Wednesday, 22 July 2015

China - staying out of the news

A tumble in stock prices gives rise to more worries about China but it is not deserving of the bad press

News about China often hits the front pages as its swift rise is both scary and a source of economic salvation.  Stock markets in China have been making news recent due to a sharp selloff in shares.  The media are quick to jump on any potential hiccup in China’s rapid expansion due to its growing importance as a global economic superpower.  Yet, the peculiarities of stock markets in China mean that the spill over effects are likely to be limited even though the financial sector will continue to be a source for headlines in the future.

New to this game

Picking the right stocks and when to buy them is never easy but it is even trickier with China being a relative newcomer to trading shares.  The shorter the period of time over which shares have been traded, the more difficult it is to pin down what should be paid for stocks.  Many of the companies themselves are also still young and are still fighting a fierce battle with rivals for survival.  On top of this, the bulk of the investors in the Chinese markets are locals and have less experience in trading stock. 

The government further muddies the picture with its plans for liberalising the financial markets.  While fewer restrictions would be welcomed, the reforms create jitters due to the potential pace of change depending on the whims of its leaders.  Yet, the government regulations in themselves are part of the problem.  One issue is limits on how much banks can pay out in interest on savings accounts.  Starved of other places to put any spare cash, too many Chinese look to make money in domestic share markets which are ill equip to deal with the inflows.

While many eager investors have managed to sidestep the barriers, heavy regulation of the financial markets keeps out many more Chinese.  This has the effect of limiting any losses when the inevitable selloffs hit the stock markets.  In this way, the government ensures that the underlying economy is sheltered from any volatility in the stock markets.  Neither is the stock market much of a reflection of what is going on in the actual economy.  Chinese stock prices had stagnated for a long time prior to the recent ups and downs so it is unlikely that any bad news in the stock markets will be a prelude to trouble with the economy.

Watch this space

All this would not make the headlines if happening in any other emerging market but China is a big deal these days.  Its importance as the main global driver for economic growth makes outsiders nervous.  Its haphazard mix of free market and government control means that pessimists are quick to spot its faults.  But, just like with the patchy rules governing financial markets, the government has adapted in the past to stay on top of problems before things get out of hand.

The fear of market turmoil spilling over to society at large will continue to keep the Chinese on a cautious path to freeing up financial markets.  Over this time, China will continue to be plagued by a jumpy stock market as its investors grow used to the ups and downs of share prices.  Considering that even Western investors have not fully mastered this, the trials and tribulations of Chinese share prices will likely to be hitting headlines again many times in the future.  But, with government policy helping to stem the spread of any losses, it is not something that needs to cause too much worry yet.

Friday, 3 July 2015

Central Banks – juggling interest rates and inflation

Low inflation is dampening the effects of low interest rates and central banks are happy to let this happen

As guardians of the economic recovery and a bulwark against inflation, central banks have a tough juggling act to maintain.  This is made even more difficult as priorities shift from getting the economy moving again to keeping an eye out for inflation.  The consequences of this can be seen in central banks’ tolerance towards low inflation with low interest rates proving less helpful as prices remain depressed.  Central banks are letting this happen due to inflation being one ball that central banks dare not come close to dropping.

Too many balls in the air

Central banks have a lot of balls in the air to watch with their remit including managing the price level as well as ensuring stability in the financial markets (and maintaining employment levels in the US).  The number of balls has increased as monetary policy has become the main way to bolster the economy with governments in many countries refusing to use fiscal policy.  But it is inflation that typically remains the main focus of central banks. 

The aversion to inflation was put to one side amid the turmoil of the global financial crisis.  Efforts to prop up the money supply through quantitative easing would have normally also lifted prices but this did not stop central banks taking bold action.  As the threat of crisis has receded, so have measures by some central banks to help out with the economy.  This shift has been made more pronounced due to low inflation as depressed prices strip away some of the positive effects of low interest. 

Juggling priorities  

The rate at which prices are rising affects decisions made by companies on whether to borrow money.  Higher inflation makes low interest rates more attractive to businesses as any products purchased today will be worth more in the future making it easier to pay off debts.  The opposite is also true and flat prices will prompt some business putting off plans to borrow and invest.  The harm done by low inflation is even more pervasive if it is a reflection of a weak economy which seems likely

By not doing more to keep prices ticking upwards, central banks are consenting with some of the potential effects of low interest rates being taken away.  It is like a hike in interest rates without interest rates actually having to rise.  It is a sign of how much central banks worry about prices rising too fast that this is happening despite the economic recovery still lacking momentum and inflation close to zero.

