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.

Let's not (Christmas) party like it's 2007

The heady days leading to the global financial crisis were never meant to last so there is no point in expecting to turn back the clock

It is the time for great merriment but Christmas office parties across London still leave many wishfully thinking back to the good old days.  Despite much talk of an economic recovery, it can still be tough to find reasons to be cheerful about and less cash being spent by companies on seasonal festivities is another reminder of this.  But we should not be asking Santa for a return to the days of lavish Christmas dos with workmates and big entertainment budgets (if they ever did exist).  The economy of old which allowed such excesses could only bring in a few good years of partying before the good times inevitably turned bad. 

Living the high life on borrowed time

The boom times that were still in swing a decade ago seem a long way off.  It was a time when all seemed good with the economy and nothing much would go wrong.  This spirit seemed best exemplified by the exuberance among economists who (mistakenly) thought that their ideas had conquered the ups and downs of the economy.  The great evil of past decades, inflation, had been kept in check and the recession following the dotcom bust passed without much strife. 

This new stable economic environment seemed to benefit the finance sector most of all.  Banks came up with new ways of making lots of money with bankers themselves reaping much of the rewards.  Even some among the rest of us got to enjoy a sprinkling of the good life with many companies splashing out the odd treat on their workers (especially around Christmas time) even if this generosity was not reflected in wages.

The enthusiasm was infectious and we all wanted our share.  The result was loads of new debt as our spending reflected these new aspirations even if our income was lagging behind.  Even the governments in many countries spent beyond their means and got their finances in a mess.  Since inflation remained subdued despite the elevated spending, interest rates never rose by much enabling the debt levels to soar beyond what was prudent.  And banks were only too happy to lend since new financial products, such as mortgage-backed securities, allowed them to pass on increasingly dubious loans to others.

Not banking on trouble

This was one party that could not go on for ever.  An increase in debt is good for spurring the economy along but this can only go so far until lending becomes more reckless.  The final straw was mortgage lending in the United States where new rules encouraged housing loans to individuals who were never likely to be able to afford repayments (so-called sub-prime mortgages).  The many who lost their jobs (including Your Neighbourhood Economist) and even their homes in the ensuing financial turmoil ended up with little to show from the good years.  Yet, on the other hand, the exorbitant pay packets received by many bank employees left them sitting pretty whatever was to happen.

We should all feel repentant like Christmas drinks where we get carried away and make a fool of ourselves.  One way of stopping ourselves getting into trouble is to rein in the banking sector.  This does not mean the equivalent of alcohol-free Christmas festivities but just stricter rules to make sure that things don’t get out of hand.   The perils of too much debt should have always been obvious but it is inability of the banking sector and the financial markets to suitably regulate lending that is perhaps the biggest lesson that we need to address.

Time to sober up

Any economic growth does not count for much if we have to give back most of the gains after a few good years.  Yet, giving up on this easy way of making ourselves richer also means that we cannot expect the economy to grow like in the past.  It will take hard work and sensible policies rather than financial wizardry to make genuine improvements in our standard of living.  The trade-off being that we can create a world where our jobs and what we make for ourselves is more secure.

The government could have a big role to play in this especially since companies are not investing as much as they used to.  Greater spending on infrastructure and education as well as lower medical costs would be a good start to help increase productivity (and wages) as well as going some way to propping up spending.  The solution sounds simple enough but politics is never easy especially at a time when the easy option is for politicians to offer up false promises.  It is voters most of all that need to be realistic in terms of what is achievable.  No party is worth a hangover on the scale of the global financial crisis.

Interest Rates – Looking for the right temperature

The economic climate is changing but that may not necessarily mean that interest rates have to change too

Setting interest rates can be as frustrating as fiddling with the heating as the seasons change.  We can rely on the weather forecast as a guide to the outside conditions but it is harder to get a measure of whether the economy is running hot or cold.  This is particularly tricky at a time when some central banks are switching from policies to warm up the economy to measures for preventing the economy from overheating.  The poor economic outlook suggests that the current monetary policy measures may be here to stay despite calls for higher interest rates.

Neither too hot nor too cold

Interest rates are often raised or lowered to nudge the economy toward what is seen as an appropriate rate of growth.  Once the economy is humming along as it should (with inflation in check), interest rates are ideally set to a level that neither helps nor hinders economic growth.  This is the concept of neutral interest rates which should be higher for fast growing economies and lower for economies with weaker growth.  Not only are there differences between countries but the neutral interest rate for one particular country can change over time.

The neutral interest rates have been slipping downward for many countries as their prospects for growth deteriorate.  Many consumers as well as governments are focusing on paying back debt leaving less money to spend.  Companies are hoarding cash instead of investing which takes away another driver of growth.  With most developed countries suffering from the same problems, exports don’t offer much help either.  Even economic growth in China, which has been one of the few bright spots in the global economy, is likely to slow from a boil to a simmer as focus shifts from investment to consumption.

Turning up the heat

There are signs that the global economy is heating up in places.  The British economy is expected to expand by around 3.0% in 2014 while around 2.0% growth is forecast for the US economy.  Yet, the effects of this are not being felt by consumers due to stagnating wages and cuts to government spending.  Low inflation is a further indication that not all is well even these economic hot spots.  These mixed signals have prompted a cautious approach by the US Federal Reserve and the Bank of England who have kept interest rates at record lows close to zero.

