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.

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.

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.

Monetary Policy – who to save?

Central banks have a host of people needing help in the economy but it may be those not yet in trouble that get priority

There are still many people struggling in the economy but the central bank does not know which of the victims to save.  Like a lifeguard having to decide which of a handful of struggling swimmers to save, central banks have some difficult choices.  Unemployment is falling but many people are still stuck in low paying jobs.  Inflation is low but fears are running high that loose monetary policy will inevitably see prices start to rise.  There is also potential for financial markets to go haywire considering all of the loose money around.  Yet, it seems as if central banks will deal with issues that have not yet arisen despite all of the people still in the water.

Monetary policy to the rescue

The global financial crisis has expanded the role of central banks.  No longer is inflation their sole concern as other issues such as unemployment or financial stability take on increasing importance.  Fulfilling one primary objective, keeping prices from rising too much, is much easier than achieving competing goals.  This was not a problem in the past as a weak economy created an overriding emphasis on shoring up the economy.  The improving situation in the UK and the US will push the Federal Reserve and the Bank of England into sorting out their priorities. 

A falling unemployment rate in both countries means that more people are being put to work.  This suggests that the economy might be close to reaching full capacity and inflation might follow as a result.  However, at the same time, wages are not rising which is what would be expected if firms are employing more workers.  Improvements in productivity have also been poor due to low level of business investment.  This is a problem as firms need to be more productive to pay higher wages and bigger pay packets are needed to boost consumer spending.

The uncertainty would suggest caution but there is one more issue worrying central banks – financial instability.  Low interest rates and printing of more cash through quantitative easing has not made much of a mark on the actual economy but has been a considerable boost to financial markets.  The prices of stocks continue to push relentlessly upward in many countries despite the cloudy economic outlook.  The mass of cheap money has also seen a boom in property prices in some countries.  The continuation of existing loose monetary policies can only result in these problems getting larger.

Saving us from the phantom menace

Central banks have to keep all of this in mind when setting policy.  Interest rates in particular should be raised sooner if fears about inflation or financial instability are given precedence.  But a weak economy may not be able to cope with higher interest rates and the job market might suffer.  Changes to interest rates will affect all of us in different ways but there will be both good and bad. 

We are all consumers so few of us would want to see a jump in inflation as we could not buy as much.  Most of us have a little bit stashed away in the bank or in our pension funds so higher interest rates and less volatility in financial markets will be helpful.  But it is the overall health of the economy that will be felt most keenly.  Economists, with an eye on the bigger picture, are worried about the threat from inflation and financial instability with many pushing for the central banks to respond according.

Yet, the concern is that higher interest rates will be used to deal with problems that exist on paper but not in reality.  Central banks will forsake those already in trouble to save people that are not yet drowning.  Some of the worries of economist might on exist in their theories.  Inflation is different now than in the past and has not caused trouble for decades.  There are also other ways of dealing with issues in finance rather than the blunt instrument of interest rates.   Better to deal with what actually is than what might be.

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.  

Economists crash but don’t burn

Economists have been caught up in their own tale of hubris but have come out barely unscathed

Sometimes life plays out like fiction and such has been the case with economists.  The advocates of economics had been riding high at the beginning of the century as everything seemed to be running smoothly.  Economists look on a renewed sense of swagger stemming from the (mistaken) belief that fluctuations in the economy had been mastered.  But as often happens in a tale of hubris, the world comes crashing down just at the point where the hero starts to get carried away.  Such has been the tragedy for economists but it is the rest of us that have paid the price.    

Set for a fall

Like the rest of us, economists are liable to go too far when things go their way.  This is made worse by the way in which economics can be seen as more like a religion than a science as it is difficult to prove that economic ideas are wrong.  This means that faith can mean more than fact.  But when faith and fact align is when the problems really begin.  Such was the case for a couple of decades after economists increasingly took charge of central banks since the 1980s. 

Central banks took on the mission of combating the scourge of inflation and their success with this began to build up confidence in their capabilities.  Their theories led economists to believe that low and stable inflation was the key to economic wealth and well-being.  But this meant that problems were allowed to fester elsewhere in the economy due to this narrow focus on consumer prices.  The dot com bubble just over ten years ago should have been a wakeup call.  Prices for tech stock had gotten out of hand but central banks preferred to stand back with the plan of letting the boom and bust run its course and then mop up afterwards.  The mild recession that followed reaffirmed the notion that central banks could fix any problems.   

