain) by the bond and FOREX markets. The demand for the government bonds issued by these countries decreased because international investors started to think the unthinkable - in the future these governments might default on their national debts because they may not be able to raise the tax income needed to pay bond interest. The sovereign debt crisis affecting the PIGS was caused by a combination of persistent fiscal indiscipline and, to a lesser extent, the one-off increase in public debt caused by the banking bailouts of 2008. The crisis that threatened to engulf the PIGS was averted by a pan-European bailout of nation states, made possible by a combination of loans and ECB quantitative easing. The cash printed by the ECB and the loans supplied by taxpayers in richer countries, such as Germany, has been used to buy government bonds issued by the PIGS. As a result, governments in these countries no longer have to find genuine buyers for the debt that they need to issue to finance their fiscal deficits. The EU has stressed that countries such as Greece and Spain cannot expect more bailouts in the future. If the euro is to survive, countries that use the euro must keep fiscal deficits under control to limit the stock of public debt. The Stability and Growth Pact failed to restrain profligate governments in Greece and Spain because the EU failed to fine countries that opted to break the EU’s fiscal rules. In June 2010 the European Commission proposed that in the future eurozone governments would have to have their tax and spending plans approved by the EU before they could be implemented. Governments that might be tempted to run huge fiscal deficits would be prevented from doing so by the EU. This proposal might help to prevent the build up of public sector debt in the eurozone, reducing the risk of default in the future. However, it could be argued that the EU’s budgetary surveillance proposals are anti-democratic. At present the electorate in countries such as Greece and Spain have the opportunity to vote for governments that promise to run a form of fiscal policy that meets with their approval. In the future this democratic power will be lost if the EU gets its way. EU budgetary surveillance will prevent the electorate of a country from voting in a government that is able to achieve a pre-election promise to combine Scandinavian public services without the high rates of tax needed to pay for them. Going forward an important decision will have to be made. To survive, the members of the eurozone must agree to give up their fiscal sovereignty. However, is this a price worth paying, in terms of the democratic deficit created by this policy?

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Supporters of the euro argue that a single currency creates price transparency within the Eurozone, which enhances competition, leading to greater efficiency. In addition, the euro also eliminates exchange rate risk, encouraging firms within the Eurozone to trade with one another. The UK’s decision to retain sterling means that the UK has, almost certainly, failed to make the most of the opportunities created by the Single European Market. Critics of the single currency argue that the British government has been right in its decision to keep the U.K. out of the Eurozone. In practice, the ECB’s ‘one size fits all’ approach to monetary policy has failed because the Eurozone is not an example of an optimum currency area. Some countries within the Eurozone have failed to abide by the rules of the Stability and Growth Pact (SGP). Countries such as Greece have accumulated huge national debts, which they may struggle to service in the future. In the future the EU may have to tighten up the rules of the SGP in order to reduce the risk of a Eurozone member state from defaulting on its sovereign debt.

Topic 7 Summary Topic 7 Questions

1. Discuss the arguments for and against the UK joining the single currency. 2. Some economists argue that central banks should combat recession by creating an export-led recovery by pursuing policies that are designed to create a fall in the exchange rate. Evaluate the arguments for and against this approach. 3. Discuss the arguments for and against imposing stricter fiscal rules on Eurozone governments.

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Topic 8 Are Fiscal Rules only Fiscal Folly?
Fiscal Deficits
Fiscal deficits arise when government expenditure for the financial year exceed tax income. Governments finance their fiscal deficits by selling bonds, i.e. by borrowing. The PSNCR (Public Sector Net Cash Requirement) is the amount that the government has to borrow this year to finance a fiscal deficit. The national debt is the total stock of debt owed by the government to its creditors. The national debt increases when the government runs a fiscal deficit. Some economists think that it is important to split the fiscal deficit into two parts: the cyclical fiscal deficit and the structural fiscal deficit. Table 1: The UK’s Fiscal deficit in context UK fiscal deficit 2009-2010: Fiscal deficit as a % of GDP: UK national debt: Debt interest payments in 2009-2010: National debt as a % of GDP: Number of UK taxpayers: National debt per UK taxpayer: Annual governemnt debt interest expenditure per taxpayer: £165bn 12% £893.4bn £33bn 62.1% 25.5m £35,035 £1,294

Source: http://www.hm-treasury.gov.uk/d/public_finances_databank.xls

The Cyclical Fiscal Deficit
The cyclical fiscal deficit is that part of the total fiscal deficit that can be explained by a downturn in the trade cycle. During recessions induced government expenditure tends to rise automatically because during recessions more adults will be forced into claiming out of work government benefits, such as job seekers allowance and incapacity benefit. In addition, during recessions the government’s tax income tends to fall automatically because a fall in the numbers in employment will lead to a fall in both direct and indirect tax revenues. The UK’s fiscal deficit rose very rapidly during the credit crunch because of these automatic stabiliser effects that pushed up government spending and cut tax income simultaneously. Keynesian economists do not tend to be overly concerned by cyclical fiscal deficits because they argue that cyclical fiscal deficits are self-curing. For example, if an economy suffering from a recession recovers the government’s fiscal deficit will tend to fall automatically because a rise in employment will boost tax income and cut government spending automatically. During booms the fiscal deficit should fall automatically as the cyclical deficit falls quickly to zero, before then becoming negative.

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The Structural Fiscal Deficit
The structural deficit is that part of the fiscal deficit that cannot be explained by a downturn in the economic cycle. In other words, the structural deficit is that part of the fiscal deficit that would remain even after the economy has recovered from recession. Structural fiscal deficits are caused by policy errors on the part of the Chancellor of the Exchequer. Economists have estimated that the UK’s structural deficit might be as much as £100bn per year. In May 2010 the UK’s total fiscal deficit was approximately £165bn. Therefore, if these calculations are true, nearly two-thirds of the UK government’s fiscal deficit is structural and only one-third is cyclical. Structural fiscal deficits can be traced back to the desire on the part of politicians to chase votes by providing vote-winning improvements to public services, whilst at the same time, pursuing equally popular tax cuts. Gordon Brown’s structural fiscal deficit was caused by a rapid increase in public spending on health and education, without the necessary tax increases to fund this additional expenditure. Britain has run huge structural deficits in the past; the most common cause being the need to finance a war. Fortunately, this type of structural deficit is relatively easy to cure. For example, during WW2 the UK’s fiscal deficit was even higher than it is today. However, as soon as the war ended government spending dropped very quickly, eliminating most of the UK’s war time structural deficit.

A Word of Warning
Estimates of the relative size of the structural and the cyclical components of the fiscal deficit are exactly that: estimates. Until the UK economy recovers nobody will know just how big is the UK’s structural deficit. Figure 1: The UK’s Fiscal Crisis 2010 and Beyond (structural fiscal deficit as a percentage of GDP)

Source: OECD, World Economic Outlook, November 2009

In 2009 the OECD forecast that the UK’s structural fiscal deficit was equivalent to nearly 10% of UK GDP, which is above the 6% forecast for the Greek economy. Structural fiscal deficits are not self-curing. In 2010 the Greek government found it very difficult to impose fiscal austerity on the Greek people, who responded to tax increases and public sector spending cuts by rioting and going on strike. The new UK Conservative / Liberal coalition government elected in May 2010 pledged to make even bigger cut backs and tax increases.
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It remains to be seen how the British people will react to fiscal austerity, when it finally arrives.

Fiscal Rules
Fiscal rules are promises that the government has publicly made regarding the annual fiscal balance and the overall scale of the national debt. Fiscal rules were designed to avoid the type of fiscal crisis that the UK economy is now suffering from. The UK government has run fiscal deficits twenty-five times in the last thirty years. Governments run fiscal deficits during years when tax income falls below government spending. Governments finance fiscal deficits by borrowing. The government borrows by selling bonds. When governments run fiscal deficits the national debt rises. The national debt is the total amount owed by the government to its bondholders. The annual fiscal deficit should not be confused with the national debt. For example, during the 2010 election campaign New Labour politicians pledged that, if re-elected, a new Labour government would, “halve the deficit within four years”. This pledge was widely misinterpreted as a promise to halve the stock of public debt, i.e. the national debt. To reduce the national debt the government must run an annual fiscal surplus. The promise to halve the deficit was a guarantee that the government was still planning to increase the national debt over the next four years. Halving the deficit means halving the rate of growth of the national debt.