The lingering hangover from the global financial crisis continues to hold back the economic recovery.  Consumers are less willing to take on debt after the disastrous results of the previous borrowing binge.  Any plans of investment are reigned amid worried about the prospects for the economy.  Proactive policies tend to go out the window as politics regresses to squabbling over limited government resources.   The likelihood for these factors to lower the neutral interest rates means that interest rates are unlikely to go up by much at all. 

Don’t touch that knob

Depending on the extent to which the neutral interest rates have fallen, it could even be argued that interest rates should stay close to zero until the medium term prospects improve.  There is no immediate reason for interest rates to be raised considering that the main concern of central banks, inflation, is not a concern.  Even looking forward, inflation is likely to remain subdued when factoring in falling commodity prices and weak wage growth.

Moreover, lending has not gotten out of hand except for in isolated sectors such as real estate in certain countries (such as the UK).  Other worries also include low rates of return pushing investors to chase after higher pay-outs by putting money into increasingly riskier investments.   Yet, these issues can be dealt with using targeted policies rather than relying solely on interest rates.  Higher interest rates are seen as helpful in that it will give central banks more capacity to respond in the case of another downturn.  But setting interest rates has less of an effect when the financial markets are awash with cash. 

Like a bickering couple arguing whether the heating is set too high or too low, expect the debate over the right level for interest rates to drag on.  Despite all this, it looks as if interest rates might be best left where they are for now.

Monetary Policy – Germany to feel the pinch

A taste of its own medicine may prompt Germany to rethink its tough guy approach to Europe

No one like a bully but that seems to be Germany’s role in Europe.  It makes other countries walk the line in policy terms (for their own good) even amid simmering discontent among its neighbours.  Germany has been mean in terms of pushing for monetary policy to be less expansive as elsewhere in spite of struggling countries needing help.  Yet, things may change as the German economy is starting to suffer from similar problems to those it bullies.  Germany is likely to be stuck with monetary policy that is too harsh for even its own economy and this may result in it softening up its approach to others in Europe.

Help wanted

It is a given that the economy in Europe could do with a boost.  Weak demand from consumers and firms means that unemployment remains stubbornly high and inflation for Europe as a whole is not far off zero.  But Germany continues to push its policy of tough love onto Europe.  As with most other developed countries, fiscal stimulus is not an option as governments deal with high levels of public debt.  Germany has gone further in cajoling other governments in Europe to sort out their budget deficits despite the likelihood of adverse economic effects.  

Germany has also not allowed the use of monetary policy as an alternative means of stimulating the economy.  Measures such as quantitative easing have been utilised with some benefits in the US and in Britain but not in Europe even though Europe needs a boost more than anywhere else.  The reasoning behind this approach by Germany is that, by offer laggards in Europe an easy way out, the current problems which are holding them (and Europe as a whole) back will remain in place.  As a result, the European Central Bank has had to be creative and try other measures such as negative interest rates.  But it is difficult for monetary policy to have much effect when its scope is limited.

Turning the tables

Germany may have been able to bully others in Europe but it may be the Germans turn to feel the pain.  The German economy is beginning to flag amid weakening demand for its exports from places such as China.  Forecasts for economic growth in Germany are being cut as its prospects deteriorate while inflation has fallen to below 1%.  The normal response to a weakening economy anywhere else would be for looser monetary policy.  But having not allowed other European countries this option, Germany’s tough stance on others may result it also being tough on itself. 

It is funny to think that the Germans would have likely allowed itself to have more stimulus via monetary policy if there was just a German central bank looking after just the German economy.  But its own actions in influencing monetary policy will mean that Germany may have to endure monetary policy that does not reflect the weak state of its economy (along with most everyone else in Europe).  When framed in this way, Germany must rethink its ideas on economic policy for Europe if just for its own good. 

Continued stubbornness by the Germans would be unconstructive even in comparison to the often dysfunctional politics in Europe.  Deflation is another concern that will only get worse with the current policy measures.  Germany was never going to go easy on others in Europe while its economy was riding high.  It is only a Germany that has been laid low that may soften up and be more willing to help itself by helping others.

Euro as the new Deutsche Mark

Germany practically controls the euro as if it were its own currency but it would gain more being less in charge

Being a big fish in a small pond can have its benefits as Germany is discovering in its dealing with Europe.  Its powerhouse economy means that Germany was one of the few countries left standing after the Eurozone crisis.  Germany has used this position of strength to turn the euro into its own de-facto currency.  It dominates the decisions over monetary policy and has influences spending decisions by politicians outside of its borders.  This level of control is alienating many others in Europe while still being insufficient to keep Germans happy.  As a result, more could be gained by Germany trading away its power to secure a brighter future for Europe as a whole.

Benefits of being the boss

Control over monetary policy is not something that Germany fought for but it came as a by-product of the Eurozone crisis that hobbled the other powers in Europe.  More prudent management of government finances meant that the government has less debt and the economy has been resilient due in part to its exporting prowess.  This left its Chancellor, Angela Merkel, as one of the few politicians who is backed by voters and in a strong position to dominate European politics.

It has allowed Germany to impose its own policy measures over the Eurozone.  Germany has set the tone regarding austerity as well as its concerns over inflation limiting the scope of monetary policy.  Countries such as Spain and Italy would benefit in the short term from more government spending and looser monetary policy.  But Germany has pushed for a range of policies which are a better fit for its own economy than others in Europe where the shortfall in demand is more pronounced.  The aim is to bring others into line in terms of implementing reforms which would improve the outlook for Europe in the future.