No so clever after all

Economists made the most of their time in the sun.  Thinking that they had all of the answers, economists started applying their ideas to other topics.  Economists also increasingly plugged their ideas to the public fuelled by the claim that economics could explain almost everything (see the photo above).  Thinking that they knew it all, economists weren’t afraid to let other know about it.  As is typical for a Greek tragedy, it is precisely at this point (where the hero thinks that the world has been conquered) that everything comes crashing down. 

The turning point in this tale of woe came with the global financial crisis.  Economists were not just unfortunate victims of unforeseen circumstance but were the architects of their own downfall.  Their conviction in their own ideas prompted economists at central banks to overlook growing distortions in the economy.  Interest rates were kept too low for too long which allowed for the levels of debt to get out of hand.  The dogma of the almighty central bank also led to complacency at banks that chased after profits without worrying about risks in the economy.

Skipping over the lesson of the tale

It does not take the wisdom of hindsight to see that catastrophe was just around the corner.  But it does help with realizing that the success that central banks achieved may have been more due to luck than clever management.  The surge in exports from China was always going to keep prices down whatever central banks did.  Inflation may not even be a major concern any more considering that prices did not jump despite the surge in lending heading into the global financial crisis or with central banks printing loads of cash as part of quantitative easing.

The saga proved to be something similar to the tale of Icarus.  Emboldened economists also flew too close to the sun but it was their ideas that went into eventually went into meltdown.  But the main difference is that, while economists have fallen from grace, it was others who got badly burnt.  This would be easier to take if economists were busying themselves coming up with better ideas to allow for less turbulence in the economy.  But economists are slow learners and policy is still guided by the same old ideas.  Change may happen and hopefully it does before we all crash and burn again.  

Inflation – More friend than foe

Inflation plays the role of the bad guy in economic theory but this may change now that we are faced with a greater threat to the economy

Inflation has been cast as a villain by economists but it could be a source of salvation.  Rising prices are often seen as one of the main evils in an economy – they push up the cost of living and eat into savings.  This may be the case in a normal economy but may not hold true considering that things are far from normal.  Instead, it might be that the high levels of debt weighing down the economy prove to be a greater menace.  In an ironic twist of fate, it is inflation that may prove to be our best weapon in our fight against high levels of debt.

I’ll be back (as the good guy)

Villains can turn into heroes with a twist in the storyline.  Just think of Arnold Schwarzenegger’s character in the second Terminator movie.  The havoc wrought by inflation in the past is almost on the same scale of a cyborg from the future but it has left economists with an innate fear of its return.  Inflation has been tamed and no longer poses the same danger to the economy having been the focus of monetary policy for decades.

It was the global financial crisis that led to a new peril.  Interest rates that were kept too low along with creativity in the banking sector set the scene for a surge in the amount of loans.  The problem of excessive debt was made worse by policies designed to bring the economy back to life.  Monetary policy has left interest rates at record lows while also resulting in a flood of liquidity in the financial markets through quantitative easing.  This combined with government policy to revive the housing market has seen a dramatic rise in the volume of mortgages.

As we have seen with government spending, a large burden of debt can result in cutbacks which damage an economy.  If consumers are also saddled with debt, the resulting limits on consumer spending have serious implications for economic growth.  Debt is not only bad for borrowers but the resulting sluggish economy dims the prospects for everyone else as well.

More inflation now to save the future

While not a new technology sent from the future, something as simple as inflation could be one way of alleviating the burden of debt on both consumers and the government.  Inflation helps by increasing the size of the economy relative to any debts.  If wages increased along with inflation, households would also have more money for repayments of their loans and the greater tax revenue will be a boost for the government. 

There are a range of measures (including one preferred by Your Neighbourhood Economist) which could be used to nudge inflation upwards in a controlled manner while also adding momentum to the economic recovery.  Many economists would recoil from the idea of higher inflation almost as fast as they would run from a cyborg.  But this has more to do with economists being stuck in the past than the destructive powers of inflation.

There are some negatives to factor in but the overall effect of increased inflation would be positive.  Inflation will eat into our spending power through higher prices for many of the things that we buy.  However, spending on everyday items takes up a smaller portion of the earnings of borrowers compared to paying off debt.  Even though a policy of allowing more inflation would be biased towards those with debt, everyone would benefit from a more vibrant economy.  As the Terminator movies have taught us, our current actions shape our future and a little more inflation would be a small price to pay to bid hasta la vista to our burden of debts.

Economics – more religion than science?