The UK’s Fiscal Rules
In the 1960s and 1970s Labour governments racked up huge fiscal deficits year after year. As a result, the UK’s national debt increased at an alarming rate. By 1976 the government was unable to fund its fiscal deficit in the conventional way because the bond market refused to purchase UK government debt. The bond market feared that the UK government would not be able to raise the tax income to pay its bond interest because its debts were too large relative to the size of the economy. New Labour won the 1997 general election. Gordon Brown and Tony Blair feared that the bond markets would react to a New Labour victory by selling-off UK government bonds. The reason quoted for the anticipated sell-off being the Labour party’s well earned reputation for fiscal imprudence and questionable economic competence. Lower bond prices would force the yields on UK government debt up, which in turn would drive up commercial rates of interest, damaging the economy. To counter this threat Gordon Brown set out to convince the bond markets that it would be different this time. Under his Chancellorship the government would not increase the national debt to an unsustainable level by running huge fiscal deficits year after year. Nor would Brown chase short run economic growth by using expansionary fiscal policy, at the expense of inflation and the value of the pound. Brown’s fiscal rules managed to change the bond markets’ expectations regarding the sustainability of the UK’s public finances. As a result, the cost of borrowing did not rise. Low and stable interest rates helped the UK economy to achieve growth and stability during the NICE decade. So, what were these fiscal rules that managed to win over the bond markets?

The Golden Rule
The golden rule pledged that the government would balance the budget over the duration of the economic cycle.
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In effect the golden rule was a promise to the bond markets that the UK would not increase the national debt over the duration of the economic cycle. The only exception to the golden rule was government borrowing to fund capital investment, which was considered to be acceptable. The government will only borrow to invest and not to fund current spending. Borrowing to invest is acceptable because it is sustainable, unlike borrowing to fund current consumption. Public investments should create a larger economy. A larger economy will help the government to raise more in taxation. The extra taxation can then be used to pay the interest on the money borrowed to fund the investment. In other words, over the ups and downs of an economic cycle the government should only borrow to pay for investment that benefits future generations. Day-to-day (current) spending that benefits today’s taxpayers should be paid for with today’s taxes, and not with borrowed money, which increases the national debt that future generations have to service. Figure 3: The Economic Cycle

The golden rule offered Gordon Brown some flexibility regarding the operation of fiscal policy. Keynesians believe that recessions are caused by a lack of aggregate demand in the economy. To counter the recession the government should use policies that are designed to increase the level of aggregate demand, an example being expansionary fiscal policy. The golden rule justified the use of expansionary fiscal policy during recessions. In the short run the national debt might increase. However, the budget would still remain balanced over the duration of the economic cycle if the government ran fiscal surpluses during the boom phase of the cycle. These surpluses would pay down the debts that were built up during recession.
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The Sustainable Investment Rule
The sustainable investment rule introduced by Chancellor Gordon Brown was a government promise to the bond market that the national debt would not exceed more than 40% of the UK’s GDP. The sustainable investment rule assumed that all of the government’s national debt was built up by the government borrowing in order to fund capital investment. In practice much of the government’s national debt has arisen because governments have borrowed to fund non-capital items (current expenditure), such as the wages of public sector workers. The sustainable investment rule measures the affordability of the national debt. If a country’s debts grow too large relative to the size of the economy a debt default becomes more likely. Governments pay debt interest from tax revenues. The amount of tax that the government is able to collect depends upon the level of economic activity. Smaller economies generate smaller tax revenues. Therefore, in order to prevent default the national debt needs to stay fairly small in absolute terms.

The EU’s Fiscal Rules: The Stability and Growth Pact
The EU has made two fiscal promises on behalf of its democratically-elected governments that have opted to use the euro as their currency. The first promise places a cap on the annual fiscal deficit. Eurozone countries are not permitted to run an annual fiscal deficit that exceeds 3% of GDP. The second promise relates to the stock of debt. Eurozone countries must keep their national debt below 60% of their GDP

The Advantages of Fiscal Rules 1. Economic stability
Economic stability is achieved when the regular oscillations in economic activity caused by the economic cycle are not overly pronounced. Stable economies still suffer from recessions. However, these recessions will be less severe when compared against less stable economies. Likewise, stable economies still enjoy booms. However, these boom periods are less dramatic than in less stable economies. Stable economies enjoy low and stable rates of inflation and unemployment. During his chancellorship, time and time again, Gordon Brown promised an end to ‘boom and bust’. Brown believed that his fiscal rules would enable him to deliver on his promise of economic stability. The golden rule would enable the government to run fiscal deficits to counteract recessions, preventing them from becoming too deep. On the other hand, the golden rule would also prevent booms from getting out of control. During this phase of the cycle the government would run fiscal surpluses to cool down an economy that would otherwise overheat. Running fiscal surpluses during boom periods would withdraw spending power from the economy, reducing the rate of growth of aggregate demand. Controlling the rate of growth of aggregate demand would help to prevent the emergence of two classic symptoms of an overheating economy: namely demand-pull inflation and a growing current account deficit. Modern Keynesian economists argue that economic stability makes the future easier to predict. If the economic growth rate remains fairly stable over time business confidence will tend to rise as uncertainty regarding the future falls. Improving business confidence benefits the economy because private sector investment will tend to rise.
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Higher levels of investment will create an increase in the economy’s long-term trend rate of economic growth. Some economists claim that Gordon Brown’s fiscal rules were critical in enabling the NICE decade.

2. Low inflation
New Classical economists that believe in the theory of monetarism argue that inflation is always and everywhere a monetary phenomenon. Inflation arises during periods when the money supply grows at a faster rate then the economy. To control inflation monetarists argue that the government must reign in the growth of the money supply to match the rate of growth of national output. Monetarists argue that the scale of the fiscal deficit affects the rate of growth of the money supply. Government bonds are a broad form of money. If the government runs a huge fiscal deficit the government will have to issue bonds to raise the finance needed to fund the deficit. Printing more government bonds will increase the broad money supply, which will increase the risk of inflation. History tends to support the link between fiscal policy and inflation. Periods of high inflation are normally preceded by wars. Most wars are financed via huge fiscal deficits. Fiscal deficits increase the supply of government bonds, which increases the broad money supply. A rapid increase in the money supply causes inflation. Fiscal rules encourage a more prudent approach towards fiscal policy. For example, the EU’s decision to cap annual fiscal deficits at just 3% of GDP limits the amount of new bonds that governments are able to issue each year. Limiting the amount of bonds that can be issued helps to restrict the rate of growth of the money supply, making inflation less likely.

3. Low interest rates
Fiscal rules that limit the size of a country’s annual fiscal deficit help to restrain inflationary forces within the economy. If inflation can be kept in control via prudent fiscal policy the central bank will have a better chance of achieving its inflation target without the need to tighten monetary policy. Fiscal rules help to keep inflation and interest rates low during economic booms. According to Keynesians demand-pull inflation is caused by an increase in aggregate demand when the economy is operating in equilibrium at, or close to, full employment. The golden rule helps to keep inflation low because the golden rule obliges governments to run fiscal surpluses during the boom phase of the economic cycle. To meet the golden rule governments must run fiscal surpluses during booms to pay off the fiscal deficits that were run up during recession. The policy of contracting fiscal policy during a boom reduces the rate of growth of aggregate demand. If the rate of growth of aggregate demand is slowed by the need to meet the golden rule the economy is less likely to suffer from overheating, making demand-pull inflation less likely. If the Treasury can help the central bank to meet its inflation target the central bank will be justified in keeping interest rates low. Keynesians believe that low interest rates benefit the economy. Low interest rates reduce the cost of borrowing for firms that wish to invest. If investment rises the economy should grow at a faster rate. Governments that run irresponsible fiscal deficits create inflation. If inflation rises above target the central bank will need to act to bring inflation back below target. This normally requires the central bank to raise interest rates. Higher interest rates reduce investment and therefore economic growth.
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Fiscal rules that constrain the stock of public debt also help to keep interest rates low. If the national debt is allowed to grow too large relative to GDP of the country the risk of default rises. Governments default when they refuse, or are unable, to pay the interest that is due on their government bonds. Debt as a percentage of GDP measures the affordability of a nation’s national debt. The risk of default rises when debt rises relative to the size of the economy because the government will find it harder and harder to raise the tax incomes needed to pay the bond interest due. If the perceived risk of a sovereign default rises the demand for a country’s government bonds will fall. In the circumstances governments that want to carry on running fiscal deficits must offer higher rates of interest on their bonds in order to compensate investors for the additional risk of buying bonds that are more likely to default. If the total stock of public debt remains low, relative to GDP, the debt will remain affordable. As a result the perceived risk of a default will remain low. If the perceived risk of a future default stays low the government should be able to finance its fiscal deficits at a relatively low rate of interest. Low rates of interest benefit firms and consumers. However, low rates of interest also benefit the taxpayer too because they reduce the cost of servicing the national debt. If debt servicing costs fall the government will be able to spend a greater percentage of the country’s tax income on public services, such as health care and education. Countries that break their fiscal rules might find themselves spending more on debt interest each year.

