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.

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.

Emerging Markets – Caught in the Crossfire

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

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

Danger zone

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

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

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

Collateral damage

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

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

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

Fiscal Policy – Not fighting back

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

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

Hit and miss

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

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

Time for a new battle plan

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

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

A winning strategy

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

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

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

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.

Question – Interest rates

In response to an inquiry from a reader, Your Neighbourhood Economist explains how low interest rates should have but didn’t affect the economy (with a surprising culprit)

Your Neighbourhood Economist was pleasantly surprised to have a proverbial knock at the door (a photo of which was posted on the blog recently along with an email address for questions) with the following inquiry on interest rates…

I read your blog entry on BOE interest rate hike and needed an opinion. I'm not a finance student but am trying to understanding why something so unusual is happening with the BOE interest rate. You have explained why there is a need to hold the rate low at the moment, seeing there isn't enough inflation yet (as posted in UK Interest Rates – putting off the inevitable). But could you explain to me in layman's terms how this has affected our economy and what other solutions could have been used?

Interest rates are a hot topic at the moment with changes afoot at the Bank of England.  Sometime over the next six to twelve months, the UK central bank is likely to raise its benchmark interest rate off its record low of 0.5% where it has been for more than 5 years.  Low interest rates are the most common way that central banks will try to raise economic growth.  The theory behind this is that cheaper loans will push businesses and households into borrowing money and this extra spending will boost the economy. 

Good in theory but not in practice

In practice, things have not worked out so well.  Businesses have held off taking out loans due to uncertainty over the future direction of the economy.  Companies need to be assured of a decent return from any investment which will typically only make money over the span of several years.  Worries about the future earning potential of any new operations have outweighed the lower costs of borrowing money to invest.   As a result, business lending in the UK has fallen for seven consecutive years with companies preferring to hoard cash instead. 

The main benefactor of low interest rates has been the property market.  House prices in London held up despite the global financial crisis and added to the myth that property values never fall.  So once the worst of the crisis was over, low mortgage rates prompted many to scramble to buy property.  The buoyant housing market has boosted the economy a bit by making people who own property feel richer and spend more.  But more mortgages only pushes up house prices rather than making the economy more productive as investment by businesses would have done.

So the actual effect from low interest rates has been less than hoped.  This resulted in central banks also using quantitative easing – creating new money to buy bonds and other financial assets.  The aim of quantitative easing is increase the amount of money in the economy and help out the banking sector.   Quantitative easing too has been somewhat of a disappointment with few places for the extra cash to be put to good use.  The banking sector typically acts as one of the main means to move cash around the economy but banks have had to focus on their own survival.  The surplus of cash has created its own problems such as distortions in the financial markets which may cause trouble in the future.

Other solutions…?

With businesses not spending and mortgages not adding much to the economy, the obvious solution would be for government to make up the shortfall.  A fiscal stimulus is the typical response to a slowdown in the economy with the extra spending by government making up for weak demand from consumers and businesses.  Yet, government finances in the UK and elsewhere were already stretched before the crisis and deteriorated further with higher welfare payments and falling tax revenues following the crisis.

The Eurozone crisis from 2010 resulted in investors shunning any countries with high levels of government debt.  This prompted the UK government to launch its austerity program with the hope convincing investors that it would sort out its finances.  The plan worked in that the interest rates on UK government debt remained low (also with help from quantitative easing) unlike some countries in Europe such as Ireland and Spain.  However, cuts to government spending hurt the economy and prolong the slump in the economy while also ironically making even more cutbacks necessary.

Still struggling

Getting ourselves out of trouble following the global financial crisis was always going to be tough going.  Recessions stemming from banking crises are typically longer than normal recessions as it takes time to work down the excessive levels of debt and fix the banks.  Less expected was how the economic recovery has been further hampered by ineffective and lacklustre policies. 

Fiscal policy has been working in reverse and the UK government should do more to boost the economy considering that investors are no longer so worried about government debt.  The Bank of England could have done more with monetary policy considering that it can print as much money as it likes but it held back due to misplaced concerns about inflation.  Your Neighbourhood Economist would have liked to have seen more spending by the government and quantitative easing going straight into the economy.

Perhaps the biggest factor holding back the recovery is that economists are slow learners.  Policies such as quantitative easing are new and have helped but more could have been done if economists had not been so caught up with their own ideas.  It is of some consolidation that lessons from the Great Depression (such as the bank bailouts) have been applied to ensure that a similar type of crises has resulted in less fallout.  We can only hope that this crisis is bad enough to ensure better policy in the future.  