Along with setting policies, being the boss of a widely used currency comes with a host of benefits.  For starters, investors looking for the safest place to park their euros will choose Germany over other European countries and this keep down interest rates in Germany.  Worries about a sluggish economy in Europe are a further boost to Germany by keeping the value of the euro weak.  The euro is both too strong considering the economic circumstances of many of the countries in Europe but considerably below what a truly German currency (a new Deutsche Mark) could be valued at. 

Getting more from less

As is often the case, its power has become like a poisoned chalice.  Not only is Germany out of tune with many of its neighbours but the euro is also increasingly unpopular at home.  The rapid rise of an anti-euro party in Germany (called the Alternative for Germany party) suggests that there are many Germans who feel as if they are getting a raw deal from being part of the Eurozone.  This party joins a growing list of populist parties in Europe worried about the level of integration needed to maintain the euro. 

If a position of strength does not come with many rewards, sometimes more can be gained from giving power away.  Germany could soften its strict stance on fiscal and monetary policy as a trade for more reforms in other countries.  This bargain would help deal with the short-term issues of a weak economy needing stimulus as well as concerns about the prospects for Europe over the long term.  Compromise also seems more likely now that deflation is a growing threat and the German economy itself is flagging.  It is time for Germany to cash in now as it may be too late if the situation in Europe gets worse. 

Europe – finding a way out

Europe seems trapped with a sluggish economy but a way out may be close

Getting out of a hole that you have dug for yourself can be tough.  This is what Europe is struggling with as the Eurozone crisis seems to have passed only to be replaced with a slow strangling at the hands of deflation.  Infighting among politicians about the best way to deal with the economic stagnation in Europe has resulted in few reasons for hope of an escape.  Yet, this may change due to recent developments such as a flagging German economy and the rise of reform-minded governments in some countries.  Sometimes things need to get worse before a way out is possible and the situation in Europe may have finally got bad enough for positive change to occur.

An economic escape route…

An economic recovery is typically an automatic progress but may not always be easy.  Companies going bankrupt and workers losing their jobs cause considerable pain but is actually something that is good for the overall health of the economy.  A cull of weaker businesses provides more space for more successful firms to grow and prosper.  This process has the label of “creative destruction” in economic theory due to the idea of the old needing to give way for the new. 

In this way, economic growth returns after a recession as resources such as workers move to more productive uses.  The economy can grow faster as a result but a certain level of economic freedoms are needed to allow this to happen.  In this way, there is a trade-off between economic growth and the potential for instability.  It is not possible to have the former without the latter but any instability can be limited through controlling economic excesses (which often show up in the financial system).

Getting the balance right is not easy.  Companies in finance have been given too much leeway and created havoc as a result.  Yet, in other areas, businesses have been burdened with too many rules.  One example is regulation which makes it difficult for firms to fire workers.  This may seem like a good way of keeping people in jobs but such regulation has an adverse effect in that companies will not want to take on new workers if their employment is almost permanent.

… and the politics to make it happen

Many countries in Europe are in desperate need of policies to free up business from such regulation but implementation is often tricky.  At a time of rapid change, voters often crave stability of bygone eras that are no longer viable.  This does not stop populist parties making false promises to turn back time and dismissing the need for reforms.  It is heartening for the outlook in Europe that some countries such as Spain have made progress with its reforms.  Others such as France and Italy also have governments that are making the right noises in terms of reforms even if not actually putting new policies in place.

The lack of reforms has been preventing the recovery in Europe in other ways.  Germany, who has a firm grip on the reins of power in Europe, has stubbornly refused to offer much help to struggling European countries.  The reasoning behind this is that offering an easy way out would mean that these countries would not deal with the problems within their own economies.  The flip side is that, once reforms begin, Germany may be more accommodating in providing support. 

This opens up the possibility of a grand bargain, such as reforms as a trade for looser monetary policy and less focus on austerity.  More action from the central bank seems likely as the German economy is beginning to falter and genuine fears about deflation in Europe grow.  Its own weak economic growth and low inflation will highlight to the Germans that the problems are plaguing Europe as a whole rather than just individual problem countries.

Your Neighbourhood Economist penned this posting with comments from readers in mind.  Europe and the euro was seen as a lost cause by one reader while others have been annoyed that this blog always had to be so pessimistic.  Hopefully, this post will hopefully prove them wrong (but in a good way).

Quantitative Easing – Waiting while Europe Sinks

As Europe cries out for more action against deflation, the central bank must wait until the situation gets even worse

It would be strange to hold off saving people in a sinking ship until the ship is just about to go under, but this is how monetary policy works in Europe.  The situation in European grows continues to get worse as economic growth stagnates and deflation sets in.  Yet, the central bank cannot help, as it is hamstrung by politics, and must hold off until the cost of inaction is too high.  This means that Europe will have to take on a lot of water until a rescue package can eventually be put in place. 

Politics muddies the water

Monetary policy is tough enough in one country, let along for the 18 countries which use the euro.  The European Central Bank has acted boldly when given the chance.  It took a stand in 2012 stating that it was willing to do “whatever it takes” to save the Eurozone.  This was the lifeboat that saved Europe from collapse at a time when national governments were absorbed riding out wave after waves of turmoil.  But the European Central Bank was only free to jump in once it seemed as if Greece and other countries were about to let go of the euro. 