Economists claim to offer salvation but the tenets of economics need reforming before we can be saved

Economics is sometimes like a religion in that its adherents keep the faith irrespective of evidence to the contrary.  The global financial crisis has tested the conviction of many economists but few seem ready to renounce their previous beliefs.  This might seem strange with a discipline that aims to be more like a science but there are factors which mean economics relies more on faith than on facts.  Considering the positions of power held by economists, we can only hope that the moment of revelation is not too far off. 

In Markets We Trust

Economics claims to offer a path to the Promised Land.  The role of God is assumed by the concept of the invisible hand which prophesies that markets will bring about the most favourable outcomes in terms of output and prices.  One of the most sacred beliefs in economics is that we must defer to the invisible hand as much as possible.  Economists help this along, with central banks keeping down inflation while governments open up their economies to global markets.   This ushered in over two decades of unprecedented economic progress until financial turmoil struck like a plague in 2008. 

Yet, despite the economic Armageddon that followed, economists have remained stubbornly tied to the same creed.  The response to the financial crisis has relied on the traditional tonic of lower interest rates with newer orthodoxy calling for the use of quantitative easing when conventional measures did not work.  Central banks have stuck with these policies despite the resulting growing distortions in the financial markets which would be anathema for economists in normal times. 

Believing in false idols

One element which makes economics more like a religion and less like a science is that it is difficult to prove when someone is wrong.  Scientific theories can be tested by experiments carried out in laboratories or similar places where the conditions can be kept in check.  Economic hypotheses cannot be proven in such controlled environments.  The sheer volume of transactions by consumers and firms means that there may be any number of reasons behind a certain outcome.  The impossibility of isolating specific cause and effect relationships means that truths in economics can only be subjective. 

This means that economists can piously hold onto their previous ideas on how the economy works despite any evidence to the contrary.  Economists tend to become wedded to their ideas as they hone them over many years in long careers in academia.  Any newcomers to economic are also indoctrinated into the existing dogma with little scope for breaking out of the mould.  The current generation of economics students have risen up in arms against being taught theories that have little relevance to economic events.

One of the more old-fashioned ideas that economists cling to is a fear of inflation.  The full range of tools for monetary stimulus has not been available as central banks have been adamant that inflation should not be allowed to get out of control.  This stems from psychological scars in the minds of economists due to damage done by inflation in a bygone era (the 1970s).  Europe has suffered the most under this economic fanaticism and has had to deal with the added difficulties of the Eurozone crisis with few policy options available. 

It is not a coincidence that the global economy and economic theory are both stagnating at the same time – economic deliverance for us all may depend on a second coming of economics in a more practical form.

Animal Spirits – Caging our Wild Side

Money can bring out the worst in people so it might be time to rein in the finance sector which offers ways for us to get into trouble

Economists tend to assume that we are all boring (and the feeling is likely mutual).  According to economic theory, we are thought to act in a rational manner, assessing how best to spend our cash like calculators with legs.  Not only is this an overly simplistic view but it has resulted in economists ignoring how our emotional sides affect the economy.  The global financial crisis is an example of what can happen when animal instincts such as greed and fear take over.  Economists need to take a closer look at how our emotions can drive the economy and how we can be saved from ourselves. 

Reality is messy

Economics is the study of allocating scarce resources.  It focuses on how consumers make the most from what they have.  At the same time, competition between firms ensures that products are priced efficiently so that as much output as possible can be generated from limited input.  Economists would like to think that our sober side helps keep everything running as it should.  But when money (and everything that money brings with it) is involved, our primal nature can take over with ugly consequences.

The worst of our traits kick in over booms and busts.  When times are good, we hear stories of people making easy money and we want in too.  Like greedy kids in a candy store, we buy a second or get shares in the latest stock market fad in the belief that prices are sure to rise further.  Prices will climb as the lust for more wealth attracts more and more victims.  But with gains in asset prices typically outpacing the rest of the economy, this can only last for so long. 

When asset prices start heading downwards, fear is the overriding response.  Companies slash plans for investment and lay off staff in order to stay in business.  Consumers also retrench by cutting back on spending and asset prices slide downwards as higher prices no longer seem sensible.  Assets often end up being sold off at bargain prices as cash is needed to pay off debt taken on during better times.  Fear also reached chronic levels among banks who would not even lend to each other in the aftermath of the global financial crisis.

How we get ourselves in trouble

Change is a necessary part of an economy developing over time as certain sectors expand while others wither away.  But what Keynes labelled our “animal spirits” result in periodic bouts of instability that can hamper the expansion of any economy over time.  Rather than dealing with our insecurities, most economists choose to ignore them.  A common argument used by economists is that financial markets constantly adjust to new information and reflect the true value of any assets.  Yet, sharp drops in stocks or house prices cannot be reasonably explained away with this line of thought.