Don’t douse the economic recovery

The various roles of the central bank can make it seem as if they are required to juggle fire and water at the same time.  Much has been left to central banks in the aftermath of the global financial crisis which has often resulted in monetary policy being pushed too far.  Central banks were never meant to take such an active role in managing the economy.  A return to their less controversial role of keeping a lid on inflation will come as a welcome relief.  It is, after all, their record on inflation that central banks will often be judged. 

However, it is still too soon to move against the potential threat of a jump in prices.  There is still scope to leave interest rates at their current low levels with other measures such as macroprudential policies available for sectors, such as the residential property market, where lending is getting out of hand.  There is a point in every juggler’s routine where everything seems set to come crashing down – let’s hope that this does not happen due to a premature hike in interest rates.

Thursday, 25 June 2015

Interest Rates – low but not low enough

Interest rates may not be low enough to get us on the road to recovery but falling prices should help

Something strange is afoot in the economy.  With interest rates at record lows in many countries, borrowing should be booming and saving on the decline but the opposite is true.  This suggests that the economy remains out of kilter without interest rates being able to set the right balance between savings and investment.  Instead, the shortfall in demand due to limited investment and weak spending may be dragging down prices as a means to put the economy back to health.  

Not so free market

The self-healing ability of any economy is one of the central tenants of economic theory.  Prices adjust as a means for the economy adapting to any changes.  For example, an increase in the supply of bananas will trigger a fall in prices and more people eating bananas.  A rise in companies looking for software experts would drive up their wages (the price for labour) and the number of people wanting to learn more about computers.  Through changes in these prices, the economy moves toward an equilibrium where everything is at appropriate levels.

Interest rates act in the same way acting as the “price of money” to make sure that there is neither too much nor too little savings or investment.  Lower interest rates are used to make borrowing cheaper and savings less worthwhile.  This was the course of action taken by central banks in order to stimulate the economy by attempting to boost investment (funded by lending) and spur on more consumption (due to lower savings).  Quantitative easing adds to this by giving banks more money to lend and less need to entice people to leave money in the bank.

Still waiting

The continued wait for a robust recovery suggests that something remains amiss.  The lack of appetite among companies to expand their operations by borrowing is both a cause of and caused by weak demand in the overall economy.  Spending by consumers is also faltering with people happy to let money mount up in the bank despite the low returns on savings.  The high levels of household debt that still persist are another reason for consumers to hold back from spending.

The persistence of the state of low investment and high savings suggests that monetary policy has not been enough to get the economy back on the right track (although it has helped to prevent a financial collapse).  A further loosening of monetary policy is not on the books for most central banks.  Interest rates cannot be lowered much further considering that negative interest rates are difficult to implement.  Quantitative easing also seems to have run its course while increasing creating negative side effects

Where to next?

The inability of interest rates to adjust is hampering a return to economic growth.  With interest rates not able to go any lower, it may be the case that it is prices which are instead moving to get the economy back to equilibrium.  That is, rather than interest rates falling to balance out weak lending and growing savings, prices are being depressed by the lacklustre economy.  The hopes for economic recovery rely on cheaper prices spurring on more spending thanks to consumers felling richer.  Further impetus would result from the extra spending helping to push up investment and lift the economy to better match the current level of interest rates.

This route back to recovery may take time considering that any decline in prices will be limited and wage gains have yet to take off.  There are ways to push this along of which easiest way would be for governments to temporarily increase spending.  Money used for investments in infrastructure or training and R&D in new technologies would be worthwhile at a time of low interest rates.  Another alternative would be for central banks to use their money-printing capabilities to transfer cash to consumers.  This more radical option would provide a short-term boost to spending.  Sometimes we all need a little bit extra to get us back on track and the economy is no different.

Tuesday, 16 June 2015

Property Market – nowhere to call home

House prices are distorted by demand from investors and governments are making the situation worse

Houses have become so much more than homes and many of us are missing out as a result.  More than just a place to live, houses have become the investment option of choice during turbulent times.  The popularity of investment properties means that buyers looking for a home are being crowded out of the market.  Rather than correcting this distortion, government policies typically make things worse and leave the dream of their own home beyond the hopes of many.