4. Preventing ‘crowding out’
According to the theory of crowding out, the opportunity cost of a decision to enlarge the public sector is a smaller private sector. Attempts by the government to enlarge the state should always be resisted because the fall in private sector output created by the expansion of the public sector will more than offset any increase in public sector output caused by additional state spending. Running fiscal deficits to boost public sector output will cause GDP to fall. Why does the crowding out effect occur? Economists have various explanations. The first revolves around the widely-held assumption that free market economists, who believe in the theory of crowding out argue that the private sector will always be a more efficient user of scarce factors of production than the public sector, because unlike the public sector the private sector has to make a profit in order to survive. The requirement to make a profit means that productivity in the private sector should always be higher than factor productivity in the public sector. It therefore follows that attempts by the government to transfer factors of production from the private to the public sector via fiscal policy should be resisted at all costs. Transferring factors of production from the private sector, where productivity is high, to the public sector, where productivity is low, will reduce the average level of productivity across the whole economy. If productivity on average across the whole economy falls the result will be a fall in GDP even if the country’s factor endowment remains the same. So why does an expansion of the state always lead to a contraction of the private sector? Economists have three explanations for the ‘crowding out’ effect. • To expand public sector output additional factors of production will be required. These factors of production must be withdrawn from the private sector. If factors of production are withdrawn from the private sector, private sector output will fall.
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Governments that want to expand the output of the public sector will have to increase government expenditure. In the long-run, the extra government expenditure will lead to higher tax rates. If tax rates rise, household disposable incomes will fall. If disposable incomes fall, consumption across the economy will also fall. A fall in private sector consumption will shrink the size of markets in the private sector. If the number of spending votes cast into the private sector falls, private sector output must also fall too. In practice most governments that try to expand the role of the state do so via fiscal deficits. To finance fiscal deficits the government has to borrow from the private sector by selling bonds. If the government increases the amount that it borrows there will be fewer funds available for firms in the private sector to borrow. The shortage of investment funds available for the private sector will drive commercial rates of interest up. Higher rates of interest will lead to a smaller private sector because higher rates of interest will reduce the levels of both private sector consumption and private sector investment.

5. Sustainable public finances
Governments that set, and then adhere to strict fiscal rules will be less likely to suffer from a sovereign debt crisis than profligate, fiscally incontinent administrations. For example, fiscal rules that limit the size of the national debt relative to the economy are a good idea because they reduce the risk of a destructive debt spiral taking hold. Debt spirals occur when governments run fiscal deficits year after year, resulting in a situation where the national debt grows too big relative to the size of the economy. A huge national debt means that the government will be committed to huge annual debt servicing costs. The economy might not be able to generate the tax incomes required to pay these costs. When this happens the government is forced into borrowing in order to pay the interest on its existing debts. Borrowing to fund interest payments is a bad idea because the stock of debt owed will increase. If the stock of debt owed increases the annual interest payments due on the debt will rise, which requires further borrowing. Most economists believe that the danger of a debt spiral becomes real once the national debt exceeds 100% of GDP. Countries that allow a debt spiral to take hold typically end up defaulting on their national debt. The main problem of defaulting on holders of government debt is that the government will find it more difficult to borrow in the future. As a result, the future cost of borrowing is likely to go up because investors will want to be compensated for the additional risk of holding the government bonds of a country that has a past record of reneging on its debts.

6. Intergenerational equity
The phrase intergenerational equity means fairness across the generations. Fiscal rules facilitate intergenerational equity because they restrict a government’s ability to provide high quality public services that benefit the current generation that have been financed via debt that future generations will be obliged to service and pay back. Politicians realise that the best way to stay in power is to provide high quality public services without raising taxation to pay for these services. In the absence of fiscal rules politicians might be tempted to finance better public services by taking on debt, rather than by raising taxes. Governments try to borrow over relatively long periods of time - 25 years or more. Therefore, future generations will have to pay additional taxes to pay the costs of servicing the debt that was taken on to finance the public services that their parents’ generation enjoyed. It could be argued that it is morally wrong for future generations to be asked to pay more in tax for public services that they never had the opportunity of consuming.
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Disadvantages of Fiscal Rules 1. Fiscal rules impose a fiscal straightjacket on policy makers
Keynesian economists argue that recessions are caused by a lack of aggregate demand. Governments should not stand back and allow the economy to remain in equilibrium with a huge negative output gap. Instead, the government must intervene and use reflationary demand side policies such as expansionary fiscal policy and/or slack monetary policy. Reflationary policies that increase the level of aggregate demand in the economy will increase the equilibrium level of output and employment, moving the economy out of recession. According to Keynesians the economy is not self-regulating. The economy will remain in recession if aggregate demand remains low and stable. Fiscal rules are opposed by some modern Keynesian economists, such as Professor David Blanchflower because they might limit the fiscal deficit that policy makers might wish to deploy in order to get the economy out of recession. For example, in the Eurozone governments must promise to keep their annual fiscal deficit below 3% of GDP. During a severe recession Keynesians might argue that a fiscal stimulus of just 3% might not be enough to provide the demand-side push required to create a healthy recovery. Figure 4: The constraint of fiscal rules

In Figure 4 initially, before the recession struck the economy is portrayed as being in equilibrium producing an output of NY1 because aggregate demand was stable at AD1. The recession decreases the level of aggregate demand from AD1 to AD2. As a result the equilibrium level of GDP crashes from NY1 to NY2. To counteract the recession Keynesian policy makers would recommend a fiscal stimulus which would increase the level of aggregate demand from AD2 back to AD1. If this policy can be enacted the equilibrium level of national income would re-bound from NY2 back to NY1. Critics of fiscal rules argue that overly strict fiscal rules might prevent policy makers from running the fiscal deficit needed to increase aggregate demand from AD2 to AD3. For example, the EU’s fiscal rule that annual deficits must be capped at 3% of GDP will limit the scale of the fiscal stimulus that policy makers can impose on the economy. A deficit of just 3% of GDP might only be enough to increase aggregate demand from AD2 to AD3. An increase in aggregate demand of this magnitude will produce an unsatisfactory, anaemic recovery; the increase in the equilibrium level of GDP is just NY2 to NY3.
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The UK’s fiscal rules do offer policymakers greater flexibility to counter recessions via expansionary fiscal policy. Unlike the EU, the UK has not made a fiscal promise to limit the annual fiscal deficit to 3% of GDP. The nearest UK equivalent is the golden rule. Theoretically, policy makers in Britain would be permitted to run an annual fiscal deficit of 10% to counter recession, and still be able to meet the golden rule promise to balance the budget over the duration of the economic cycle. Keynesians like David Blanchflower argue that policymakers in Europe have a deflationary bias. The EU’s stability and growth pact fiscal rule that limits a country’s annual fiscal deficit to just 3% of GDP is too restrictive and overly prudent. The opportunity cost of this prudence is that during recessions fiscal policy measures might lack the power to move the economy out of recession. In contrast, the UK’s fiscal rules are far less restrictive, and therefore, preferable.