Despite a temporary reprieve, the economies of Europe have been like a listless ship with leaks.  Reforms have been put off in the hope that the worst is over and economic growth would return without any further encouragement.  Yet it is not a surprise that Europe is close to being sunk again but this time in slow motion.  The problem is the rules and regulations that get in the way of more efficient ways of doing business.  Economic growth cannot be seen as a given and government policies must allow resources to move to more productive uses.   

Such reforms tend to be unpopular as the costs are borne upfront while it takes time for the benefits to show.  So politicians in Europe have put off these measures as pleasing voters is proving tough enough as it is.  Instead, it has been easier to blame others and wait in the hope that economic growth will return.  This wait-and-see approach relies on the central bank to help out with the economy but this is beyond what the European Central Bank can achieve.

The politics behind the European Central Bank is made even more difficult in dealing due to some countries floundering more than others.  Amid all of the concerns about deflation, it is already a fact of life in some countries such as Greece and Spain.  Yet, even Europe as a whole is edging closer to deflation which is typically the symptom of a sluggish economy.  The fear is that deflation will create its own problems if falling prices prompt consumers to hold of spending in the hope for cheaper goods in the future.

Waiting until things get worse

The central bank has already responded to the threat of deflation through a policy of negative interest rates.  Quantitative easing, which has already been used (with limited success) in other countries, is the obvious choice to ramp up monetary policy.  This option has been kept off the table due to its potential to cause inflation which raises hackles among Germans.  Since any measures by the central bank could be deemed to be inflationary, Germany has used its influence to restrict the ability of the central bank to act. 

Yet, even the Germans will eventually have to see deflation as the greater threat.  But, at the same time, it is tough to gauge when too little inflation (or too much deflation) will be enough for a change of tack.  Germany has stuck to its guns since the outbreak of the Eurozone backed by an economy which had until recently remained buoyant.  So Europe is likely to get quantitative easing sometime (soon) and hopefully before the Eurozone is too far under water.

Economic Recovery - Downgraded

Amid talk of economic recovery, we may not get back to living the life we had in the past

Being downgrading can be tough – no one likes having to get by with less – but this is what we might have to put up with regard to the economy.  Life was much easier around a decade ago when we were enjoying the perks of strong and steady economic growth.  But the upgrade was likely temporary when considering that it was funded with a borrowing binge that was unsustainable.  With wages likely to continue to stagnate for years to come, we may not have it so good again for a long time.

Anything but first class

Gains in wages are typically the main route to the good life for most of us.  Bigger pay packets at the each of the month give us more money to spend.  This money goes back into the economy to create a virtuous cycle helping create a healthy economy so that wages to rise again in the future.  The main avenue through which wages rise is higher output per worker.  This involves people being put to more productive use whether through raising their levels of skills, working together with machines or computers, or doing business in a better way.  The economy usually operates to ensure that this happens automatically as businesses, which want to maximized their profits, will try and make the most of their staff. 

Yet, the past few years, if not the past few decades, have shown us that the tendency for higher wages is not something that we can take for granted.  This is because the two forces of globalization and technology have made life tougher for many people in richer countries.  The sectors of the economy which typically supported the middle class with stable and steady jobs have been eroded.  Jobs such as those in manufacturing along with clerical work have been either moved to countries where labour is cheap or increasingly carried out by machines or computers. 

This has led to a polarization of the work force between high and low skilled areas with a shrinking middle ground.  At one end of the spectrum are bankers, IT experts, and professionals whose knowledge and training ensure a high level of pay.  The rest of the workforce is left with menial jobs such as taxi drivers, shop assistants, and delivery personal only because these are jobs that can’t be shipped overseas.  On top of this, austerity measures in many countries also mean that public sector workers are also suffering.

No route out

With many of us now competing with machines or overseas workers, our bargaining has been considerably diminished.  So while wages rises is a perk that many are missing out on, profits for many businesses have never been higher.  Profitable firms could be the agents of economic growth by expanding their operations and investing in more equipment.  Yet, with weak wages crimping consumer spending, most companies prefer to hoard their cash until the economic recovery is more robust.   What seems like a common sense strategy for each firm has added up to a prolonged slump for the economy as a whole.

The government could step into the breach and provide the investment in worker training or infrastructure to boost productivity.  Yet, the infiltration of pro-market economic theory has pushed the government to the sidelines of the economy.  Even the wealth that had been created in the boom years before the crisis was only benefiting a small portion of the economy.  One example is the finance sector that was creating wealth that mostly went to those working in finance rather to the economy as a whole.  Building a road or new schools creates benefits now and in the future while repackaging of loans only generates money for a lucky few working in banking.

Stuck with a second class economy

Workers have been battling with the consequences of globalization and technology for decades but could rely on debt in the past to enjoy some of the high life.  But like an ever expanding credit card balance, this spending spree was never built to last.  To make things worse, even politicians got involved.  The US government with Bush junior in charge slashed tax rates while the Labour government spent lavishly on the UK public sector around the turn of the century. 

Government finances had been boosted by economic growth fuelled by debt but this was a luxury that would prove fleeting.  Now government is like the rest of us in having to cut back.  Without many goodies going around, voters are likely to become increasing tetchy.  Politics is also getting ugly with constructive policy making likely to go out the window.  Low interest rates and more debt have been offered up as a way out but this creates even more problems in the absence of economic growth.