No home sweet home

The property market is never far from any topic of conversation.  Since everybody needs a place to live, it affects us all.  The substantial price tag that comes with buying a house would be enough to weigh on anyone’s mind.  But property purchases take on even greater significance as real estate also counts as a form of saving for the future.  The money tied up in property is the biggest investment that many of us make.  This means that the ups and downs of the housing market shape the financial well-being of many families. 

The predominance of property investment is further accentuated as buy-to-lets become increasingly popular as a means of putting ones wealth to work.  The abstract nature of shares and bonds along with the shenanigans in the financial markets makes property seem like the safe-as-houses option.  Yet this extra source of demand for real estate inflates house prices beyond their value as a mere place to live.  Investment in real estate brings benefits, such as providing rental accommodation and improvements to neglected properties, but the costs also mount as investment in property increases.

With a relatively fixed amount of housing in large cities, one person’s buy-to-let gets in the way of a house becoming a permanent home.  Along with the benefits to home owners, neighbourhoods also have a greater sense of community with stable residents.  The higher house prices due to property investment results in home ownership being coupled with a larger amount of mortgage debt.  This makes the property ladder more tenuous for debt-laden buyers who could easily be caught out by any economic hardship.

Need to make room for more

Governments, which could work to limit these negative consequences, tend to only exacerbate the problem.  Policies targeting the real estate market differ across countries – tax breaks for mortgage debt, low levels of capital gains tax, easier access to loans.  But the common thread is that it is all too tempting for governments to please better off voters by bolstering the property market.  The predominance of monetary policy as the main tool for managing the economy makes this even worse by stoking up borrowing (and the property market) when the economy is weak. 

While pushing up demand, governments do too little to boost supply.  It is more housing that is often cited by politicians as the solution to buoyant property prices but government regulations and zoning rules are not reflective of the growing need for new houses.  Houses take too long to build while elections are never far off even though more building would make for good economic policy at a time when the economy is still suffering from a shortfall in demand.

Financial markets are awash with other places to invest.  Our animal spirits should be limited to parts of the economy where the ups and downs can be absorbed without wider consequences for the rest of us.  Housing is too important to get caught up in such investment games.

Thursday, 14 May 2015

Emerging Markets – Caught in the Crossfire

US monetary policy has missed its mark and it is a handful of emerging markets that look set to pay the price

The big guns of monetary policy used to combat sluggish economic growth are about to be put away but the real damage may be just about to kick in.  The Federal Reserve adopted loose monetary policy to get the US economy moving again but it is elsewhere where the effects have been felt the most.  Having benefited more from the loose monetary policy than the intended target, some emerging markets look set to suffer as a policy reversal prompts US investors to stage a destructive retreat back home.

Danger zone

The proverbial printing presses at central banks are like the heavy artillery of monetary policy.  Central banks such as the Federal Reserve had been pumping out cash to buy bonds as part of quantitative easing.  Yet, the US economy had failed to fire up with companies unwilling to invest while spending remains weak.  Investors with cash in hand turned their sights overseas and targeted emerging markets where economic growth was still perky. 

The surplus US dollars helped to lower interest rates for borrowers in many countries which had not gotten caught up in the global financial crisis.  The reduced borrowing costs pushed up lending elsewhere despite not having the same effects in the US economy.  The muted effects of monetary policy in the domestic economy prompted the Federal Reserve to unleash even more firepower.  Money, like some things, is fine in moderation but the bombardment of US dollars inadvertently created its own minefield. 

Borrowers in emerging market were only given access to cheap cash by borrowing in US dollars for a short period of time.  This was fine as long as the prospects for the US economy were poor and US dollars were readily available.  But any significant improvement in the US economy would see investors shift their money back.  A stronger US economy would also push up the value of the US dollar and make it tougher for overseas borrowers to pay off any debts in US dollars. 

Collateral damage

Like solider stationed in a hostile region, investors were set up to bail when the opportunity arose.  Just the mere mention by the Federal Reserve in May 2013 that quantitative easing might be coming to an end was enough to trigger a rush by investors to get their money out.  Six months of market volatility followed even though quantitative easing did not actually end until October 2014.  With the Federal Reserve now mulling lifting interest rates up from their low levels, more upheaval seems likely.