2. Fiscal rules will only be effective if policymakers adhere to them
Fiscal rules have the potential to create economic stability. However, fiscal rules are only targets. If governments set impressive fiscal rules, but then subsequently disregard and break their own rules most of the potential benefits of fiscal rules will be lost. For example, in the UK the government promised that the national debt would not exceed 40% of GDP. The government also promised to balance its budget over the duration of the economic cycle. Unfortunately for the UK the government broke its own fiscal promises. The national debt exceeds 65% of UK GDP because the government broke its golden rule by running fiscal deficits throughout the economic cycle. Gordon Brown’s attempts to meet the golden rule by ending the duration of the economic cycle have also adversely affected the credibility of the UK’s fiscal policy. UK fiscal policy also lacks transparency too. For example, under Gordon Brown the Treasury hid public sector debt off balance sheet, using various creative accounting dodges, such as PFI, unfunded public sector pension liabilities and the debts run up by the government owned not for profit company, Network Rail. If these liabilities were included the UK’s national debt would already exceed 100% of UK GDP. Figure 5: UK Budget Deficits

Source:http://seekingalpha.com/article/117374-u-k-debt-burden-from-current-crisis-to-last-20years

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During Gordon Brown’s time as Chancellor the Treasury increased the length of the economic cycle several times over the last few years, which, conveniently, had the effect of helping the government to meet its golden rule! Figure 5 shows that during the period from 1980 to 2008 the UK government only managed to run a fiscal surplus on five occasions. If policymakers break the fiscal promises that they have made the government will lose credibility will the all important bond market. Governments that allow the national debt to get out of control run the risk of default. To compensate for the additional risk of holding government bonds higher rates of interest will need to be offered to investors. In 2009 the UK government tried to re-assure the bond markets by passing the Fiscal Responsibility Act. This new fiscal promise pledged that the next government would halve the annual fiscal deficit in four years. It remains to be seen whether the bond market will be influenced in a favourable manner by this new fiscal promise. Will the bond markets trust the UK government to take the actions required to meet this promise, or will the government continue to break its promises? In the Eurozone fiscal rules have been poorly enforced. In theory the EU has the power to fine member states that break the rules of the stability and growth pact. Unfortunately, some member states that have broken the rules have failed to pay their fines, creating a moral hazard. Over time more and more member states have elected to break the stability and growth pact rules because they know that the EU will not penalise them effectively. There have also been allegations that some member states have only managed to stay within the rules by using creative fiscal accounting. For example, the Greek government hired the American investment bank, Goldman Sachs to hide part of its national debt off balance sheet in order to qualify for Eurozone membership.

The UK government’s off-balance sheet items identified
In October 2008 the Conservative MP, Brooks Newmark, released a report that itemised the off balance sheet items of government debt that Gordon Brown had swept under the fiscal carpet. These items were:1 Unfunded public sector pension liabilities: £1,071bn PFI: £100bn Network Rail: £20bn Banking bailouts: £530bn Total of all these off balance sheet items = £1,721bn Official national debt: £633bn True national debt, including off balance sheet items: £2,354bn At the time, the official national debt was still below 50% of UK GDP. However, if the off-balance sheet items were included the true figure would have been 161% of GDP.

1

http://www.spectator.co.uk/coffeehouse/2532196/the-debt-adds-up.thtml
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The need for fiscal discipline within the Eurozone
The Eurozone debt crisis has been caused by excessive sovereign debt. In countries such as Greece highly indebted governments are now finding it harder to finance their fiscal deficits because investor demand for Greek government bonds has fallen due to the increased risk of a sovereign default. To re-establish the credibility of the single currency the EU must impose fiscal discipline on countries like Greece to reassure the bond markets that the EU and the ECB will never again allow governments like the one in Greece to rack up huge unsustainable debts. When the euro was established the EU was supposed to impose the EU’s fiscal rule, the growth and stability pact, on member states. Unfortunately, sovereign governments ignored both the 3% annual deficit rule and the rule that capped a country’s national debt at 60% of GDP. Some countries used creative fiscal accounting to comply with the growth and stability pact. Other countries, such as Italy simply refused to pay the fines imposed for breaking fiscal rules. Other countries, such as Spain carried on running fiscal deficits above 3% of GDP when instructed to stop by the EU. The single currency will only be able to survive if the EU is able to impose fiscal discipline on the countries that use the euro as their currency. If fiscal discipline can not be imposed on countries like Greece, the EU will face the following choices: 1. Greece’s national debt will carry on growing until Greece defaults. When Greece defaults commercial banks in other parts of the Eurozone that own Greek government bonds will experience bad losses. A sovereign default in Greece could create a banking crisis in Germany. 2. To prevent a Greek default, richer Eurozone countries like Germany will have to bail out the Greek government at the German taxpayers’ expense. 3. To prevent a Greek government default the ECB could agree to quantitative easing. The cash printed by the ECB could then be used to buy up Greek government bonds. The only problem is that history shows that monetising fiscal deficits tends to be highly inflationary. 4. Impose fiscal austerity on the Greek government. If the Greek government stops running a fiscal deficit the Greek government will no longer have to find buyers for its bonds. This route is unlikely to win popular support amongst taxpayers in Greece.

The likely outcome
The EU looks to be trying to tighten up its fiscal rules and to deal with the debt crisis by imposing austerity onto profligate governments like the one in Greece. The German Chancellor Angela Merkel has suggested that the EU should withhold social fund payments (EU regional policy money) from governments that fail to abide by the stability and growth pact. Another idea that has been raised is that every European finance minister (including Britain’s Chancellor, George Osborne) should be compelled to send his Budget plans to Brussels for approval before announcing them to his own MPs and citizens. Chancellor Osborne, understandably, was having none of it, using his inaugural European summit to insist that when it came to a country’s budget, “the national parliament must be absolutely paramount”.

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Policymakers in Europe face a very difficult decision. On the one hand it is now fairly clear that the EU needs to impose fiscal discipline on more profligate member states if the single currency is to survive. However, imposing a European Commission veto on an elected government’s tax and expenditure plans would be undemocratic. The single currency has been a force for both economic integration and globalisation. Consumers (lower prices) and shareholders (higher profits) have benefited from globalisation. Preserving the single currency might help to boost trade and facilitate economic growth in the euro zone. The question is whether these material benefits are enough to outweigh the non-material costs of a loss of national sovereignty over fiscal policy. The benefits, in terms of economic development, of a truly democratic national parliament should not be underestimated.

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A fiscal deficit occurs when a government spends more than it collects in taxation. Governments that run fiscal deficits have to borrow the shortfall by selling interest bearing bonds. If a government runs a fiscal deficit, the total stock of debt owed by the government, the national debt, will rise. Therefore, the promise made by Gordon Brown in spring 2010 to, “halve the deficit over the next parliament” was actually a commitment to increase the UK’s national debt! Halving the annual fiscal deficit just halves the rate of growth of the national debt. The fiscal deficit can be split into two components: the cyclical and the structural deficit. The cyclical deficit is that part of the budget deficit caused by a downturn in the economic cycle. This is because during recessions, when unemployment rises, tax revenues tend to fall and welfare expenditure tends to rise. The structural deficit is that part of the fiscal deficit that cannot be attributed to a recession. A high proportion of the UK’s fiscal deficit is, almost certainly, structural. Structural deficits are created by politicians who attempt to buy votes by promising better public services without the tax increases needed to pay for these improvements. Fiscal rules are promises or pledges made by politicians to restrict the annual fiscal deficit and to control the rate of growth of the national debt, making the risk of default less likely. Fiscal rules are designed to reassure bond markets. If the buyers of government debt believe that politicians are committed to their fiscal rules they should be willing to lend to these governments at lower rates of interest. Lower rates of interest will enable politicians to devote a greater proportion of tax income to public services, rather than to debt interest. Keynesian economists tend to be less enthusiastic about fiscal rules because they limit the flexibility of policy makers to counteract recession. During recessions, Keynesians believe that governments should run fiscal deficits to increase the level of aggregate demand. If fiscal rules are too strict the government might struggle to engineer the fiscal stimulus needed to push the economy out of recession. In recent times policy makers have ignored their own fiscal rules, running up huge national debts. For example, Gordon Brown completely ignored his own pledge to balance the budget over the duration of the economic cycle. During the boom years when the government should have been running fiscal surpluses, Brown elected to run deficits. Fiscal rules will only be effective if they are credible. In principle, fiscal rules should create a degree of intergenerational equity: fairness between the generations. Brown’s decision to ignore his own fiscal rules for short-run political gain will impose financial pain on future generations. These future generations will be asked to pay higher taxes in order to service and pay off the debts built up to finance the lavish public services and pensions provided for the baby-boomer generation.

Topic 8 Summary Topic 8 Questions

1. Distinguish between a structural and a cyclical fiscal deficit. 2. During the 2010 general election Gordon Brown promised that, if re-elected, his government would halve the fiscal deficit during the next parliament. Many members of the public, and even journalists, misunderstood this pledge, believing that Brown had promised to reduce the UK’s national debt. Explain this error. 3. Should policymakers disregard their own fiscal rules? 4. Discuss the case for and against stricter fiscal rules in the eurozone.