Something special will be needed to get both consumers and businesses to hope for something better.  Yet, the grim realities of life mean that this may not happen anything soon.  Like being in a long haul flight in economy class, we might be stuck here for a while.  

Economic Recovery and the Politics of Slow Growth

When the economic pie stops expanding, everyone wants their fair share and politicians are unfortunately only to keen to oblige

Slow economic growth is like hot weather – people become easily irritable and argue a lot.  This because, while economic growth makes it easier for everyone to feel better off, the opposite is true when the economy stagnates.  A sluggish economy leads to a shift in focus from creating more wealth to dividing up whatever is already there.  This creates fights over resources with people mostly looking out for themselves. 

Politicians pander to such self-interest among voters and constructive policy making goes out the window.  Voters are get all hot and flustered as the economic recovery since the global financial crisis has proven anything but balmy.  With the outlook for the economy not looking so bright for years to come, politics may continue to get people steamy under the collar.

Politics turns cold

Democracy is the best political system we have for ensuring the implementing of policies for the common good.  Politicians get elected by pushing a package of measures that the majority of voters believe will make them better off.  When times are good, policies tend to be aspiration in promoting economic growth with some resources also going to the less well off.  But things are not going so well, the focus of voters narrows to their own specific well-being.  As such, voters become less generous in terms of social spending and immigration while wanting the government to do more for them. 

The result is that politics become short-sighted and politicians pick more policies that target their own particular support base.  Honest assessment of the economic ills are typically in short supply while voters grow increasing frustrated as timid government policies can only provide limited relief.  Many voters have been tempted with the false hopes of more extreme policies offered by populist politicians.  However, turning back time with less government or less globalization will only create bigger problems rather than providing answers. 

The political infighting comes at a bad time for many developed countries who are increasingly feeling the heat of global competition.  This process was already underway with the rise of China and other emerging economies and the global financial crisis has been a further setback.  The narrow-minded politics currently prevailing in many countries will further hasten the relative decline of the West.  On top of this, government action is also hampered by economic theory that argues for less intervention in the economy. 

Still sweating it out

It is more than a tad ironic that it is now more than ever that positive and proactive government measures are needed more than ever.  This is because government has traditionally been the guardian of the long-term health of society.  The government has even more to offer at a time when businesses are not investing and gains in productivity (output per worker) are proving hard to come by.  Higher productivity is the main route to increases in wages and consumer spending at a time when low skilled work is carried out in developing countries.   

Yet, as described above, governments have been more of a hindrance rather than helpful with regard to the economy.  A push for austerity has dominated in many countries such as the UK despite going against the grain of economic theory.  In the place of increasingly distracted politicians, central banks have take centre stage in reviving the economy (which comes with its own problems).  With minor squabbles often dominating politics, it may take time before governments and voters are ready to sweat over the big issues.  Like a muggy summer that never seems to end, the combination of economic and politic malaise is not a problem that will go away any time soon.

Time to rethink the role of Government

While their reputation has suffered at the hands of economists, it is time for governments to show that they have wised up

It must be tough being repeatedly told that you are stupid but that is what governments have had to put up with.  Mainstream economic theory tells us that markets know best and clumsy governments only get in the way.  But the global financial crisis has highlighted that financial markets are not smart enough to be left to their own devises.  This is just one of several areas where it would be wiser to bring back government as a power for good.

The Invisible Hand was always seen the clever one

Economists like to think that markets are the smartest thing around.  Markets refer to not just places where anything from sausages to shares are sold, but also to the economic system where numerous companies compete to offer goods or services.   The clever thing about markets is that prices and output can change to reflect demand from consumers and this helps to determine the best allocation in an economy.  The best bit is that this optimal outcome is not based on decisions made in one controlling body but market information gleaned from the individual decisions of consumers and firms. 

This belief stems all the way back to the father of economics, Adam Smith, who argued over three centuries ago that the private actions of individuals in the market would work for the public benefit.  Governments, on the other hand, are seen as more of a heavy hand in the economy.  Governments get in the way by creating red tape that strangles business and misallocating resources by dishing money out to favourite sectors.  Examples of misspent money abound as do unworthy recipients of taxpayer cash.  

Yet, all economists would also agree that some government actions are needed for markets to function properly.  Basics such as national defence and policing are essential for any business to operate and can only be provided by governments.  Companies also rely on a supply of workers with some degree of education as well as communication and transport infrastructure.  So while some level of government intervention is necessary, the extent to this is something that is defined by politics.   

The trend started by Thatcher and Regan has been for an increasingly shrinking role for government in the economy.  Economic theory was enlisted to make the case for smaller government which came as a backlash against decades of expanding government.  Much of the initial cases for privatizations and deregulation were justified due to numerous areas where government had overextended itself.  Yet, faith in markets and distrust of government has become so embedded in politics that cases where more government might be good are dismissed.  Governments are so timid in their actions that much of policy to do with the economic recovery has been outsourced to central banks (which creates its own problems).

Who looks stupid now?

Government policy does not always work out as hoped.  But bureaucrats are not alone in making mistake – just think of Enron or BP.  Yet, the most obvious example of where government involvement has been missed is the finance sector.  Deregulation over the past few decades let loose forces that even the banks themselves were not smart enough to understand.  Banks messed up in terms of the seemingly common sense notion of putting long-term survival ahead of short-term profits.  