This is because money often does more damage on the way out compared to the gains when it is initially welcomed.  Yet, the lure of cheap cash is too much to ignore.  Even the financial sectors in richer countries have shown themselves to be unable to cope when too much money is on offer.  Less developed banking systems in emerging markets are often even worse at putting any cash to good use.  This increases the likelihood that many borrowers will struggle when US dollars are harder to come by. 

As the aftermath of the global financial crisis has made painfully clear, a swift end to a lending boom is not something easy to get over.  In its attempts to deal with an US economy sagging under the weight of excess debt, the Federal Reserve has inflicted the same woes on others who are less able to deal with the consequences.  Like any form of warfare, it is the innocent victims that suffer the most.

Wednesday, 6 May 2015

Quantitative Easing – Getting less from more

The European Central Bank has been late to try quantitative easing and may find that additional euros cannot buy much relief

We all have the tendency to rely on the tried and true tricks we have found helpful in the past even when their usefulness has faded.  This also seems true of central banks who have come to rely on quantitative easing even though its effects show signs of fading.  Even the initial boost provided by the first attempts at quantitative easing was limited and the situation has deteriorated amid its continued application.  As the last major central bank to give it a go, the European Central Bank will not get much return from any extra cash. 

Why more is not always more

Economist should know that repeating the same policies does not always work considering a well-used idea in economic theory known as diminishing returns.  This concept refers to the way in which more of the same often comes with fewer additional benefits.  Economists use this to describe why the second plate of ice cream does not taste as good as the first or why one more cook in a crowded kitchen doesn’t necessarily improve the food. 

Printing more money, which is the basis for quantitative easing, sounds like a sure-fire way to generate economic growth but any economy can only handle so much money.  The world is already awash with cash even before central banks started with quantitative easing.  This means that every additional dollar, euro, or pound printed as part of quantitative easing is being added to an already substantial pile of cash.  With money already being hoarded by many companies and governments not wanting to spend more cash, there is not much use for any more.

No need for more

With the meagre effects of quantitative easing on the wane, it was the earlier versions that would have generated the most bang for each additional buck.  It was the Federal Reserve and the Bank of England that tried out the first rounds of quantitative easing – the goal was to push investors away from government bonds to more risky investments such as corporate bonds or stocks.  The hope was that this would help provide companies with easier access to cash and to perk up investors by boosting share prices. 

Not all of the extra dollars and pounds would have stayed local but also headed overseas to find places to earn more money.  This meant that the effects of quantitative easing would have been felt far beyond the countries where the cash was originally coming from.  It has been helpful in places such as Portugal and Spain with overseas investors buying bonds issued by the Portuguese and Spanish governments as worries about Europe eased.

With the effects of quantitative easing having already spilled across international borders, there is not much more to be gained from even more cash.  As such, the additional euros coming out of the European Central Bank following the recent launch of quantitative easing in Europe may not amount to much.  Any further action may also be limited as the saga over whether or not to implement quantitative easing has highlighted how the European Central Bank only has limited room for manoeuvre when running in opposition to Germany.  Now, more than ever, it is time to try something new.

Tuesday, 28 April 2015

China – Playing Catch Up

Many expect the Chinese economy to misbehave but it is more likely that China will grow out itself out of trouble

China is growing up in front of our eyes and there is an expectation that, like any adolescent, it will get into trouble before fulfilling its promise.  Naysayers predict that China’s growth spurt has left it with a number of issues that must be worked through before it can get any bigger.  Yet, China has a good head on its shoulders in the form of the Communist Party which will do all it can to keep the economy buoyant.  While the years of stellar growth are likely over, it need not mean that the Chinese economy will be held back.

Big trouble in (not so) little China?

The spectacular rate of growth achieved by China over the past decade could never continue forever.  Quite the opposite, the rapid expansion would have been harmful if it had been maintained and a slower pace of growth is actually a preferable outcome.  This is because much of the economic growth had been fuelled by investment – construction of new factories to sell cheap goods overseas along with the expansion of megacities in China to accommodate an influx of workers from the countryside. Normally, investment accounts for around 10% to 15% of GDP in most developed countries but reached 50% of GDP in China. 

This building frenzy could not continue especially when it is becoming more difficult to make money and some investments would be wasted on pointless projects.  It is the examples of this, empty apartment blocks and overly lavish public spending, that pessimists point to as evidence that China has gone too far.  With large amounts of bad debt expected to result from these poor investments, the financial sector is expected to take a big hit and drag the whole economy down with it.  The argument is basically that China has gotten too big for its boots and will need to shrink.