The devastating effects of our emotions getting the best of us are evident in the wake of the global financial crisis.  Instead of ignoring base instincts, economists should be thinking of ways to rein them in.  One of the key ways for greed and fear to influence the economy is through the finance sector.   Banks are geared to generate as much borrowing as possible but their loans more often than not go toward speculative investments in property or stocks.  Such lending creates unnecessary instability with the economy as a whole suffering as boom turns to bust.

It is no coincidence that the worst recession of a generation comes at a time when the finance sector has grown to dominate many developed economies.  Limiting the scope of banks, with more rules following decades of deregulation, would be a good place to start improving the system.  Measures such as taxes on financial transactions would also take out some of the volatility from markets for stocks and bonds by pushing investors to take a more long term view.  Such policies may lead to higher fees for loans and lower returns from investing but the costs of continuing with the status quo will only mount up.  Better to save us from ourselves than to let our passions run wild and cause even more havoc.

Economic Growth – Why good times never last

Central banks let the good times continue for too long and we are all paying a higher price as a result

Economic growth is like a party – the longer it continues, the more trouble is likely to ensue.  Investors, like partygoers, are likely to push the limits to make the most of the good times.  The longer this is allowed to continue, the greater the carnage that is likely to be left in the wake of the revelling.  Thus, it is not a coincidence that a period known as the “Great Moderation” has been followed by the “Great Recession”.  This is not the first cycle of boom and bust, but if it could have been predicted, why did central banks let things get so out of hand?

Theory behind boom and bust

The business cycle is a normal part of any economy.  The key driver of the cyclical nature of the economy is perceptions of how the economy will perform in the future.  Views about the economy change over time meaning that it is unlikely economic growth will continue at a steady rate.  This is because, when the economy is operating smoothly, confidence perks up.  Consumers will spend more and save less as worries about the future ease.  Greater spending by consumers will prompt companies to invest more due to expectations that their businesses will expand.

Optimism will also spill over into asset prices.  As prices for assets such as houses or stocks rise, the higher values attract more buying.  The hope of easy money lures in more and more buyers spurred on by the belief that prices will continue to rise.  Debt levels expand as consumers and businesses take out loans to take advantage of the economic growth.  Instead of this extra credit being put to productive use, it is easier to make money with speculative investments on property or stocks.  Thus, debt increases along with asset prices, each fuelling a rise in the other. 

This cycle inevitably gets out of hand as rising asset prices outpace the growth of the economy as a whole.  Prices reach unsustainable levels with the potential to trigger a financial crisis.  The cycle then goes into reverse with businesses slashing investment and consumers cutting back on spending.  The economy retrenches for a period as debt is repaid and asset prices fall back to more reasonable levels.  The harsher economic climate weeds out the weaker companies and business eventually picks up as the economy stabilizes again.  At this point, the party spirit returns and the business cycle begins afresh.

Economists make for bad students of history

The business cycle has been repeated throughout history but this is quickly forgotten when times are good.  Economists at central banks were patting themselves on the back for a decade or two of low inflation and steady economic growth which the previous head of the Federal Reserve Ben Bernanke labelled the Great Moderation.  Central banks thought they were keeping a lid on the economic boom time.  Interest rates were raised in an attempt to keep some semblance of order but hindsight has shown that this was insufficient.  

Everyone was getting too carried away with no one to rein in the revelry.  The indulgent ethos of the time was best captured by the head of Citibank who foolishly said in late 2007 that “as long as the music is playing, you've got to get up and dance”.  Central banks should have acted like police, stepping in to turn the music down, but were more like cheerleaders urging on the good times. Any Cassandras who prophesized the coming of the global financial crisis were marginalised as party poopers.

There was a line of thought that the financial markets knew best and central banks should just step in to clean up the mess when anything went wrong.  But letting the party go on for much longer than it should have done has only made the clean-up job that much bigger.  Even new tools are not proving much good in mopping up the aftermath.  If the partying had been cut short sooner, we would probably not be still suffering from the hangover.