More proactive government policy would have gone a long way to preventing many elements of the crisis and is something that we should apply now with the benefit of hindsight.  But the notion that more government is good can also be applied elsewhere.  Transport infrastructure has been neglected amid the trend for smaller government while other areas such as R&D and training for workers could do with more government input.  Governments which are not willing to take an active role in the economy leave voters feeling frustrated and opens the way for the rise of populist parties.

This is not an argument to re-establish government dominance over the economy.  A bigger government need not involve significantly higher taxes and large welfare payments.  But, there are parts of the economy where action is needed to ensure the public good and only government can respond to this.  While politicians on the right need to be more accepting of the positive effects of government, it is up to left-wing parties to make a better case about the good that government can achieve.  It is time that we were all smarter in the way they think about government.  

Economic Recovery – Reasons to be Pessimistic

The economy seems to be picking up so why are economists still so dour?

Economists are not known for being moody but many are depressed when it comes to the state of the global economy.  This seems out of place at a time when economic recoveries in some countries are showing signs of taking hold and stock markets are setting record highs.  The mood among economists was already negative after being caught out by the global financial crisis.  Are economists right to be worried or just hung up on past mistakes?

Why so glum?

My father inquired, after a recent post on my blog, why my views had to be so downbeat.  Given that much of the business cycle is driven by the sentiment of consumers and businesses, his line of thinking was that the economy would jump back to life if we could all just be more positive about the future.  People would spend more while companies would invest and take on more workers.  All we would need is economists to tell us that everything will be alright.

The problem is not that economists are always a grumpy bunch.  The problem is the opposite – that economists have been overenthusiastic in the past.  This optimism was fuelled by a belief that economic theory could provide a route to a steady rise in prosperity.  Instead, economists have been chastened as a result of their previous ideas being proved wrong by the global financial crisis.  The crisis has also focused minds on what can go wrong.  Now, even periods of prosperity are seen to have a darker side and to create the seeds for trouble in the future.

Grumpy for a reason

It may just be the case that economists are caught in a crisis of confidence.  There is a core belief among economists that markets have the ability to correct themselves.  This means that any periods of weak economic growth should only last until the economy gets back on its feet again.  There is much data on the economy to get excited about.  Consumer spending is up, buoyed by the job market recovering faster than expected.  The worst of the crisis seems to be behind us and stock markets reflect this new upbeat outlook.

Yet, economists have learnt their lessons and know better than to place too much trust in the data.  Behind the numbers lurks a less cheerful story.  Investment by companies is low with few businesses seeing opportunities to expand despite balance sheets laden with cash.  One reason for this is that labour productivity is weak.  This means that the extra earnings for companies from employing more workers are likely to be poor.  Low labour productivity also implies that wages are not likely to rise much which raises concerns about whether households will struggle to pay off rising levels of debt.  A lack of new innovations suggests that investment and productivity may not improve for a long time to come, prompting talk of prolonged stagnation.

When the markets are not functioning normally, it is typically the government that steps in to correct any problems.  However, the governments in many countries have been more hindrance than help.  Mismanagement of government finances, slow and timid responses to crises, and a lack of forward-looking policies are common complaints.  With voters lacking genuine alternative political parties, politicians have become engrossed in petty political positioning rather than constructive policy making.  Managing the economy has been left to central banks which has caused its own problems. 

This is why Your Neighbourhood Economist is one of many who struggle to find reasons for cheer.  It would be great to be caught up in the euphoria that has taken hold of the financial markets but economists have been burnt too badly to get carried away.  Only time will tell if the gloom among economists is warranted.

The Economics behind Populist Parties in Europe

Voters kick up a stink in the European elections but mainstream politicians only have themselves to blame

The success of anti-EU parties in the European elections has been in the news over the past week but it is economics that provides much of the backstory.  Voters in Europe have flocked to political parties offering the illusion of a way of opting out of the changes that threaten their livelihoods.  Such frustration is understandable considering that the more established parties have only offered up piecemeal measures as a solution.  Acceptance of the limited options available will be the first step to making real progress.

Going with the flow

The economic prospects of those with few skills are dire.  Many of the sectors that provided jobs for workers in earlier generations have shrunk due to the double whammy of technology and globalization.  Gains in technology have seen a rise in the mechanization or computerization of many tasks.  Globalization has allowed firms to search the world to find the cheapest workers.  These are not trends that are expected to change anytime soon.

Despite the large number of those put out by these trends, the benefits for the economy as a whole have been unprecedented.  Technology has brought a wealth of information and possibilities to our fingertips and outsourcing has made the bulk of things we buy much cheaper.  There is no one who has not gained in some way with the overall gains far outweighing the costs.  The problem is that these costs are borne by a relatively limited number.

In an ideal world, some of the wide spread benefits would be used to compensate those missing out due to the rise of technology and globalization.  However, governments in the Western world have been moving in the opposite direction.  People are increasingly left to fend for themselves with few hand-outs from the government.  The affected workers need money during periods without work as well as help with reskilling to move into growing industries.  Yet, unemployment benefits are being trimmed back and education is becoming more expensive. 