Growing up is never easy

Your Neighbourhood Economist would instead argue that China has a similar problem to what he had when he was growing up.  His mother would buy Your Neighbourhood Economist clothes that were too big for him in the knowledge that he would grow into them.  It is ungainly to be sporting oversized gear and this seems to be similar to the phase China is going through.  This is partly because China had been expanding so quickly that any investment needs to be put up in a hurry.  There is also the added complication of spending getting out of hand as regional politicians try to impress their bosses in the Communist Party.

Yet, China, like a much younger version of Your Neighbourhood Economist, still has a lot of growing to do.  Some of the ill-fitting parts of the Chinese economy may be put to better use as its citizen will continue to migrate toward the cities in search of work.  China has also learnt lessons from its investment binge with the central government shifting emphasis from economic growth to other benefits of greater wealth such as a cleaner environment and a more efficient bureaucracy.  Local officials are being brought into line through a crackdown on corruption and concentration of power within the Communist Party.

Along with changes to policy, the Chinese government also has the resources to deal with any past mistakes.  With both domestic savings and government reserves at high levels, there is plenty of money around if needed.  And, with an eye firmly fixed on keeping the economy growing, the Communist Party would not be as timid compared to Western governments in terms of stepping in and shoring up the banking sector if needed.  China is also moving away from investment as the driver of its economic growth and consumption is expected to pick up the slack (albeit with growth at a slower pace).

Growing while you watch

Your Neighbourhood Economist has seen the change in China with his own eyes.  In a visit 15 years ago, the Pudong area across the river in Shanghai seemed like a ghost town but one that had been freshly built with a scattering of skyscrapers.  Now, Pudong is anything but quiet and the pace at which new buildings continue to go up is testament to China’s growth.  It also shows that it you build it (in China at least), they will (still) come.

Thursday, 16 April 2015

Monetary Policy – where has the magic gone?

The European Central Bank tries to cast another spell to save the Eurozone but its magic has been stolen

Monetary policy is like magic – you have to use tricks to get people into believing what you want them to believe.  Both magicians and central banks apply various devices to convince their audience that they can pull off amazing feats.  A bit of showmanship can be crucial in creating an aura of the fantastical when your powers are actually rather limited.  Central banks have pulled this off in the past but quantitative easing by the European Central Bank is more likely to show that it does not have any rabbits left to pull out of the hat.

Trying to work magic

Your Neighbourhood Economist likes to look back fondly to an era when central banks had the financial market enthralled with their mastery of all things economic.  This admiration was won the hard way in the 1980s by bringing double-digit inflation back to more manageable levels and ushering in an era where the booms and busts seemed to have past.  But central banks have been taken down a notch by their inability to revive the economy after the global financial crisis. 

Slashing of interest rates has not worked as high levels of debt meant that no one wanted to borrow. Upping the ante, central banks tried pumping money into the financial system through quantitative easing.  The effect on the actual economy due to quantitative easing also looks to be limited at a time when there is already a lot of spare cash in the financial system.  Financial markets were buoyed by quantitative easing but a side effect has been the potential for heightened volatility in the financial markets

With few other options seen as viable, quantitative easing has gone from an unconventional measure to the mainstay policy for central banks despite questions over its usefulness.  The European Central Bank has been slow to try its hand at quantitative easing even though the Eurozone economy was struggling more than most.  This was because Germany (who had initially done well despite its neighbours being in crisis) was firmly against the central bank in Europe printing cash to buy government bonds.  It was only after a further considerable deterioration in the prospects for the Eurozone (as well as that of Germany itself) that the European Central Bank to override this opposition.  

No more magic left

The European Central Bank has been put at a disadvantage considering that the other big central banks have already tried to work their magic through quantitative easing.  Investors are becoming harder to impress having already seen central banks pull off similar tricks.  To maintain the wow factor, quantitative easing has needed to get bigger and bigger.  The central bank in Japan pledged to double the money supply within two years but had to offer up even more cash when its initial plans proved to be lacking. 

The European Central Bank cannot compete on scale as it has to perform magic with one hand behind its back due to the political constraints within the Eurozone.  Any extra boost using the element of surprise was also dented by the protracted process as the European Central Bank and Germany squabbled publicly over quantitative easing in the months before the policy was launched. 