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Topic 9 Is Deflation a false threat?
What is deflation?
The economy suffers from deflation when the average price level within the economy falls over time. Deflation increases the purchasing power of money, i.e. more goods and services can be bought using a unit of domestic currency than before. Deflation produces a negative rate of inflation. Deflation is often confused with falling inflation. For example, during the second-half of 2008 and into 2009 the UK’s rate of inflation, as calculated by the government’s and the Bank of England’s official measure of inflation, the consumer price index, fell. Table 1: Inflation rates in the UK Time period Annualised inflation rate (CPI) 2008 Q3 4.8% 2008 Q4 3.9% 2009 Q1 3.0% 2009 Q2 2.1% 2009 Q3 1.5%
Source: www.statistics.gov.uk/statbase/TSDdownload2.asp

Table 1 shows that the rate of increase in consumer prices fell for over a year. This is not the same as deflation. It is important to note that throughout this period prices were still increasing. As a result, the internal purchasing power of money in the UK also fell. In other words, £1 in 2008 bought more goods and services than £1 in 2009. Falling inflation should never be described as deflation! Some commentators also mistakenly refer to falling asset prices as deflation. Falling asset prices are falling asset prices. On their own, falling asset prices do not constitute deflation. Deflation is the fall in the average price level.

Alternative definitions of inflation and deflation
Austrian economists, and others that believe in the theory of monetarism, argue that the most important influence on the average price level is the rate of growth of the money supply. According to monetarists inflation is always and everywhere a monetary phenomenon. If the money supply grows faster than the economy the result, assuming a constant velocity of circulation, will be a rise in the average price level. Economists that believe in the views of Ludwig von Mises argue that monetary inflation is a far more important concept than price inflation because monetary inflation causes price inflation. The rise in the average price level recorded by indices such as the CPI and RPI (price inflation) are merely symptoms of what inflation really is (monetary inflation): an expansion of the money supply flowing around the economy.

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Austrian economists view deflation as being a situation where the money supply contracts. If the money supply shrinks at a faster rate than the economy the result will be a fall in the average price level, assuming that the money supply circulates around the economy at a constant rate. In March 2008 the Bank of England announced that it was going to inject money into the economy by printing money. The Bank called this policy quantitative easing (For further discussion see Topic 6). The money printed has been used by the Bank of England to buy government bonds. By February 2010 the Bank of England had printed over £200bn of cash, which doubled the UK’s narrow money supply. Austrian economists would definitely not agree with the assertion that the UK economy has undergone a period of deflation. The reverse is true.

The problems of measuring price inflation
Central Banks measure price inflation by selecting an average basket of goods and services that is supposed to be representative of a typical household’s expenditure. Each month the price of each of these items in the average basket of goods is monitored. A weighted average of the price changes is then calculated, producing the official inflation figure. Official rates of price inflation, calculated using weighted indices tend to be presented as objective facts. In reality these indices are subjective. In countries such as Argentina, some economists have argued that the government manipulates price indices for political or economic reasons. Theoretically it is possible for a government to deliberately set out to under-record inflation. Governments that might want to pursue this goal could achieve this objective by adjusting the contents of the average basket of goods used to calculate inflation. From time to time all governments substitute items in and out of the average basket of goods to reflect changes in consumer tastes and advances in technology. To minimise the official rate of inflation a corrupt government could instruct statisticians to substitute items that have gone up in price with cheaper alternatives. Item weights could also be set so as to minimise the rate of inflation. For example, products such as I-Pods and lap-top computers that tend to fall in price over time due to technological advances could be given higher weightings within the index than warranted. On the other hand, products such as petrol that are more likely to rise in price in the future could be given relatively low weights in the index. This may all seem far-fetched. However, governments do have a very strong incentive to under-record inflation. For example, governments that have used inflation to default on their sovereign debts in the past may have to index-link a very high proportion of their gilts. If the government is able to under-record inflation the government’s expenditure on debt servicing will be lower than it would have otherwise been. Under-estimating inflation will also help the government’s fiscal balance. The pay rises of public sector workers tend to be linked to the official rate of inflation. A lower official rate of inflation makes it easier for the government to justify relatively modest increases in public sector pay.

Did the UK economy suffer from deflation during the period 2008 – 2009?
The answer to this question depends upon the index used to calculate price inflation. The government’s preferred measure of inflation prior to 2003 was the RPI (Retail Price Index). The RPI is a relatively broad measure of price inflation that includes housing related costs, such as mortgage interest, council tax and buildings insurance. The RPIX measure of inflation excludes mortgage interest payments only.
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In 2003 the government changed the official measure of inflation. The new measure of inflation adopted was the CPI (Consumer Prices Index). The CPI is a much narrower measure of inflation that excludes all the housing-related costs that are included within the RPI. During the housing boom that ended in mid-2008, CPI inflation lagged behind RPI inflation. Rampant house price inflation certainly increased the cost of living for many UK households. However, due to a political decision made by the government this inflation was masked from the official figures. At this time the media studiously chose to ignore the rise in RPI inflation created by rising house prices. Inflation was only thought about from the point of view of the CPI. The onset of the credit crunch in 2008 led to a period of credit contraction. This contraction of credit decreased the demand for housing, causing the property bubble to burst. Figure 1 shows that from September 2008 onwards the rate of CPI inflation declined. However, the rate of RPI inflation fell at a much faster rate than CPI inflation because at this stage house price inflation was strongly negative. According to the Nationwide the average price of a house in the UK at the end of 2007 was £184,000. One year later, the same house cost £150,000 - a fall of nearly 19%. The weighting given to housing-related costs in the RPI is relatively high, which magnified the effects of falling house prices on this measure of inflation. In February 2009 the RPI turned negative. At that time media interest in the RPI, which had been studiously ignored since 2003, was mysteriously re-born. The headlines screamed alarm: the UK economy was suffering from deflation! But was this assessment factually accurate? The RPI stayed in negative territory until November 2009. Throughout this period of ‘deflation’ the official rate of inflation, the CPI, remained positive. The government and most of the media seemed keen to promote the view that the UK was suffering from deflation, which was not strictly true. Figure 1: Different price indices in the UK

Source: www.statistics.gov.uk/CCI/nugget.asp?ID=19

Who’s afraid of deflation?
Keynesian economists argue that deflation should be avoided at all costs because it can create a downward spiral in economic activity. According to Keynesians, if deflation persists for a long period consumers will choose to postpone some of their purchasing decisions in anticipation of lower prices. If prices are expected to be lower in the future it pays to wait and save because in a deflationary environment £1 spent today will buy less than £1 in one year’s time.
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If households respond to deflation in the way suggested by Keynesians, i.e. by saving a greater proportion of their income, private sector consumption will fall. Other things being equal, a fall in consumption will lead to a fall in aggregate demand. Keynesians believe that the level of aggregate demand determines the level of output and employment within an economy. If the general level of spending in the economy falls, sales will also fall too. In order to avoid the build up of unnecessary stock, firms are likely to respond to falling sales by reducing output and employment. Figure 2 shows that a fall in aggregate demand from AD1 to AD2 will lead to a fall in the equilibrium level of national income from NY1 to NY2 and a fall in the level of employment from E2 to E1. Figure 2: Deflation