Bitcoin – Geek’s Gold

Geeks use technology to make things better and may be close to coming up with a better form of money

The rise of Bitcoin has been as meteoric as its price.  Your Neighbourhood Economist had dismissed the phenomenon as a fad but decided to take more notice after even my recently retired father showed an interest.  The best way to describe Bitcoin to my father was like geek’s gold – a new form of money for techies who no longer trusted traditional forms of money (even though there are other reasons for holding bitcoins).  Bitcoin’s surge in popularity is a sign of a new era of abundant computing power coupled with feckless printing of new bundles of regular cash.

Bitcoin is a type of digital money where each bitcoin is a piece of complicated computer code.  The Bitcoin system operates so that bitcoins only increase at a fixed rate – new bitcoins are given to individuals who maintain a gigantic ledger which keeps tabs on the entire history of all bitcoin transactions.  This setup allows for a public record of transactions to ensure that nothing goes awry while allowing access to bitcoins without going through a central dealer.  This is all made possible through the freedom of the Internet and masses of computing power.

Boom and bust of a gold rush

The key to forming any new currency is that people believe in it as something of value.  A bitcoin was worth less than one dollar in early 2011 before a steady rise to just over 10 dollars by the end of 2012.  It was in 2013 that the price of bitcoins exploded, reaching a record high of 1,242 dollars in late 2013.

One reason behind the dramatic rise of Bitcoin has been that it is relatively difficult to track down the individuals who use it.  Users are known through a Bitcoin address which allows for a high level of anonymity compared to a bank account.  This aspect of Bitcoin makes it popular with those who obtain cash through dubious sources and wish to remain undetected.  Once Bitcoin had shown that it could at least hold its value (with a steady, if not rising, price), it attracted the attention of people with money to hide.

The relatively long period (in terms of technology fads) during which the price of Bitcoin rose sparked a surge in interest from speculative investors.  The quest for a quick buck lifted the price for bitcoins beyond what was sustainable with bitcoins trading below 500 dollars in early April.  Bitcoins are likely to continue to have a volatile price but the price variability will probably decrease over time as bitcoins are used in more transactions.

Money doesn't grow on trees

The key driver for interest in Bitcoin is as an alternative to the normal notes and coins type of money.  The relative ease and lower costs of online transactions make it popular with people that buy and sell via the Internet.  However, Bitcoin has been thought of as something more.  At a time when central banks are printing a deluge of new cash, Bitcoin is seen as a form of money that is not overseen by a profligate governing body. 

The number of bitcoins can only increase by a fixed amount over time whereas it is possible for a virtually endless amount of notes and coins to be produced.  For techies that are always dreaming up new and better products, the case for a new type of money must have seemed a no-brainer.  Limited and always sought after, gold has typically been the main option for investors worried about excessive expansion of the money supply.  In this way, Bitcoin could be considered gold for geeks.

While gold is an out-of-date (but still valuable) form of money, Bitcoin is a potential model of how money might be in the future.  Despite only being accepted in a few offline locations, over-the-till payments with bitcoin are now possible using mobile phones.  So digital currencies could become commonplace although Bitcoin itself may not last the test of time.  A limit to the eventual number of bitcoins could prevent its spread into the mainstream.  Yet, alternatives may be created to build on the concept. 

It just remains to be seen whether digital currencies will be the latest tech fad to go from geek to global. 

Interest rates - how not to manage the money supply

How central banks thought they had slain the main threat to the economy but the real menace was lurking elsewhere

Economics is a narrative on how the economy is supposed to work, but the path to economic success and riches is often fraught with danger.  The cautionary tale of interest rates and money supply serves as one such example.  The hero of the story was meant to be central banks whose role was to control monetary policy which involves looking after the amount of money in the economy.  Interest rates were deemed the best weapon to regulate the money supply and a couple of decades of success ingrained a belief in this view of the world.  However, the global financial crisis put an end to hopes for a happy ending and economists are still struggling to come up with a new script.

What was supposed to happen

The original scenario relied on central banks being able to influence the money supply by setting interest rates to the appropriate level.  Central banks would not target money supply directly but focus on inflation instead.  Economic theory states that inflation is the result of an expanding amount of money in the economy.  More money equals higher prices.  So, if prices are rising too fast, this is due to an excess of money in the economy.  Higher interest rates act as a damper on inflation because the amount of money moving around the economy drops off as the demand for loans falls and consumers leave more cash in the bank.

The focus on inflation also stemmed from its leading role in telling how well the economy was doing.   Inflation has gotten out of hand and wreaked havoc in the past so economists are determined that this storyline was not to be repeated.  Inflation is also easy to keep tabs on compared to money supply which is tough to define, let alone measure (the money supply could include cash as well as money in banks (current or savings accounts) and other funds).