The fractious politics in Europe has sapped power from the central bank who had previously been the main shining light in saving the Eurozone.  Political squabbles have highlighted the limited power at the disposal of the European Central Bank.  It is like a magician who is being sabotaged by their own assistant – it will take more than magic to escape this spell.

Friday, 23 January 2015

Productivity – cutting both ways

Far from being a cure-all, productivity gains are instead cutting into the number of jobs

Higher productivity seems like the answer to all of our economic woes but being more productive is not all good.  Doing more with less is a way of making us wealthier by getting more out of the limited resources available.  Improvements in productivity often thus translate into more profits or lower prices (or both).  But there is also a nasty side in that one of the resources that can be done away with is workers.  Trends such as greater globalization and improvements to technology have resulted in many (well paying) jobs being put to the chop and we should not be expecting any respite soon.

Doing more with less

Economics is a discipline which is based on the notion of scarce resources.  It is no surprise then that economists rave about how improvements to productivity are the key to prosperity.  Any business that can produce the same products using fewer inputs is bound to do well.  Being more productive as a worker is also opens up the way for the opportunity to demand higher wages.  Any gains from higher productivity are split between companies, employees, and consumers but it is not always the case that everyone gets a share.

My favourite example of productivity gains where everyone got their cut was Henry Ford and the motorcar.  Ford did not invent the automobile or the assembly line but he did figure out a way of manufacturing cars cheaply.  The continued existence of the Ford Motor Company is testament to how much he and his family have thrived.  On top of this, workers at the firm also benefited from the new jobs that were created as well as the higher wages on offer.  Cars also became available to many more people thanks to the mass production of the Model T resulting in a lower price tag.

Suffering from cut backs

The example of Henry Ford and the Model T shows how more can be produced cheaply using more workers.  But this is only a viable way of making money when there is a rapidly expanding consumer market and an appetite for more and more goods.  This seemingly came to an end in the richer countries when most households became wealthy enough to buy the basics such as a car, a fridge, and a TV.  Without being able to tap into economies of scale by producing more and more, the emphasis has since shifted to producing goods at the lowest cost. 

One of the main avenues for cutting costs has been outsourcing manufacturing and some services to countries where wages are lower.  Computers and the Internet have also helped companies save money by better optimising their operations and reducing the need for some clerical work.  Companies have obviously benefited from this and we have as consumers (due to lower prices) but not as workers.  There is no modern-day version of the Model T that might provide a new source of lucrative job opportunities.  Instead we spend our money on services (eating out or going away on holiday) or goods where much of the value is in design rather than the goods themselves (such as clothing or electronic gadgets).

Cut yourself free

The challenge for developed countries is to create more high paying jobs for its educated workforce.  Instead, the opposite seems to be happening and the economic recovery after the global financial crisis has been characterized by a proliferation of jobs with low pay.  Higher unemployment allowed companies to hire workers on the cheap and this has dulled incentives for business investment.  It is easier to get things done using cheap labour than spending money on making your current workers more productive. 

Unemployment in countries such as the US and the UK has fallen but this has yet to translate into significantly higher wages.  Neither is a rapid improvement likely as companies are still timid about investing due to the weak momentum of the economic recovery.  Government policy is also a hindrance due to the focus on austerity measures rather than taking advantage of low interest rates to invest.  

The only way out for beleaguered workers seems to be setting up their own business which has become increasingly more popular.  The jump in entrepreneurship may be one of the few silver linings as people cut themselves free to become their own boss and to have productivity gains there for the taking.

Friday, 16 January 2015

Low Oil Prices – Feeding the Addiction

Cheaper oil will bring about much cheer but it will help keep key oil producers happy in years to come

Oil is like a drug that the world economy cannot do without and we are in the midst of a turf war over who will call the shots.  A few dealers have had a stranglehold over the market for oil and have been able to set prices as they please.  The arrival of new kids on the block (with the rise of fracking in the US) has triggered a fight for control of the oil market.  The result has been a plunge in oil prices which is a blessing for the global economy but is part of a bigger strategy to keep us all addicted to oil for years to come.