However, is this nightmare scenario likely? Will the fear of deflation really cause consumers to postpone purchases? In practice, consumers are not put off by the prospect of lower prices. Take the market for consumer electronics. The price of HD TV’s, mobile phones and computers have been deflating for years. Furthermore, consumers expect prices to carry on falling in the future too due to technological advances. Consumers also expect future improvements in product quality and functionality too. Despite this consumers do not respond in the way predicted by the deflationists. In practice households do not postpone their purchases. Instead households buy a new TV or computer whenever they are needed. Households know full well that the price of an I-Pod will fall in the future. They also know that the next generation I-Pod will be better than the current one, but that does not seem to put them off buying today. Deflation does not cause consumers to postpone their purchases. This argument is one of many deflationary myths. A second reason why deflation is feared relates to debt. During periods of deflation prices fall, including the price of labour: wages. If wages fall existing debts will be harder to service. If debt servicing costs form a higher percentage of wages, disposable incomes will fall.
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If disposable incomes fall, consumption is likely to fall too, pushing down on aggregate demand. According to Keynesians a fall in aggregate demand will push the economy into recession. During recessions national income falls. Falling incomes will increase the burden of debt a second-time. Indebted households will be forced into cutting expenditure again, creating the dreaded debt-deflation spiral. A debt-deflation spiral would be extremely bad news for a highly-indebted economy such as the UK. However, UK households can rest easy in the knowledge that there has never been a sustained period of deflation in an economy running a fiat currency. Central bankers won’t let it happen! In practice the reverse is true. History shows that central banks such as the ECB, Federal Reserve and our own Bank of England have an inflationary bias. Central banks actively go out to create inflation, especially in countries that have a debt problem. Why? Inflation reduces the real value of debt. Central banks create inflation by expanding the money supply faster than the economy. In the past when the world’s major currencies were backed by either gold or silver central banks found it hard to expand the money supply quickly because extra precious metal would have to be acquired to back every extra note and coin in circulation. The switch to fiat currency that occurred when the gold standard broke down removed this problem. Fiat currencies are not backed by precious metals, such as gold or silver. Fiat currencies gain acceptance by government decree. Today all of the major currencies of the world are fiat currencies. According to Federal Reserve chairman, Ben Bernanke, deflation is easily avoided. “Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost... We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”1 History shows that deflation has only ever occurred in economies that have had commodity, rather than fiat money.

Japanese ‘deflation’
Deflationists frequently quote the example of Japan in the 1990s to prove that deflation is possible in an economy operating with a fiat currency. The only problem is that the facts do not entirely back up this assertion. Figure 3: The economy of Japan: the CPI index

Source: http://www.econstats.com/r/rjap_aa20.htm 1 Comments made by Ben Bernanke during a speech to the National Economists Club, Washington DC, November 21st 2002. www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm Crisis Economics: The Cutting Edge Topic 9 107

Figure 3 shows that the Japanese economy experienced mild negative CPI growth during the period from 1998 until 2003, and again during 2008 -2009. However, the data also shows that the average price level in Japan actually rose during the whole period, i.e. 1991 - 2009 by 3.4% (100.6 – 97.3 * 100). So during Japan’s lost decade(s), there was actually more inflation than deflation! The yen is not backed by precious metal or anything else. It is a fiat currency. If this is the best example of deflation in a modern economy, running a fiat currency, the deflationists need a better example. During Japan’s lost decade Japanese asset prices certainly crashed. Take the value of Japanese companies: the Nikkei share index peaked in 1990 at nearly 39,000. By 2003 the same index stood at 7,600, a drop of over 80%. The fall in Japanese property prices was even more dramatic, which fell between 50 and 90%, depending on the area. However, to reiterate, falling asset prices, on their own, do not constitute deflation.

Conclusions
In recent years central banks, including the ECB, have operated with an inflationary bias. Policies such as quantitative easing and zero interest rates have increased consumer prices. These same policies have also managed to put a floor under asset prices, such as housing and shares, which were in danger of collapsing from their bubble levels. Preventing further falls in house prices is seen as being important in order to prevent further bad debts for Britain’s commercial banks. The UK’s national debt is at a record peacetime high. Fortunately for the UK, the government has been able to borrow in our own currency. After WWII the UK government used inflation successfully to reduce our debt burden. It seems likely that the UK government will try to inflate away our debts again. At the same time the bogus threat of deflation has been used to keep UK interest rates artificially low, which has reduced our debt servicing costs. The City has also been instrumental in creating deflationary hype. The UK banking sector has been the major beneficiary of quantitative easing, a policy justified by the false threat of deflation.

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Topic 9 Summary Topic 9 Questions

Deflation occurs when the average price level across the economy falls. Historically, deflation is an extremely rare event for any economy running a fiat currency. Instead, inflation, which occurs when the average price level rises, is very much the norm. Deflation increases real wages, enabling workers to enjoy a higher standard of living. However, Keynesians argue that deflation encourages consumers to postpone consumption, leading to lower levels of aggregate demand, and ultimately, recession. In practice it is not certain whether consumers really do respond to deflation by postponing consumption. To combat the perceived threat of deflation in Britain and the USA central banks have slashed interest rates and printed money via a policy called quantitative easing.

1. Distinguish between fiat and commodity money. 2. Explain why inflation is more common than deflation in economies that operate with fiat currencies 3. Some economists believe that inflation measurements that rely upon price indices are unsatisfactory because they are, to a large extent, subjective. Do you agree or disagree with this view? How else might inflation be measured apart from price indices? 4. The UK is a highly indebted economy. What problems might deflation create for an economy that has very high levels of public sector and private sector debt? 5. According to Federal Reserve chairman Ben Bernanke central banks can prevent deflation by printing money. Discuss whether Ben Bernanke is right. Is deflation always preventable?

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Topic 10 Why does the world economy need to re-balance?
Introduction
It could be argued that it is impossible to appreciate what caused the credit crunch without first understanding the balance of payments and the persistent trade imbalances between creditor (e.g. China, Germany and Japan.) and debtor nations (e.g. USA, Ireland and the UK).

What is the balance of payments?
The balance of payments records the currency movements in and out of a country created by foreign trade and by changes to a country’s net wealth, i.e. currency flows generated by changes to a country’s assets and liabilities. The balance of payments is split into two accounts: the current account and the financial account. The current account compares foreign currency income earned from the sale of exports and income from assets held abroad, with expenditure on imports and UK liabilities owed to foreign creditors. The income recorded on the current account can be generated in three ways: by exporting goods, by exporting services, and by receiving unearned income from assets owned overseas. The expenditure recorded on the current account comes from importing goods and services, and by paying rent, interest and profit to foreign nationals. The financial account records currency inflows and outflows created by changes to a country’s net wealth. For example, if a country sells a domestic asset to a foreign buyer a currency inflow will be created on the financial account. However, if a citizen purchases a foreign asset a currency outflow will be created on the financial account. Country’s that run current account deficits invariably spend more on imported goods and services than they receive in income from the sale of exported goods and services. To finance a current account deficit a country must run a financial account surplus. A financial account surplus can be generated by selling off UK assets to foreign buyers, or by borrowing from abroad, i.e. UK nationals and firms taking out new liabilities with foreign creditors.

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Figure 1: Current account positions (per cent of own GDP) in 2007

Source: World Economic Outlook, October 2007

Figure 1 shows a world divided according to current account balances. One half of the world are net producers and net savers. These ‘creditors’ run current account surpluses and are shown in orange on the map. Creditor countries like China and Germany run current account surpluses. The other half of the world is shown in green. These ‘debtor’ countries are net consumers and borrowers. Debtor countries like Britain and the USA run current account deficits.

The UK’s current account balance
The UK economy has run a current account deficit every year without fail for more than a decade. The main reason for this situation is the UK’s huge balance of trade deficit. For example, in March 2010 expenditure on imported goods exceeded export income from the sale of goods by £7.5bn1. This annualised figure needs to be put into context. There are approximately 25m households in the UK. So a trade deficit of £7.5bn equates to a deficit of £300 per household per year. The UK’s trade deficit reflects relatively high levels of domestic aggregate demand, that suck imports into the UK economy; poor UK international competitiveness; and the long-term trend of UK deindustrialisation has left the UK economy with a very small manufacturing sector, relative to UK household demand for manufactured goods. Table 1: The relative decline of the UK’s manufacturing sector Output as a % of GDP Primary Sector Manufacturing Services 1964 1969 1973 1979 1990 2005 2009 5.8 40.8 53.8 4.3 42 53 4.2 40.9 54.9 6.7 36.7 56.5 3.9 32.5 64.4 3.7 23.1 73.1

13.5

Source: www.vig.pearsoned.co.uk/catalog/uploads/Griffiths_C01.pdf 1 www.telegraph.co.uk/finance/economics/7721166/UK-trade-deficit-widens-sharply.html Crisis Economics: The Cutting Edge Topic 10 111

Fortunately, the UK does run a small invisible surplus because the UK exports more services than it imports. The UK’s main service exports are City related activities, such as banking, accounting, insurance and other financial services. However, the invisible surplus generated by the City, which in March 2010 was £3.8bn, is well below the amount needed to avoid a current account deficit. During the first wave of the financial crisis (2008-2009), the Bank of England responded to the threat of depression by cutting interest rates sharply. As a result, hot money flowed out of sterling and the exchange rate fell by at least 25% against most currencies. Theoretically, a fall in the exchange rate should have helped the UK economy to recover because a weaker exchange rate will make imports more expensive and exports seem cheaper. Unfortunately, the anticipated export-led recovery created by a weaker currency has thus far failed to occur. The structural imbalances within the UK economy have held it back. For example, it is very difficult to benefit from a weaker currency if the domestic manufacturing sector is relatively small.

