Wednesday, 21 November 2012

Zombies causing havoc (with monetary policy)

Halloween has come and gone this year but stories of zombies are still haunting the dreams of some.  One person in particular is Mervyn King who is the governor of the Bank of England (the central bank in the United Kingdom) and the walking dead are making the difficult job of guiding the economy through a weak recovery into something even more treacherous.

Nothing is ever too exciting in economies so rather than brain-munching corpses, zombies instead refers to companies who are saddled with excessive levels of debt which should drive them into bankruptcy but who are artificially kept alive by lower interest rates.  But firms closing down is a necessary part of the functioning of an economy and here’s why. 

During periods of growth, an economy can expand so rapidly that not all funds are put to good use – too many firms may be making too much of the same products.  So, a recession is normally a time where the less successful are weeded out.  As part of a process which is referred to as creative destruction, some firms go bust and this frees up money and workers that can be put to better use elsewhere.  While it sounds a nasty prospect, it is crucial to the vitality of an economy.  Think of a jungle where no animal would die - eventually the jungle would be overrun and even the strong would struggle.

The Bank of England (BoE) released data last week showing that, while three out of ten firms in the UK are losing money, the number of firms going under is low compared to other recessions.  This could be seen as a good thing in the short term – fewer workers out of jobs mean that the slump in the economy is milder than it might have been.  It also means that companies which have viable businesses but are going through a rough patch can stay in business and go on to prosper in the future. 

However, the effects over the long term are less benign.  Zombie firms take business away from better run companies which hampers the expansion of successful businesses and hurts investment which is already sluggish as firms try to navigate a high degree of uncertainty (for more details, Tale of Two Recessions).  The rise of the walking dead has been given as a reason why the BoE now predicts that economic growth in the United Kingdom over the next few years will be slower than predicted with the economy not expected to reach the same levels as before the global financial crisis until 2015.

Like in the movies, zombie companies also have a weak spot – interest rates.  Because the zombies typically have large amounts of debt, higher interest rates increase the costs for these companies and act as magic bullet that will send them to their graves.  But increasing interest rates also makes everyone else suffer and hurts the economy in the short term.  This leaves Mervyn King and the BoE with a dilemma.  The current low interest rates are prolonging the lives of businesses that need to be put down but the harsh measures required to do this could kill off hopes for a recovery.  Such a conundrum and talk of zombies would be enough to keep Your Neighbourhood Economist awake at night.

Friday, 16 November 2012

Winning the election was the easy part…

In a presidential election which was more notably for the money spent (an estimated US$6 billion) than any notion of what each candidate would do in power, Barack Obama managed to pull off a relatively easy (but not emphatic) victory.  But now Obama faces a bigger challenge - the fiscal cliff.  The fiscal cliff refers to painful measures which will be implemented if Democrats and Republicans are unable to come up with a solution on how to deal with high government spending and low taxes.  But the political stalemate looks set to continue in the United States following an election which was supposed to help provide impetus for new policies but may instead result in further gridlock.

Improving the government finances was increasingly becoming a concern in the United States due to a large budget deficit of 7.8% of GDP in 2011 and rising government debt topping 100% of GDP in the same year.  Investors are still happy to buy government bonds as the United States is seen to have a more viable economy whereas similar levels of debt would cause panic among investors in Europe.  Yet, it is unclear how much longer investors will tolerate rising debt.  Politicians realise the necessity for action but are ideologically opposed to how to go about it – the Democrats want to see spending cuts accompanied with higher taxes on the wealthy whereas Republicans flatly refuse to even consider higher taxes. 

The origin of the fiscal cliff is an attempt by the two parties to force themselves into a compromise by upping the stakes.   Politicians passed the Budget Control Act of 2011 whereby, if an agreement on how to cut the deficit was not reached by the end of 2012, a range of deficit-reducing policies which are painful for both Democrats and Republicans (and the economy) would automatically kick in from the start of 2013.  Politicians have been too consumed with electioneering up until now for a deal to be struck and only have a short time left to figure out a compromise before US$600 billion of spending cuts and tax rises come into effect - the consequences of which is expected to push the United States economy into recession in 2013.

Just the possibility of recession as a result of these measures is already having an adverse effect on the economy.  The uncertainty created by the lack of a deal means that businesses are holding off from making new investments and hiring extra workers at a time when the economy should be on a path to recovery.  The election should have been a great chance for each party to convince the voters that they had a plausible solution but the outcome has only seen minor changes to the political landscape and the status quo has been maintained so that continued gridlock is a real possibility. 

Life would have been difficult for whoever won the election.  With the Republicans controlling the House of Representatives and the Democrats holding sway over the Senate, agreement between both parties is needed to pass any new laws.  But neither Obama nor Romney put themselves in a strong position due to the bulk of the campaigning being negative rather than providing any ideas on new policy direction (see An election with no winners).  As such, despite winning, Obama does not have much of a mandate - an entitlement to implement policies due to the perceived backing of a substantive majority of voters following an election.  The going will be made tougher with Obama having failed to exhibit much leadership in his first term as president.  Yet, Obama has come out of the blocks strongly with a bold statement that any new measures must include higher taxes for the rich.  On the other hand, Republicans are still not convinced that Obama has much support from voters and are likely to stand firm for now with regard to their demands for no tax hikes.