All good in theory.  And it even worked in practice for a couple of decades from the late 1980s.  Economists thought that their ideas had enabled them to conquer inflation and smooth out the boom and bust cycles.  But all of the good work of economic policy was undone due to an inherent flaw in the theory.  Growth in money supply not only affects consumer prices, which central banks watched over-closely, but also in asset prices, which were not seen as a concern.

Need for a new narrative

It is no surprise that the villain in this story is the banking sector.  Banks were left in charge of setting the money supply which rises and falls depending on the amount of lending.  The volume of loans (along with the money supply) exploded during the favourable economic conditions over the years leading up to the global financial crisis.  Banks were able to take advantage of the growing demand for credit due to innovations in finance that meant that banks could pass loans onto others and not have to worry about loan repayments. 

A large portion of the loans was used to buy existing assets such as houses or shares.  The resulting gains in asset prices, which surged ahead of growth in the underlying economy, sowed the seeds for the crisis to come.  Meanwhile, a dramatic increase in global trade meant that inflation was no longer determined in the domestic economy but was highly influenced by global markets.  Cheap imports from China reduced the prices of products like clothes and electronics.  Imports were also on the rise and the prices of any internationally traded goods no longer depended on the money supply in any one economy.

Subdued inflation meant that the results of the rampant increase in money supply did not jump out at central banks.  Their focus on consumer inflation led central banks to disregard the asset price bubble growing in their midst.  Instead, it was argued that financial markets would always set the appropriate prices and that central banks should not get involved.  The irony is that any extra cash tends to influence asset prices even more than consumer prices (as shown by the effects of quantitative easing) but this effect is near impossible to separate from other factors (hence the reliance on inflation).

It was revealed that central banks had been setting interest rates too low to keep the economy from getting into trouble.  The whole messy chapter could have been avoided if the money supply had been kept under control.  A simple solution would be for the economy to be left to its own devices with a relatively stable money supply.  Greater demand for loans would push up interest rates, stopping debt levels from becoming excessive while also benefiting savers. 

Despite the obvious solution, economists are loath to give up on the fairy tale they always believed would come true.  It may take time for a new economic story to be written but the changes should mean a brighter turn in the future of the economy.  With this, at least the sobering ending to the latest chapter of the economy should come with a silver lining. 

GDP growing out-of-date

GDP is becoming increasingly outdated as we do more and more online

It is hard for most of us to keep up with the blistering pace of changes in modern technology.  This is also true for economists and the discipline of economics.  Nowhere is this more glaringly obvious than when trying to assess how well the economy is doing.  Measures such as GDP (gross domestic product) hark from a time when our economy was mostly made up of physical goods which did not improve much over time (such as fridges or lawn mowers).  Advances in computing were already making life hard for economists, but greater use of online services may be the last straw.  How can we measure the economic output if we can get stuff online for free?

More is better?

GDP is an aggregate figure of the market value of all goods and services produced in an economy.  This way of measuring output focuses only on transactions where money changes hands and is based on the premise that more is better.  Things have become more complicated with rapid improvements in technology.  The problems started as exponential leaps in processing power made computers both faster and cheaper.  Progress is now so rapid that computers from just a few years ago are no longer available, making price comparisons over time near impossible (also causing issues with measuring inflation).

The impact is spreading as people find better ways of putting cheap computing to good use.  Replicating any content in digital form is virtually without cost.  Thus, the problems that initially confronted the music industry were soon felt by TV and movie studios as well as newspapers.  The effects are becoming more pervasive now that almost all of us have small computers in our pockets in the form of mobile phones.  Even mobile network providers, who would have been expected to benefit from greater use of mobile phones, are under pressure from cheaper alternative methods of communicating such as Skype or WhatsApp.

What really matters

Things we may have needed to pay for in the past are now considerably cheaper if not free, whether it be making international phone calls, reading the news, or posting job ads.  Computers are also able to do most of the grunt work of online services, making it easier to launch new products.  For instance, WhatsApp, which was recently purchased for US$19 billion, only has around 50 employees.  As a result, computers and the Internet can be used to provide more for less. 

It follows that a stationary GDP does not necessarily indicate a lack of progress.  This creates a dilemma for economists.  Economic data such as GDP is usually trimmed back to take account of inflation as higher prices by themselves do not mean that the economy is any larger.  Yet, better computers and cheap services provided online suggest that normal GDP figures need to be increased to account for the wealth of benefits that are available without having to pay more money.