One country’s current account deficit is another’s current account surplus
One country’s exports are another country’s imports. For example, when Sony exports a £300 TV to the UK this transaction will increase Japan’s export income and increase the UK’s import expenditure. It therefore follows that one country’s current account surplus is another country’s current account deficit. Table 2 below shows that the current account surpluses of creditor countries, such as China and Germany are broadly equal to the current account deficits run by debtor countries, such as the UK, USA and Ireland. Table 2: Current account balances of selected countries in $ billions China Germany Japan USA Spain UK Debtor Countries Creditor Countries +426 +243 +156 -628 -154 -46

Source: CIA World fact book August 2008

Debtor Countries
Figure 2 shows the UK’s current account balance as a percentage of GDP over the period 1980 to 2009. Unfortunately, for the UK economy import expenditure has exceeded export income for the majority of this period of nearly thirty years. Furthermore, the scale of the deficits has, for most of the time, been huge too. Some economists believe that current account deficits are not a cause for concern, so long as the country concerned has borrowed in order to purchase capital goods. Borrowing money from abroad to fund investment should boost the productivity of labour. The additional economic growth created by the rise in productivity should boost the GDP of the country that has run the current account deficit. The increase in GDP will hopefully create the additional income required by the debtor to pay the interest on the debt that has been taken on.
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Figure 2: Current Account Balance of the UK

Source: www.statistics.gov.uk

Unfortunately, over the last 30 years, most of the money borrowed by UK households, firms and the government has been borrowed to finance consumption, rather than productive investment. For example, the securitisation of the UK mortgage market enabled British financial institutions to raise cash by selling off a considerable part of the UK’s owner occupied property stock (an asset) to overseas buyers; the bulk of the mortgage-backed securities raised on UK property were bought by overseas buyers. Borrowing in order to finance the consumption of imported goods creates a temporary improvement in the material standard of living. Unfortunately, this improvement in the standard of living will only be temporary because debt has to be paid back with interest. Borrowing to finance the purchase of consumer goods will always be unsustainable because, unlike capital goods, consumer goods do not create an income for the owner of the good that can be used to pay the debt and interest due. Those that choose to borrow in order to consume effectively pull forward future consumption into the present. When the debts and the interest fall due, those that have borrowed in order to consume will have to accept a lower disposable income. Unlike an imported capital good, a flat screen TV or a German car will not generate an income, creating a repayment problem for those that chose to borrow in order to consume. Thirty years ago the bulk of the funds lent out by UK banks originated from the pockets of UK savers. Over time this situation changed as the banking system became globalised. Today, most of the UK’s banks are highly geared. This means that a very high percentage of the capital employed by UK banks has been borrowed from foreign creditors, mostly foreign banks, located in creditor countries that run current account surpluses, where there is a surplus of saving. Some economists have claimed that a current account deficit is a sign of economic strength, even if most of the borrowing undertaken is to finance imported consumer, rather than imported capital goods! Keynesian economists following this line of thought would argue their position by stating that the high levels of domestic demand that are sucking in imports are a sign of strength, not weakness because high levels of aggregate demand tend to be associated with healthy economies that have high levels of output and employment.
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Furthermore, during boom periods, when domestic aggregate demand is high, policy makers should not be overly concerned about a growing current account deficit because most of this deficit will be cyclical, rather than structural. Cyclical current account deficits are caused by economic booms. The structural current account deficit is that part of the current account deficit that cannot be attributed to an economic boom. Unfortunately for the UK a very high percentage of our current account deficit is structural, rather than cyclical, reflecting deep seated supply-side weaknesses within our economy. For example, during the decade long debt-fuelled Brown boom the UK economy still managed to run huge current account deficits. The UK as a nation has lived beyond its collective means for far too long, selling off assets and taking on liabilities from overseas creditors in order to raise the funds needed to import more consumer goods than we export. The UK’s persistent current account deficit explains why most of the UK’s banks are highly geared. UK banks have fed credit hungry households by borrowing from foreign banks located in countries where the savings ratio is much higher. Persistent current account deficits also explain why UK households are so heavily in debt. According to figures collected by the charity Credit Action in May 2010, the average UK household that has some form of unsecured consumer debt, such as a credit card or personal loan, owes over £18,000. A very high percentage of this borrowed money will have been spent on imported consumer goods, contributing towards the UK’s trade deficit. The UK’s current account deficit also explains why the UK is forced to sell off successful British businesses, such as Cadbury, Abbey National and Manchester United. The cash generated from these asset sales has enabled the UK to enjoy imported consumer goods that it otherwise would not have been able to afford. Over time, debtor countries like the UK and the USA make themselves poorer in the long-run as a result of their decision to live beyond their means today.

Creditor countries
At the same time as countries, such as Britain, America and Spain were running huge current account deficits, other countries, such as China, Germany and Japan were running huge current account surpluses. Countries that run a current account surplus export more than they import. As a result these countries generate more than enough export income to pay for their import expenditure. Countries that run current account surpluses tend to have higher savings ratios than countries that run current account deficits. The savings ratio measures the proportion of GDP that is saved. The savings ratio in China is 0.4, implying that households in China, on average, save 40% of their incomes. Income can either be saved or spent. A high level of saving therefore implies a relatively low level of consumption. These low levels of consumption have helped to reign in China’s demand for imports. In addition, in China wages form a relatively low percentage of GDP, which also constrains domestic demand, and hence import expenditure (See Topic 3). Much of the funds lent to British and American banks came from the savings made by households in the creditor countries. Figure 3 shows Japan’s current account balance over the last 30 years.

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Figure 3: The current account surplus of Japan

Source: Bank of Japan

Countries like Germany, China and Japan that run a current account surplus use the wealth created from their international competitiveness to purchase overseas assets and /or to pay off external debt owed to foreign creditors. In the last decade famous name companies such as Jaguar; van maker, LDV; and Vodaphone, that were once British owned, have all been sold off to foreign buyers. The profits generated from these assets flow abroad to shareholders living in creditor countries, boosting their incomes and living standards. In addition to physical assets, creditor countries have also used their surplus incomes from foreign trade to make interest bearing loans to British companies and households (via loans carried out via international money markets to UK banks). Again, the interest income paid by UK nationals to our foreign creditors will boost incomes and living standards abroad at our expense. The Chinese government has used a significant proportion of its export income to purchase American government bonds. The US government sells bonds to finance its fiscal deficit. The bonds issued by the US government pay a fixed rate of interest each year, which will create a currency inflow on China’s financial account. These currency inflows will add to China’s national income, adding to the material standard of living there. China is the number one holder of US government debt. The total amount owed by the US government to the Chinese is nearly $900bn. A debt this large is difficult to service, even for an economy that is as large as the US. Some economists have cast doubt on whether the US government will ability to raise the tax revenues required to pay the bond interest, and eventually the debt, owed to the Chinese. If the US government defaults, the bonds owned by the Chinese will become worthless.

July 2007: The Minsky moment
The American economist Hyman Minsky is famous for describing turning points in the credit cycle2. According to Minsky, periods of credit expansion cannot go on forever. Periods of credit expansion end when households and firms have racked up huge debts relative to the borrowers’ incomes. As a result, households and firms cannot take on any more debt because they are unable to pay the interest on the debts that they already have from their current incomes. (See also Topics 2 and 5).

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When the Minsky moment arrives consumption will tend to fall; debtors will not be advanced new lines of credit if they are unable to pay the interest that is already due on their existing debts. If past consumption has been propped up by debt, a removal of debt will cause spending to fall. The Minsky moment for the debtor countries arrived in July 2007 when international credit markets suddenly froze. Why did the credit markets freeze? Throughout 2007 the number of American sub-prime mortgages falling into default rose steadily. When mortgages fall into default homeowners refuse to repay their mortgages. As a result the securitised assets based on these sub prime mortgages lost most of their value because they were no longer expected to deliver an income for the owner of the asset. Banks and other financial institutions in creditor countries acted rationally to this development by failing to buy new mortgage backed securities from American banks. Banks such as Northern Rock that relied upon international credit markets, rather than domestic savers, for loanable funds, found that they were unable to finance new mortgage lending and consumer credit. Most of the funds lent out by British banks to British households during the boom years did not come from deposits made by British savers. Instead, the credit came, via international money markets, from the savings made by people living in creditor countries such as China, Germany and Japan that run current account surpluses. The crunch reduced the availability and the price of consumer credit, which in turn led to a fall in aggregate demand. Firms responded to the build up of stock caused by the fall in aggregate demand by reducing output and employment, creating a recession.