(Please add any further questions on this topic using the comments section at the bottom of the page or email any inquiries on different issues related to the economy to Your.Neighbourhood.Economist@gmail.com)

Monetary Policy – Losing its Power?

With the finance sector already awash with cash, we can no longer rely on central banks to help us out of trouble

After having worked like a charm for a long time, monetary policy now seems to be losing its mojo.  The source of power for central banks mainly comes through their tricks of printing money and controlling interest rates.  With many governments mired in debt, it has only been the wizardry of central banks that has stood between us and a greater tragedy.  It is of great concern that the capabilities of the once almighty central banks to manipulate the economy are under threat from the large amounts of liquidity in the financial system.  The spells with which central banks hold sway over the economy may amount to little more than illusion when there is already lots of cash around.

Where has the magic gone?

The power to create money seems nothing short of sorcery; however, the rise of digital cash means that it is in fact easier than ever.  Central banks have even lost their monopoly over generating electronic cash with normal banks able to pull off the same trick by making loans.  It was thought that control of interest rates would be sufficient to steer the economy through any ups and downs.  Yet central banks left interest rates too low in line with their narrow focus on keeping inflation in check and banks were free to churn out loans at an unprecedented rate.  The prices of assets such as property have surged upward as a result but only until the inevitable crash in prices.

Central banks stepped in with record low interest rates and new policy tricks such as quantitative easing.  Yet these measures lack potency considering that cash was already cheap and in abundance.  Both banks and businesses hoarded cash – the former worried about their own survival while the latter had few investment options available due to the weak economy.  To add to this, many emerging markets such as China had been building up massive reserves since well before the global financial crisis. 

With the international financial system already flooded with cash, it has been no surprise that monetary policy has not worked as well as expected.  It has been like trying to use sweets to modify the behaviour of a child that lives in a candy shop.  Instead of being much help, the extra funds from central banks have seen the financial markets deformed and distorted as if suffering from some form of voodoo.  Some emerging markets have also suffered from this black magic with their banking sectors unable to handle the volume of cash on offer.

Nothing up their sleeves

Central banks have been looking to develop new powers to influence different sectors of banking.  The Bank of England has been given greater scope to deal with a runaway property market.  Yet, the central bank seems ill at ease with its new policy options, such as restrictions on mortgages, and prefers to rely on its old act of manipulating interest rates.  If central banks no longer have the power to bewitch the economy, it will be tougher to clean up after a crisis like the one we have just been through.

This shifts the goal of policy to stopping problems forming rather than merely attempting to limit the ensuing trouble.  Restricting the dark arts conjured up by banks will be essential to preventing future disasters.  The fairy-tale time when we could believe in the magic of central banks may have passed – we will need to rein in the wicked elements of the economy now that there is nothing to save us from potential misfortune.

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.

Drowning in Debt – Need Help

We are being pushed into borrowing our way back to economic growth but staying afloat also involves selling off our future

The last thing a drowning man needs is more water but this is how policy makers have chosen to react to the global financial crisis.  The global financial crisis came about due to consumers being allowed to take on too much debt in the past.  Yet, the policy response has been to push for greater borrowing by lowering interest rates and feeding money into the banking system.  Higher debt now can only mean greater repayments in the future.  This would be acceptable if a swift return to economic growth was on the way but this seems too optimistic.  Instead, while the economy is getting a temporary boost now, growing levels of debt are being forecast to depress the economy for years to come.

Cheap loans anyone?

The debt and water analogy works on many levels.  In the same way that water is essential for life to flourish, debt is needed for an economy to grow.  Yet, like water, too much debt can be as bad as not enough.  The appropriate level of debt depends on the pace of economic expansion.  Rapid economic growth will create greater demand for loans as business opportunities arise and asset prices rise.  Like a garden requires watering when the weather is hot, a booming economy can absorb more debt as the money generated through the loans makes it easier to fund debt repayments. 

The opposite is also true.  It is desirable to have fewer loans as an economy cools since paying off debt is tougher.  It seems a strange time to convince people to rack up more debt but that is what central banks are pushing for.  This is because the tools of monetary policy work by reducing the cost of money (through lower interest rates or printing more cash) when the economy is floundering.  Such policies make sense when assuming a rapid recovery in economic growth but even economists are pessimistic about the prospects for the global economy.

The other bail out option is for the government to ramp up spending through increased borrowing.  This is the typical response to dampened economic growth but concerns about high levels of government debt have limited the capacity for such a fiscal stimulus.  This has resulted in monetary policy having to take on the bulk of the heavy lifting in getting the economy moving again.  Businesses have typically not made use of the cheap credit on offer through the low interest rates (except to buy back their own shares).  It is the increased debt taken on by households that has been the main driver of economic recovery but this is neither balanced nor sustainable. 