Instead, governments look to shield themselves from the blame, and since no one is going to come out against technology, globalization is the obvious fall guy.  The EU takes the blame in Europe as the epitome of the uncontrollable external forces pushing for more open borders.  Rather than admit that they are almost powerless in the face of outside influences which are part of globalization, politicians offer temporary reprieves.  Typical responses include attempts to limit immigration, moves to block factory closures, railing against takeovers by foreign firms, or moaning about a strong currency hurting exports.  The failure of such actions to have any substantive effect leaves governments open to criticism.  Hence, the rise of political parties proposing to do more.

A dose of honesty

The policies of populist parties will not offer any long-term respite.  It is possible for an economy to shut itself off from the global economy.  However, fighting against the tide of history is not a long term option - a faster pace of economic growth in other countries which are more open will inevitably reveal the folly of such isolation.  Instead of being a viable alternative, the anti-immigration political parties tend to function as a form of protest for voters to vent their frustration at the status quo.  But there is still the possibility of one of these protest parties snatching power, likely with dire consequences.

The main remedy might be something as simple as a bit of honesty.   Politicians need to be more open with voters about the limits of their policies.  This would give them the scope needed to deal with the negative effects of technology and globalization which need more than ad hoc measures.  Long term investment in education and infrastructure will be key in terms of both dealing with the negative and reaping the most benefits.  Now is the time for governments to step up and act or else face a more rapid tumbling down the global pecking order.  Politicians and voters need to come to their senses.  And soon.

Free Trade – Missed by Many

Free trade is a route to greater prosperity and better government but its biggest advocate has retreated from its crucial role

US foreign policy was something that people loved to hate.  America was portrayed as a global bully who pushed everyone else into playing by its rules.  The Iraq War is perhaps the most obvious example of this but the conflict also marked a turning point when the US started to withdraw from its dealings with other countries.  While this might appear to be cause for rejoicing, the retreat of the US from international affairs has left a gap that has yet to be filled.  A lack of impetus in the promotion of free trade is one key area where the world is missing the US in a way that is not yet widely understood.

More than just buying and selling across borders

Free trade is something that many people would be glad to see the end of.  It allows for greater globalization which has been vilified as costing jobs and hurting our economy.  Although a source of pain for some in the West, globalization has been a boon for most of us, providing a range of cheaper goods for everything from bananas to iPhones.  At the same time, export industries in less developed countries have pulled millions out of poverty.

Openness to free trade with the rest of the world involves more than just exporting and importing.  It is part of a bigger package that includes less overall regulation and more economic freedom.  This may not seem like much to those in countries that already have this in place, but to places under the rule of an autocratic government, it is something worth fighting for.  Such a battle has dominated the news so far this year as it plays out in Ukraine.

The protests that overthrew the oppressive regime in Ukraine were triggered by the government stepping back from an EU trade agreement and instead opting for a closer relationship with Russia.  This was taken to have the broader meaning that the Ukrainian government was choosing the autocratic style of government characterised by Russia rather than the democratic freedoms of the EU.  Yet, the unrest in Ukraine shows the preference of its citizens and how opening up to trade (and expansion of the EU) can spur on hearts and minds when seen as part of a bigger picture. 

Free trade can have a positive influence in other ways as in Japan.  Political lobbyists such as farmers have tended to block greater access for imports into Japan.  Japanese politicians are apt to side with such vested interests instead of with voters in general who would benefit from cheaper imports.  In the past, it has only been pressure from outside the country - typically from its main ally, the US – that has helped open Japan up to free trade.  Delayed but critical reforms needed to fire up the Japanese economy could be pushed through if a deal were to be done on the Trans-Pacific Partnership which is a free trade zone encompassing countries on the Pacific Rim.

China can only offer so much

The fight for free trade typically needs a champion.  This is because the negative impact of greater trade is concentrated in a few sectors which are proactive in their opposition.  The gains from more open borders are, on the other hand, spread out amongst us all, resulting in only weak support.  Thus, despite the substantial advantages of free trade, progress has been halting.  The problem is exacerbated by each country having its own boisterous domestic forces against free trade so that getting a large number of governments to sign up is a tricky proposition. 

The US government had been the driving force behind free trade, using access to its own lucrative domestic economy as a bargaining piece.  Rather than being a bully, the US spread economic freedoms through trade like a benevolent power.  But, the US no longer has the ability or willingness to play this role.  A rebalancing of the global economy means that the lure of the US economy pales in comparison with other countries such as China.  The weakening of its relative economic strength also means that the US is less generous in its bargaining with other countries.  This is reflected in the stalling of what was supposed to be the next big round of global trade talks which started in Doha in 2001.

The lure of Western ideals as embodied in free trade still remains.  Countries clamber to join the European Union despite its recent troubles.  Economic power may be shifting away from the US and Europe but their democratic style of government is still sought after by many (although politicians have not been showing themselves in a good light).  Free trade in itself is not the answer but it will help push many countries in the right direction. 

Tax Hike in Japan to test fight against Deflation

The Japanese government has been proactive in its battle with deflation but higher consumption taxes will show how much progress has actually been made

There is a big test coming up for the Prime Minister of Japan, Shinzo Abe, and his own brand of economic policies which have been labelled “Abenomics”.  Abe has launched a range of aggressive measures to end deflation and get the Japanese economy moving again.  However, a rise in the consumption tax from 5% to 8% in April will provide a thorough examination of the economic recovery in Japan.  The results will matter not only for the long-suffering Japanese citizens but may also provide crucial lessons on how to combat the growing threat of deflation.