This sets the scene for last minute dramas and for uncertainty to continue to plague the economy.  The extent to which politicians can be trusted to make pragmatic decisions is unclear and Your Neighbourhood Economist is unsure of what will ensue.  Even Greek voters showed a considerable degree of pragmatism in backing pro-bailout parties in elections in June 2012 (Back from vacation in Greece).  Yet, like the situation in Greece, any possible solutions regarding the fiscal cliff are likely to be drawn out with stopgap measures likely before the end of the year (if at all) and more long-term policies discussed in 2013.  The prolonged uncertainty and political sideshows could have not come at a worse time but it is even more frightening to think that the worst may not be over. 

Tuesday, 6 November 2012

An Election with No Winners

Any crisis should be seen as a boon by politicians.  Problems become evident during times of turmoil and voters are more open to the prospects of sweeping change.  This gives opportunities for leaders to implement a raft of new policies and stamp their mark on the pages of history.  Yet, the opposite seems to be true with regard to the current presidential election in the United States.  The candidates have provided few details of what changes they would implement and how to better position the United States to face a rising number of challenges which stem from both internal problems and external threats.  The election has instead concentrated on the flaws of the candidates themselves rather than the ideas they espouse.  The United States looks likely to be bogged down for at least another four years until the next presidential election which may offer up a chance for decisive leadership.

The presidential election comes at a time when the country is in desperate need of leadership.  Obama has failed to deliver on his promises from the election four years ago.  It has been ironic than a presidential candidate that has given rise to so much hope among disparaged Americans has been so underwhelming even by normal standards to which presidents aspire.  In an election which should have been easy for any politician to beat Obama, Romney ended up the Republican candidate by default as other challengers each had their moment in the spotlight but all were deemed to be flawed.  But as the default candidate, Romney has struggled to even animate Republicans.  As such, the United States has been left without a genuine choice and campaigning has focused on the negatives of each candidates’ character due to a lack of new ideas. 

In an uninspiring election, Obama may be the lesser of two evils.  Obama has done a reasonable job of fixing the way in which the United States is seen by other countries in the world.  The Democrats as a party are also less entrapped by ideologues on the left and have been more pragmatic at a time when action is necessary.  On the other hand, the Republican Party has fallen under the sway of the Tea Party movement which has a virile hatred of government and taxes based primarily on ideological grounds.  The stubbornness of Republicans has stopped progress being made on dealing with the government budget deficit.  The party refuses to consider any tax increases to be implemented alongside cuts to government spending when this mix of more taxes and less spending is seen as optimal policy by many.  Instead, Republicans choose to squabble while Rome burns which may see the fall of another “empire”. 

There are signs that the United States may be heading into a period of gradual decline which its leaders refuse to confront.  Along with the rise of China and other emerging economies which is destined to reshape the global economy, the United States is also being challenged internally by problems such as a lack of investment in infrastructure and education, growing inequality and falling social mobility, and unsustainable levels of pensions and health care.  Obama has done little to solve these problems.  But there is a fear that a Republican president could make the problems worse.  Ballooning government debt in the United States during the Regan and Bush junior administrations has already shown Republicans to act more on ideology and less on economic realities.  Your Neighbourhood Economist would (if possible) vote for Obama - better the devil you know - but would rather fast forward four years in the hope for real leadership.

Monday, 5 November 2012

“It’s the economy, stupid” – or is it?

The phrase “it’s the economy, stupid” encapsulates the strategy used by Bill Clinton in his election battle with George Bush senior in 1992.  The blame for the recession at the time was attributed Bush senior and this helped Clinton to victory.  Twenty years later, Mitt Romney may have thought that a similar message would aid him in his bid to become president.  The four years that Barack Obama has been in power has coincided with the harshest economic downturn in living memory and a surprisingly weak recovery such that GDP has only edged up 0.7% between 2009 and 2011.  But the outlook for the economy has brightened a tad recently following the release of upbeat data on GDP and jobs in the United States.  Anecdotal evidence would suggest that this would be a boost to Obama but this may not hold true in an election where the candidates have sidestepped the big issues.

Economists like to point out that the state of the economy is a good guide to the plight of an incumbent in a presidential election.  Voters everywhere tend to hold politicians accountable for economic growth even though there is little that politicians can do to in this regard.  Obama was unlucky to have been voted in while the global financial crisis was still wreaking havoc.  The record of Obama’s management of the economy is hard to asses given the unique circumstances – Obama has been criticised for the assistance given to the finance sector and for the bailing out of firms such as the car maker GM but no one can know whether these actions actually staved off more wide spread disaster.

But it is economic welfare of the voters and their beliefs on how the future will pan out which is the crucial factor.  And in this regard, Obama has been getting small bits of good news among all of the doom and gloom.  In GDP figures for the third quarter (July to September) of 2012 released in late October, the economy was shown to have grown by 2.0% which is slightly faster than was expected.  Job data published one week later also exceeded expectations with 171,000 jobs being created in the US economy in October and unemployment below 8%.  Neither bit of news permits much optimism about the end of tough times and businesses will have to hire significantly more workers to make a significant dent in the unemployment rate (for more, see US Jobs Data).  But the signs of improvement may be enough to some to have hope.

But it is still unclear whether the slightly brighter outlook will be much of a boost to Obama.  Your Neighbourhood Economist would argue that news on the economy will only sway those who were undecided but these voters have been side-lined by campaigning which has vilified the personalities of the candidates rather than proposed solutions to the problems plaguing the United States.  So the election results are more likely to depend on how many Democrats and Republican can be bothered to vote for their respective candidates as both Obama and Romney have been underwhelming and failed to inspire a following from anyone else but their core supports.  Not the best way to decide who will be leading the country for the next four years and something that is likely to result in further disappointment (but more on that coming soon).