All of this tweaking of GDP is making the actual data less and less significant.  The weak recovery in places such as the UK may be due to a shift towards doing things online as people try to tighten their belts.  It may be the case that similar or even greater amounts of goods and services are being consumed but online and at a lower cost.  How can we account for this?

Rather than trying to add up everything in the economy, we could look at median earnings and how people spend their cash (including online freebies).  This is likely to be a better gauge at a time when wages are stagnating for most people.  Finding out whether the average person is better off has more real world relevance than focusing solely on levels of production.

Quantitative Easing – Get to the chopper!

What do you do when the economy needs a fiscal stimulus but there is no money for it?

Central banks have an ever expanding range in their toolkit to choose from to fix their individual economies but none of them seem to have worked so far.  This may be because they lack the right tool for the job.  In this case, the right tool is likely to be a large hammer in the form of a substantial fiscal stimulus but this is the preserve of governments who, at this point in time, are saddled with too much debt.  Yet, there is a way in which central banks could use monetary policy to act like a fiscal stimulus and generate the boost to demand that the global economy desperately needs.

Even new monetary policies are falling short

Economists thought we had it figured out.  Simply control the money supply by setting interest rates and it will be possible to ride out any booms and busts.  However, the weak recovery following the global financial crisis has shattered this belief.  Even manipulating the money supply using newly contrived measures such as quantitative easing has been less fruitful than hoped as well as creating unexpected problems. 

Quantitative easing has relied on a convoluted process where central banks create cash in order to buy bonds which frees up money for use elsewhere.  The problem has been that there is little demand for money in the actual economy as businesses are not keen to borrow as a result of the weak underlying economy.  Instead, what is needed is an instrument for inserting money straight into the economy.  This is because, rather than just cheap credit, companies need greater revenues from stronger sales in order to encourage investment and jump-start the economy again.

A fiscal stimulus fits the bill and has been tried already but only in small doses.  The key spanner in the works in this case has been high levels of government debt.  Before the crisis, politicians everywhere were almost as amped up as bankers and government finances were managed as if the boom time would continue forever.  The results have left us short of workable options to bolster the sluggish global economy.

Using Monetary Policy like a Fiscal Stimulus 

It may sound like a strange solution, but if monetary policy is not working and higher government spending is not possible, central banks could use their money-printing capacities to engineer a fiscal stimulus.  Rather than using freshly printed cash to buy bonds, central banks could just give it away.  Or, to use an analogy that economists like to use, drop money from a helicopter. 

Central banks operate the valves which control the supply of money, which is already being expanded on a temporary basis using quantitative easing.  The helicopter idea is a much more direct approach than shovelling money at the bond market.  Recipients of the cash would be free to spend it as they please, thus injecting money into the actual economy and creating a bonus for firms.  

The cash would not actually be in in the form of notes or coins but could be paid as a cheque or straight into the bank accounts of tax payers.  It strikes at the core of the main problem in the economy, a shortage of demand, allowing for more rapid results and less distortion compared to having surplus cash in the financial system.

The main drawback of this seemingly too-good-to-be-true policy is worries about inflation.  This is also the biggest obstacle as inflation is the primary concern of the central banks that would need to print the cash to be distributed.  It is the belief of many economists that it is the discipline of central banks which has kept inflation down over the past few decades.  Any sign that central banks might allow for more inflation is thought to push prices into a perilous upward spiral.  Yet, inflation is no longer the threat it once was and would not become an issue until the economic recovery was well under way.

Just like any handyman, economists have their favourite tools and are sometimes loath to admit that there might be a better option.  Unfortunately, it may just be a step too far for central banks to overcome their fear of inflation and leave the safety of familiar ground despite the extra firepower on offer.

Nasty Breakup from Forward Guidance

Central banks have been led astray by the policy of forward guidance and it is time to move on

There has been a big breakup in the world of economics just before Valentine’s Day.  Central banks in the US and the UK had been wed to the concept of forward guidance.  This policy involves keeping interest rates low will have greater potency when combined with an outline of how long the policy will remain in place.  With the impact of low interest rates on the wane, central banks in the US and the UK were courted by the idea of forward guidance as a way to eke more out of current policies.  Yet both the Federal Reserve and Bank of England have been caught with their pants down due to the failure of forward guidance to deliver an economic boost.  The falling out has been made worse by debilitating issues with policy execution.