Debt – paying the price

It is the role of policy makers to create an environment for encouraging economic growth.  Tough choices are necessary when few options are available but relying on households to pile up more debt seems irresponsible and short-sighted.  The ratio of earnings to house prices is on the rise at a time when wages are standing still.  This means that consumers will be saddled with debt repayments for longer (especially if house prices stagnate as is probable) and this will depress consumer spending in the future.  It seems a poor trade-off even at a time when the economy is underwater. 

This policy seems even dafter when considering that consumer debt is mostly unproductive.  Buying a house off someone else does not add anything to the economy (while spending on renovations does help a bit).  On the other hand, if the government were to borrow and spend more on education or infrastructure, this would increase the output capacity of the economy.  Yet, this sensible alternative is being dismissed even though investors are no longer shunning any government with excessive debt and interest rates on government debt are near record lows for many countries. 

It will ultimately be people like you and me who pay the price.  Our spending power is being put at risk at a time when the government’s own finances are drained and businesses are not putting their balance sheets in jeopardy.  It is likely to remain tough for many people to keep their heads above water and an economy saturated with debt may not provide much help.

Banking – Back to Basics

Time for banks to return to their bread-and-butter operations after having almost poisoned the global economy

Banking is like food – best kept simple with as little processing as possible.  This is because, in their role as the intermediaries controlling flows of money in an economy, banks provide the nutrients which help the economy grow.  What was supposed to be a straightforward process became convoluted as banks cooked up ways to move loans onto others.  The resulting concoctions were devoured by investors around the globe, resulting in serious indigestion once the toxic nature of the ingredients was discovered.  Given that the packaging of dodgy debt was one reason for the scale and severity of the global financial crisis, the common sense move would be to change back to a plain vanilla variety of banking.

A recipe for trouble

We rely on food getting from the farms where it is grown to our supermarket shelves every day.  Too much or too little food would cause problems as would food ending up in the wrong places.  We also rely on banks to look after our money in the same way.  Savers leave their surplus cash in banks who make it available for others to borrow.  This simple analogy is how we tend to perceive the role of banks but, as with many things, the reality is more complicated.

Banks have access to a growing range of funds allowing them to lend as much as demand allows.  This gives them a substantial amount of control over how much money there is in an economy.  Central banks look to control lending using interest rates but the global financial crisis has shown that this is insufficient.  Interest rates tend to be too low when economic growth is booming, giving banks scope to lend more than is optimal.

This problem has been exacerbated with banks being able to sell on loans to investors in the form of bonds.  By passing on the risk associated with lending to others, banks circumvented the normal limits on lending and levels of debt exploded as a consequence.  Debt from banks was sold on as bonds such as CDO and MBS with this alphabet soup of financial instruments eventually proving sickening to the financial system.  Banks had our cake and ate it and the result has been years with the economy being starved of credit.

Creating these nauseating bonds was like using MSG to flavour food – an easy way to get an immediate boost but not good in the long term.  Most of us would steer clear of extra nasty additives in our food for fear of the future consequences.  Bankers, on the other hand, gobbled up any magic pills which boosted their profits in the knowledge that it would not be the banks themselves that would pay the price.  This is a problem which is endemic to banks operating without sufficient regulation.

Smaller is better

Considering the propensity for banks to poison the entire economy, their operations should be pared back to a more traditional and wholesome role.  One means to do this would be to limit the activities of banks and break up larger financial institutions that have parts which operate like conventional banks.  Banks should be limited to a scope within which they cannot get into trouble and need to rely on the government for support.  More speculative aspects of their business should be left to others who should be prevented from accessing our deposits.  Other forms of financing are flourishing and this is already replacing part of what banks do.

The basic idea behind this is already out there and is known as the Volker rule.  It has been endorsed in principle by many in politics including President Obama.  Yet, the implementation of this idea has stalled due to opposition from an unsurprising source - the banking sector.  This highlights another benefit of having smaller banks – a reduction in the dominance of the finance sector.  The wealth generated by banks has given them the political clout to push for more freedom to chase profits.  Banks have built themselves up to be the champagne in the economy (providing skilled jobs and lots of tax revenues).  Yet, since it is all too easy for the bubbles to go flat, a return to a bread-and-butter setup would be preferable.

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.

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.

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.

Global liquidity: have we created a monster?

Money in the financial system overwhelms all it encounters making it a growing threat that needs to be dealt with

We are being overrun – by money.  There may be worse things to have battering down one's door but a surplus of cash in the financial system can have scary consequences.  The financial system was set up to facilitate the movement of cash to parts of the economy where it is needed but has instead become a behemoth exerting a dominating influence over the creation of goods and services in the actual economy.