Not a buyers’ market

The sharp drop in oil prices will provide a welcome boost to the economic recovery in many countries.  Oil is like a drug in that it is always in demand and buying continued despite high prices in the aftermath of the global financial crisis.  Prices for oil have only recently eased off (playing havoc with inflation) as demand from energy-hungry China has weakened while supply from the US has expanded.  Oil is also plagued by a further similarity to drugs in that the suppliers of oil tend to be some ugly characters such as Russia, Iran, and Venezuela (as well as some nice ones such as Canada and Norway).  But the kingpin of the oil market is Saudi Arabia due to the size of its reserves of oil and its willingness to adjust its output to market conditions.

Saudi Arabia is the top dog of a club called OPEC where some of the major producers of oil banded together to wrestle control of the oil market away from Western energy firms.  OPEC came to prominence in the 1970s when the countries cut oil output as a protest against Israel.  Along with the devastation wrought due to the resulting surge in oil prices, efforts to conserve energy also acted to weaken the need for oil.  Once oil prices returned to normal, OPEC has looked to set its output so as to make the most money while also suppressing incentives to cut back on oil consumption. 

Sticking to the optimal level of output was always going to be tricky when cheating would bring in extra cash.  This meant that not all members of OPEC stuck to their quotas set to manage the supply of oil and it was left to Saudi Arabia to shoulder the burden of larger cuts to production when required.  Saudi Arabia could pull this off due to its revenues from oil being more than enough to fund its government spending.  In contrast, governments in countries such as Venezuela and Iran spend big to support their anti-Western antics which tend to max out the cash from their energy sectors.

Trying to stay on top

The arrangements behind this oil cartel have been bust wide open due to the surge in oil output coming out from the US.  New fracking technology has unlocked previously inaccessible oil reserves and turned the US into a big player in the oil market.  Faced with a choice of cutting its output or suffer falling prices, OPEC chose the latter.  The Saudis, in particular, were not willing to take a hit and lose out in terms of market share.  As Saudi oil is typically cheap to get out of the ground, their hope is that a lower price for oil will drive others out of business.  A drop in oil prices will also scare away any investment in oil fields that would boost output in the future.

It pays for Saudi Arabia to take a long term view of the market seeing that it has so much oil still underground.  An abundance of new sources of oil or new technologies that eliminate the need for oil would take a big chunk out of the value of its underground stash.  Saudi Arabia is in a strong enough position to sacrifice short-term gain to lock in future control over the oil market.  Be thankful that the Saudis want oil to be cheap for now and keep us all addicted but don’t expect it to last (much more than a few years).

Monday, 12 January 2015

Fiscal Policy – Not fighting back

The government has been subdued in the fight to revive the economy despite a change in strategy being long overdue

Considering the trouble we are having fighting back against the aftermath of the financial crisis, it seems strange that the government is not using its full arsenal.  Central banks have come out all guns blazing with their monetary policy but governments have held back from firing up fiscal policy.  Worries about their levels of debt were behind this tepid response by governments but such concerns have eased while the economic recovery struggles to pick up momentum.  Why should be suffer further losses while saving our ammunition?

Hit and miss

Central banks launched themselves into the front line while governments remained in the background due to self-inflicted wounds.  Monetary policy had been enough to deal with past recessions and resulted in a belief that central banks were infallible in this regard.  High levels of debt along with a banking sector under attack meant that low interest rates had little effect and quantitative easing was not much better.  Along with not making much headway, monetary policy also caused considerable collateral damage in the form of financial instability.  This was a sign that central banks were being asked to do too much in the face of a once-in-a generation economic slump.

Most governments were happy to sit back having mismanaged their finances resulting in high levels of government debt prior to the crisis.  The Eurozone crisis prompted governments to further retreat amid worries that investors would shun any government with too much debt.  This pushed governments off on a trajectory of austerity which continued even though fears about government debt abated within several months.  The economic recovery has been muted due to weak demand with companies not willing to invest despite low interest rates and consumers hurting due to large debts and stagnating wages.

Time for a new battle plan

Monetary policy was always likely to struggle to make much ground while there is little impetus to spend, let alone borrow.  This shortfall could be overcome by the government which fixes problems, from crime to pollution, that are caused by others.  Keeping the economy ticking over when spending would otherwise be weak would prevent more damage being done to the economy.  Otherwise, the economy becomes less productive as firms stop investing in new technologies and the skills of people out of work deteriorate.

It seems an even more obvious solution at a time when there is so much that the government could spend its money on such as improving Internet access, accelerating the uptake of renewable energy, and updating transport infrastructure.  The low interest rates provide the perfect opportunity to invest for the future especially when companies are not up to doing so.  Investment projects could be set up to boost output in the economy for a few years until spending from other picks up the slack. 