January 2010: The world economy begins to de-couple
The symbiotic relationship that existed between the debtor and the creditor countries was not sustainable because it was not possible for households and firms in debtor countries to keep on taking on yet more debt in order to finance consumption forever. The collapse of this relationship has caused severe economic problems for both creditor and debtor countries. For creditor countries, such as China and Germany that have relied upon a strategy of export-led economic growth, the credit crunch decimated export markets. Consumers in debtor countries such as the USA and Britain are no longer able to obtain the credit needed to buy their exports. Creditor countries are also concerned that debtors might choose to default on their liabilities, either conventionally by refusing to pay interest due, or via inflation, i.e. by paying creditors what is owed to them in freshly printed devalued currency. On the other hand, the debtor countries now struggle to obtain the credit needed to just maintain existing living standards. If debt is to be re-paid conventionally, the most likely outcome result will be a 1930s style deflationary depression caused by deleveraging (debt reduction). However, if the debtor countries choose to repay what they owe via quantitative easing the most likely result will be currency collapse, leading to hyperinflation.

The credit crunch is (part of) the solution, not the problem!
Misguided politicians on both side of the Atlantic have argued that the economic crisis will be resolved once the flow of consumer credit is resumed. Nothing could be further from the truth. For debtor countries such as Britain the problem has been too much, rather than too little, credit.
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The persistent current account deficits run by the British economy over the last 30 years indicates that we, as a nation, have lived beyond our collective means for too long, explaining Britain’s record levels of debt. To recover the UK will need to produce more and consume less. The UK economy also needs to be re-balanced. For too many years the UK economy was overly dependent on the tertiary sector. During the NICE decade interest rates were kept too low for too long. Low interest rates postponed the Minsky moment. In addition, low interest rates combined with relaxed lending standards, stoked up the demand for UK housing. Cheap and easy mortgage credit made a speculative bubble in UK property possible. In the long-term to create a more sustainable form of economic growth the UK economy will need to enlarge its secondary sector. By doing so the UK should be able to sell more exports, reducing our current account deficit. The government and the Bank of England should also pursue economic policies that encourage saving rather than speculation. Interest rates need to be increased sharply in order to discourage debt and speculation. Higher interest rates will also tend to encourage saving. The UK has gone through a prolonged period of using debt to live beyond its means. This long-period of credit expansion has now come to an end. According to the Austrian economist, Von Mises, periods of credit expansion are always followed by periods of credit contraction; eventually debts have to be re-paid! David Cameron’s assessment of the UK economy is probably accurate: a decade of austerity for the UK economy looks more than likely!

Will China carry on painting America’s fence?
Peter Schiff, the American economist has argued for years that the world economy resembles the book Tom Sawyer. In the book Tom is able to convince his friends to whitewash his fence for him, and to not only do that but to pay him for the privilege. According to Schiff’s analogy, Tom Sawyer is the US economy and Tom Sawyer’s friends are the creditor countries, such as China. For the last decade the USA has been able to convince the Chinese to work long hours in factories at low rates of pay. This work has not benefitted the average person living in China because the vast majority of the goods produced in China are exported to countries like the US, benefiting American, rather than Chinese consumers. This is analogous to the US asking China to paint its fence. However, in addition, to working on America’s behalf China also supplies America with the savings needed to live beyond its means. Much of the debt used by Americans to buy Chinese manufactured goods comes from the savings made by Chinese households, which are exported to US banks in order to be lent out to American consumers. This is analogous to the US convincing China to not only work for the benefit of Americans, but also, in addition, China pays the US for the privilege of doing so. Schiff does not expect this situation to last forever. The US cannot keep on borrowing from the Chinese to finance the purchase of Chinese imports. From a US perspective the current situation is unsustainable in the long-term because eventually the US will default on its external debts. And from a Chinese perspective the prospect of a future US default will force the Chinese government into alternative investments.

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In the long-term the Chinese may simply decide to consume a greater proportion of the goods produced by Chinese industry, and export less to debtor countries, such as the US. The decision to consume a greater proportion of domestic output and to reduce exports will improve the standard of living in China at the expense of American living standards. According to Schiff, “Why should we (America) expect a billion Chinese to carry on painting our fence and to also pay us for the privilege? That situation is going to end”.

The end game
Before the credit crunch struck in 2008, debtor countries such as the US and Britain found it relatively easy to generate the financial account surpluses needed to generate the foreign currency needed to pay for current account deficits. At this time British and US banks found it relatively easy to borrow from foreign banks in order to feed British and US consumers with the cheap and cheerful personal credit needed to purchase, predominantly, imported goods. For example, banks on both sides of the Atlantic were able to raise additional finance by converting mortgages, car loans and credit card debts into bonds, which were then sold on to investors living, predominantly, in the creditor countries. The credit crunch began when US households began defaulting on their mortgages, car loans and credit cards. As a result of these defaults the bonds that were based on these debts also defaulted. Investors responded rationally to the growing number of bond defaults by shunning new bond issues. Banks like Northern Rock that relied on this method of raising finance very quickly ran short of cash (liquidity). Consequently, the supply of new credit in Britain and the US for both households and firms quickly dried up. The resulting credit crunch created a sharp fall in both consumption, investment and, therefore, aggregate demand, which led to a recession. The British and US governments responded to the banking crisis caused by the credit crunch via a combination of state ownership and bank recapitalisations; both approaches were very expensive and were financed by government borrowing. In Britain, banks have been able to resume their lending activities, consumption and house prices are now starting to recover. However, the recovery depends upon the creditor countries’ appetite for UK government bonds. The debt mountain that brought down some of the world’s biggest banks has not gone away. The banking bailouts of 2009 did not solve the underlying cause of the crisis that brought the financial system to the edge of disaster. The debts were simply moved from the private sector to the public sector. The bailouts have been used to buy time for the economies of countries that have lived beyond their means for too long. The next leg of the financial crisis will begin when creditors stop buying government bonds of the debtor countries because they have suffered from, or are fearful of, a sovereign default.

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The UK has run a current account deficit for many years. This means that the UK’s expenditure on imported goods and services has exceeded the amount of income that the UK has been able to generate from the sale of its exports. Countries like the UK finance their current account deficits by selling off assets and by borrowing from overseas. Overtime, countries like Britain that sell assets and take on debt to live beyond their means make themselves poorer, especially if the bulk of the deficit was created as a result of importing consumer, rather than capital, goods. Other debtor countries that have sold cows to buy milk include: USA, Spain, Ireland, Portugal and Greece. The liquidity (cash) needed to finance the current account deficits of the debtor countries came from the savings made by the creditor countries that have run current account surpluses for many years. Countries like China that run current account surpluses generate export earnings that exceed import expenditure. During the boom years creditor countries like China pursued an export-orientated economic growth. A high percentage of the goods produced in China’s factories were exported to be consumed by Americans and Europeans. The money required to buy up these goods was, in part, supplied by the savings made by the workers in the creditor countries. The boom ended when debt levels in the debtor countries reached critical levels. Borrowing to consume is not a sustainable strategy because eventually the stock of debt owed grows too high relative to the borrower’s income. When this happens the debt can no longer be serviced. The bad losses caused by defaulting borrowers in the US inflicted huge losses on the banking sector, which prompted the credit crunch. The world economy needs to re-balance. China can no longer rely on indebted consumers in the US and in Europe to buy its goods. In the future the creditor countries must consume more and save less. On the other hand, in debtor countries like the UK we must consume less and produce more, which will require a rise in our savings ratio.

Topic 10 Summary Topic 10 Questions

1. Current account deficits arise when a country’s import expenditure exceeds its export income. Explain two ways in which a country might obtain the funds to live beyond its collective means. 2. Are current account deficits always undesirable? 3. Explain why living standards in debtor countries such as Britain and the US are likely to fall in the future, and why is the reverse likely to be true for creditor countries such as China? 4. Discuss the possible impacts of a rise in wage rates in China for the US economy.

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