Quantitative easing feeds the beast by flooding the banking system with even more cash in the hope that a few crumbs will drop down into the actual economy.  However, not only is the financing no longer having the desired effect, but the extra money is becoming increasingly erratic and hard to control.  Policies are needed to yank banking back into line.

Money getting out of hand

Spare cash in the form of savings is the basis for economic growth.  Surplus from current production is invested to enable higher output later on.  Banks were first created to shift extra money elsewhere so that production could be expanded.  Yet, banks have gone beyond the basic operation of allocating money and moved into the business of making money from money.  This is a waste of resources considering our best and brightest could be put to better use.  But more than that, the colossal size of the financial sector is in itself a problem – it is like a giant trampling everything in its path.

Money is free to move around the globe on a whim.  Too much free-flowing cash turns into a menace in terms of stability.  The danger always seems close at hand – banks and others creating more cash out of thin air by increasing leverage when times are good while central banks unleash a mass of new money to shore up the economy when things turn bad.  Yet, money is not always forthcoming - the impact of the global financial crisis was exacerbated by a flood of cash fading to a trickle.

The money is out there lurking and waiting.  The skulking leviathan surfaces only in a few places but creates distortions wherever it emerges.  A clear example is the property prices in London and other places in the UK which are booming at a time when the underlying economy is stuck in a faltering recovery.  Emerging markets have also fallen victim to the ebb and flow of global finances due to their less developed financial markets and limited domestic savings.

Making money work for us

If massive money movements are causing chaos, it is only sensible to conclude that greater controls should be put in place to rein in the rampaging.  The current direction of policy on finance has turned to re-regulation after decades of deregulation gave banks the freedoms which allowed the phantom cash to wreak havoc.  The finance sector has railed against any restrictions, but the monster now rearing its ugly head cannot be left uncaged.

It is argued that free movement of money is essential despite the risks, as credit is cheaper as a result.  But even the cheap cash from central banks has not been enough to convince banks to lend which suggests that easy money does not bring the benefits previously thought.  This means that we should not fear the utilization of policies as controls over the movement of money, the separation of retail banks (which take in savings and give out loans) from investment banks (which deal in financial wizardry), or the introduction of higher standards for banks in each individual country.  Money in itself is not evil – it just needs to be kept in its proper place.

British banks gone AWOL

The banking sector is in dereliction of its traditional duties in the economy and quick fixes will not be enough to make amends

After nearly collapsing and bringing the economy down with them, UK banks are further adding to their bad name by holding back the economic recovery.  Banks are either too weak or too caught up in making easy money to fulfil their traditional role in the economy.  The situation is made worse because monetary policy works through the financial sector and banks are crucial links through which money is fed into the actual economy.  Instead, bank lending to UK businesses has been falling, thereby dampening the impact of lower interest rates and pushing the Bank of England to pump more and more money into the economy (which is not healthy).  Why have banks seemingly abandoned their posts?

Banks have traditionally acted as intermediaries between those with money to spare and those in need of financing.  There is a surplus of funds at the moment due to quantitative easing by the central banks which is aimed at getting more households and companies to borrow.  But this money is not getting to businesses - partly because the weak economy has hit demand for loans but also because of the reluctance of banks to lend.  A large amount of debt, which could go bad due to the weak economy, is making banks cautious while new banking regulations are restricting banks’ capacity to take on fresh loans.  Small businesses have been hit hardest as there are few other options for getting cash.  As a result, there has been a large knock-on effect on the economy as small businesses are a significant source of jobs and innovation.

Other parts of the finance sector have failed to pick up the slack.  Investment banks (which are different to retail banks who carry out the functions above) have long had only weak links with the actual economy and continue to generate profits through their ability to make money from money while also attracting some of the best and brightest who could offer more in other sectors (see previous blog).  Firms such as Wonga, which offer lending services now shunned by retail banks, are being hounded for their trouble.  The only bright spot has been mortgage lending but that has been targeted by government initiatives along with monetary policy to the extent that the Bank of England has had to apply the brakes due to concerns about a housing bubble.

The failure of banking to facilitate the circulation of funds around the economy has resulted in surplus cash flowing into financial assets such as property or the stock market rather than being put to productive use in the actual economy.  The Bank of England has tried a scheme of providing banks with funds for lending but more needs to be done to clean up banks and change their behaviour.  One of the reasons why Japan took so long to recover from a financial crisis more than two decades ago was that it allowed problems in its banking sector to stagnate.  Let’s hope that it doesn’t take that long to learn the same lesson.