Economic Policy - could do better

A report card for Japan's Prime Minister might see him get an “A” for effort but a “C” for execution.  Abe has had a busy first year in power and has attracted plaudits for his three arrows of economic policy encompassing fiscal stimulus, monetary easing, and structural reforms.  This has translated into 10.3 trillion yen (or around US$100 billion) in extra government spending and the Japanese central bank aiming to double the money supply over a two year period.

Hopes were buoyed as the Japanese economy perked up in early 2013 while the stock market in Japan was one of the best performers last year.  Unfortunately, Abenomics did not live up to the hype with economic growth slowing and many investors selling their Japanese shares in 2014.  The shortfall against expectations has been due to an unwillingness to push through the reforms which are key to getting the economy moving again.

Your Neighbourhood Economist had always been sceptical about the outlook for the reforms as Abe is a conservative in a political party which is known as a bastion of old-school traditions in Japan.  The Japanese government is not alone in using expansionary monetary policy as a shortcut to improving the economy.  Yet, two decades of stagnation show that there is no easy route to scoring good marks where the economy in Japan is concerned.

Economic recovery put to the test

The hike in the consumption tax (which has been on the cards for decades) is a move to sort out the government finances but threatens the goal of defeating deflation.  Consumer prices have begun to edge upwards but this depends on the central bank in Japan continuing to print a torrent of new yen notes.  Rising prices are a novelty in Japan after decades of deflation with the higher consumption tax set to bump prices up a further notch.

It is not clear whether Japan is ready for this real-life lesson on the effects of inflation.  Many companies in Japan are not yet convinced that inflation has taken hold with some even lowering prices to absorb the higher taxes.  As a result, wage gains have been timid despite the government's efforts to bully Japanese firms into paying their workers more.  Inflation without higher wages is even worse than deflation as consumers increasingly feel the pinch.  The increase in consumption tax could exacerbate this trend and depress spending.

Little to learn

A poor showing in economic policy in Japan will seldom make the news elsewhere but it does not bode well as other places look set to face a similar set of problems.  The causes of deflation in Japan are becoming more prevalent in Europe – high government debts, an ageing population, a stagnating economy, and companies struggling amid globalization.

Lessons learnt in Japan could be applied elsewhere.  Yet, successes have been few and far between.  Japan does not make a good case study for fiscal stimulus (more due to problems within Japan rather than problems with the idea of a stimulus).  Neither has monetary policy had much impact with an increase in the supply of money only having a limited effect on inflation (due to the link between money supply and inflation being weaker than assumed).  Europe is instead contemplating negative interest rates which is something that Japan has not tried.

Too much inflation will drag down the grades of central banks but deflation could earn them a fail.  Part of the reason is that deflation has been seen as a cause of the malaise of the Japanese economy (even though deflation is more likely just a symptom).  If the Japanese economy could return to being the star pupil it was in the 1980s, deflation would no longer come with such a bad reputation.

Dysfunctional Politics – Time for a Reboot?

The failings of democracy have become more obvious and need more than just a tweak

Some things get better over time but politics seems to be getting worse.  Like a clunky computer that takes ages to get anything done, our political system has outdated hardware and buggy software which means that programs often don’t proceed as planned.  In computing terms, our governments’ failure to deal with the aftermath of the global financial crash is the equivalent of a number of flashing warnings and error messages.  With the faults more obvious than ever, perhaps it is time to look into rebooting the system.

Viruses in the system

Politics needs a remake as it has moved away from the ideals of democracy.  Our leaders have gradually become more and more separated from the world of the voters.  Direct contact has been replaced with communication through the media.  Policies espoused by the different parties take the form of grandstanding statements that fit into a newspaper headline.  The message contained in anything more complicated is often lost on voters with short attention spans. 

The result of this is that politics has become just another form of marketing vying for our attention.  We, in return, now also struggle to relate to political parties.  The number of those among us who are affiliated with a political party has been falling for decades.  Politicians instead work with pollsters and media firms to guess at what voters might want and how to package their policies. 

At the same time, politicians can only offer voters less bang for their buck.  In an increasingly globalized world, many choices that had previously been available to governments have been taken out of their hands.  No country can make decisions in isolation and this limits what politicians can offer voters.  Not that they will ever admit as much.  Yet this unspoken reality further separates voters from politicians who offer too much and can seldom deliver on their policies. 

Some rewiring needed

A good place to start in terms of rebooting politics would be to re-establish links with voters.  As with all forms of communication, this needs to be two-way street.  Politicians need to not only listen to the concerns of voters before forming policy, but more importantly to explain their actions.  Too often politicians sound as if they are talking in code with formulaic messages devoid of content or meaning.  More direct contact with normal people might help politicians to rediscover the benefits of speaking frankly and honestly.

The best politics these days seem to be happening at the city level.  Mayors are closer to the people they govern, even in the larger cities of London and New York, and they are better at solving problems with regard to things that matter in peoples’ lives such as transport, schools, and crime.  From personal experience, the mayor of my city is having a positive effect on the world around me even though I did not vote for him.  I cannot say the same for my representative in parliament (who only turns up once every four years at election time) - let alone our Prime Minister in the UK. 

Politicians serve many roles in their jobs.  At a time when politicians are offering less in terms of leadership, the least they could do instead would be to spend more time among those who elected them.  Something needs to be done to fix the systems that will only become more of a problem (see here for one idea).  A malfunctioning computer is a hassle but a broken-down political system is far more dangerous.