Seemed like a good idea at the time

The Federal Reserve slashed interest rates to 0.25% in December 2008 while the Bank of England pruned UK interest rates back to 0.5%.  In the face of the harshest recession in a generation, this normally dependable form of monetary stimulus failed to have much of an effect.  Continued weak economic growth spurred on a search for something extra and resulted in central banks delving into more unconventional measures.  Quantitative easing (buying bonds with newly printed money) is one example of such measures, forward guidance being another.

It was thought that forward guidance would act as a means to encourage economic growth as low interest rates were not having much of an effect on borrowing by themselves.  The hope was that a pledge that rates would be kept low for at least a few years would be the catalyst that would kick-start lending.  However, the assumption that there was a pent up demand for loans was wrong (as Your Neighbourhood Economist thought it might be). 

Bad idea made worse by shoddy execution

If the thinking behind forward guidance was not the best, the implementation was worse.  Both the Federal Reserve and the Bank of England based the forward guidance on the unemployment rate.  Unemployment was seen as a reliable yardstick of economic performance so the two central banks used it as a marker for changes in policy.  This later became a stumbling block when the number of people out of work declined faster than expected catching out many others along with the central banks.

Having to readjust the policy of forward guidance has been a PR disaster for central banks for whom reputation is key to influencing the financial markets and achieving their goals.  The Bank of England recently explicitly dropped the link between interest rates and unemployment and the Federal Reserve is sure to follow suit.  The necessity for central banks to assuage concerns that interest rates may rise defeats the whole purpose of forward guidance in the first place.

The Bank of England has instead stated that it will rely on a wider range of economic data.  Despite protestations by Bank of England governor Mark Carney that forward guidance is working, the new policy is too vague to act as any guide to the future of interest rates.  The reworking of forward guidance has failed to find any love from the markets.  Expectations that the Bank of England would not be faithful and would hike interest rates sooner rather than later resulted in the value of the UK currency jumping following the statements by Carney.  The saga over forward guidance has left central banks wondering what went wrong but it is time to get out and start afresh. 

UK economy is growing but not yet in recovery

Some good news at last for the UK economy but don’t expect the tough times to be over

The outlook for the UK economy is finally beginning to brighten following a harsh recession and weak recovery.  The Office for Budget Responsibility raised its forecasts for the UK economy with growth of 1.4% expected in 2013 up from a previous estimate of 0.6% in March while 2014 is expected to see growth of 2.4% instead of a prior March forecast of 1.8%.  While the government was keen to publicise this as good news, much of the improvement is due to factors that are likely to be temporary.  Government measures along with monetary policy are behind the perkier economy but the effects will not last and a proper recovery may still be some time away.

The unexpected boost to the economy has come through higher spending by households.  Many UK consumers are feeling better off with UK shares near record highs and the UK property market going through a period of resurgence.  Stock markets in many developed countries have been providing stellar returns as extra cash being printed by central banks flows into shares.  House prices have benefited through a range of government schemes aimed at increasing the availability of mortgages.  This has translated into more consumer spending through a mechanism known as the wealth effect which is the notion that people will spend more if the financial assets which they own are worth more.  The UK government has tried to tap into this effect on spending using schemes such as Help to Buy to lift house prices as a means to boost the economy due to few other options (such as higher government spending) being available. 

The wealth effect relies on growing levels of financial wealth which can be lifted by different measures but which ultimately rely on the health of the economy.  As such, temporary boosts are possible but asset prices (and wealth) can only be pushed up so far and may involve potential negative effects for the economy.  Higher prices for financial assets now come at the cost of price gains in the future  (such as a weaker property market in the future) with a reduced wealth effect.  This may be a necessary price to pay with few other avenues for generating growth but the tactic of pushing up property prices has also been used by the UK government to provide cover for its program of austerity measures. 

With public debt reaching around 75% of GDP in 2012, the government has given priority to cutting back its spending but this is controversial coming at a time when the overall economy is weak.  The government claims that the cuts are necessary as investors would not buy UK government bonds (resulting in the government having to pay higher interest rates) were government debt to get even more out of hand.  Concerns about debt levels have eased considerably since reaching near frantic proportions during the Eurozone crisis, but the government remains unrepentantly committed to slashing spending levels.  Cuts to government spending are going to continue for years to come with the stated goal of reaching a budget surplus by 2018 despite calls for a change in policy.

Other areas of the UK economy also have little to offer in terms of growth.  Exports from the UK have failed to pick up despite a weaker pound and the value of the currency has begun to rise again which does not bode well for UK exporters.  Investment is also weak with lending to businesses in decline.  It is proving tough to come up with an engine to drive growth in the UK – a recovery is long overdue but we may still have to wait.