A winning strategy

Despite the still faltering economic recovery, governments loathe changing direction and austerity continues to reign in Europe and the UK (as well as US to a lesser extent).  Moves to fix government finances made sense following the jump in interest rates on government debt in the Eurozone but this turmoil in the financial markets has long passed.  Weak overall spending and the threat of deflation setting in is now the dominant problem facing many countries. 

Higher spending by the government that lifted the productivity of the economy could be funded through borrowing at low interest rates and repaid through higher taxes that a more efficient economy would generate.  This is the opposite of what is happening in the UK where austerity is hurting the economy and efforts to reduce the government deficit are being thwarted due to a fall in money from taxes. 

There is still time for a change of strategy to have an impact in the fight for an economy recovery that improves the lives of us all.  Even if it is too late, investing for the future when interest rates are at record lows seems like a no brainer.  A change is due as this is a battle that no one wants to lose.

Monday, 5 January 2015

Inflation – Hard to ignore again

Low inflation is a nuisance for central banks looking to increase interest rates but they would be wrong to dismiss it

Family get-togethers over Christmas often involve naughty children but it is inflation that is making trouble for central banks.  Inflation unexpectedly shot up in the aftermath of the global financial crisis but is now surprisingly falling despite a burgeoning economic recovery.  Central banks ignored the jump in inflation in 2011 and are now stuck figuring out how to deal with persistently low inflation.  The antics of inflation will be difficult to disregard a second time around considering that the causes for static prices are not all external.

Inflation acting up

The level of inflation is used as a measure to check whether all is well with the economy.  There should neither be too much inflation (suggesting an overheating economy) nor too little (which is a sign of weak overall demand).  With countries increasing sourcing goods from overseas, prices levels in any country can be influenced by prices of commodities on global markets.  This can push inflation in a different direction to the particular circumstances of any economy.

The best recent example of this was a plague of high inflation in 2011 when the economies of many countries were still in the doldrums.  The Chinese economy was still humming along despite financial turmoil elsewhere and China continued to buy up commodities on the global markets.  The result higher prices were most prominent in the UK where inflation topped five percent in 2011.  This bout of inflation was not just a brief spike with prices rising by more than four percent for over a year.  Despite inflation being well above its target of two percent, the Bank of England maintained its loose monetary policy to support the weak economy.  The argument behind this was that the inflation was temporary and not related to the underlying economy. 

Behaving badly again

Inflation is currently misbehaving in a different way and is causing concern due to being too low.  Prices are not rising by much due to lower commodity prices with the spurt of growth in emerging countries having run its course.  While this is a positive for consumers who benefit from a boost in spending power, low inflation is a source of anxiety for central banks.  The Federal Reserve and the Bank of England are getting set to increase interest rates to more normal levels.  Even the prospect of the economic recovery gaining further momentum would not provide central banks with enough of a reason for higher interest rates when inflation is around one percent. 

This irritation is not likely to go away anytime soon if the high inflation in 2011 is any guide.  Inflation is likely to slip even lower in 2015 as the effects of the plunging price for oil feeds through into the economy.  On top of this, swings in commodity prices tend to last for a few years so that inflation is unlikely to pick up for the next couple of years.  This would suggest that inflation will be below target for 2015 and 2016 which is the two-year time frame that central banks look at when deciding interest rates. 

Ignoring inflation would be naughty

Low inflation should imply low interest rates but central banks could choose to ignore this and raise interest rates away.  This is because the same argument as in 2011 could be applied – disregarding trends in inflation that are attributed to outside sources.  It is a convenient strategy for central banks worried about the economic recovery triggering a jump in inflation due to the potential for wages to rise as unemployment falls.  Such an outcome does seem optimistic considering that wages are not budging by much even as the economy picks up steam.

A further problem with turning a blind eye to inflation is that it is tough to gauge what the inflation level would be without the fall in commodity prices.  It is not as if consumers have money to spurge having been stuck with stagnating wages and considerable debts from the pre-financial crisis spend-up.  Sluggish prices are harder to dismiss considering that low inflation is also caused by weak domestic demand.  With inflation likely to continue to play up for a while yet, central banks will need to be patient and bide their time before raising interest rates or else it will be the central banks that may be the ones getting into trouble.