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.

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.

Question – where next for Japan

An inquiry from a reader prompts Your Neighbourhood Economist to look into the prospects for Japan

There has been another knock at the door of Your Neighbourhood Economist, with a reader what I thought Japan should be doing in the short and medium term?  The question arrived just days before another big policy development in Japan with the central bank ramping up its monetary policy.  This is the latest attempt by policy makers in Japan to resurrect an economy that has been languishing for decades.  To get an idea of what Japan should be doing, we need to start with what went wrong and why Japan has not made much progress.

What is not going right?

Japan got itself into trouble in the 1980s with the spectacular collapse of a financial bubble from which it has never recovered.  Property prices have fallen almost every year for two decades while prices for consumer goods have been inching lower for almost as long.  Japan has repeatedly tried to use fiscal stimulus but higher government spending has been unable to mask deeper problems with the economy.  Along with numerous roads and bridges which are hardly used, the main result of these rescue attempts has been a ballooning amount of government debt which only adds to Japan’s woes.

Monetary policy has been adopted recently as the potential saviour in the fight against what has been deemed as the main problem – deflation.  Falling prices were seen as prompting consumers to hold off spending and preventing companies from investing.  With this in mind, the central bank in Japan announced plans to double the money supply in early 2013.  But the policy of pumping more money into the economy was based on the false logic that deflation was a problem rather than just the symptom of a weak economy.  Instead, it is likely the case that deflation persists because prices rises had gotten out of hand in the past and need to fall back to appropriate levels.

Fix-up job not working

The result of this monetary policy has been as Your Neighbourhood Economist might have expected with just a brief and temporary boost to inflation.  Prices for consumer goods cannot rise consistently if consumers themselves do not get a similar rise in pay.  Higher wages in Japan seem unlikely as a declining population hurts aggregate demand and Japanese firms invest more overseas than domestically.  Yet, rather than change tact, Japan’s central bank has opted for more of the same. 

This involves the Bank of Japan aiming for an even larger boost to the money supply in Japan with annual purchases of 80 trillion yen (US$720 billion or £450 billion) in government bonds.  The timing of the new policy comes as the Japanese economy is faltering under the added weight of a tax hike designed to fix the government’s finances.  Japan has gotten itself deeper and deeper into trouble and seems likely to be an example of what not to do in terms of fiscal and monetary policy.   

Where to from here

The best option left to the Japanese government is to reform the economy so as to increase competition and improve efficiency.  There is substantial domestic opposition to reforms even within the current government headed by Prime Minister Shinzo Abe who included reforms as one of his key policies.  An easy way to sidestep domestic politics would be to jump on-board to plans for the Trans-Pacific Partnership (TPP).  This is a free trade agreement with the United States, Australia, Mexico, Chile, and other countries around the Pacific Rim.

Left to themselves, Japan will probably continue to stagnated due to the stifling effects of its consensus style of politics which make it tough to come up with reforms that keep everyone happy.  As such, Japan has a history of positive change only coming when imposed from the outside and this free trade agreement looks likely to follow this trend.  Greater competition from foreigners will help lower costs of business and create impetus for freeing up businesses in Japan from a host of restricting rules.  Facing up to the outside world looks like the best way to inject life back into a Japanese economy that has been slowly decaying for years.

Economic Recovery and the Politics of Slow Growth

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

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

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

Politics turns cold

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

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

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

Still sweating it out

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

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

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)

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.

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.

UK government needs to play its part to lift the economy

The government and the Bank of England should be working in tandem but one is taking a free ride

A good partnership is crucial in many aspects of life.  Take the UK economy for example - it is vital that the government and the central bank work in harmony if they are to provide support for the stumbling recovery.  Both seem to share a common view of the task in hand, painting a gloomy picture of the economy.  Yet, to borrow an analogy from the recent Winter Olympics, the combination is more like an ice skating duo that not only can’t stay in synch but where one is sabotaging the efforts of the other.

Working from same play sheet

The starting point of the government and the Bank of England is the same.  Economic data coming out of the UK shows that the country is performing better than most – GDP was up by 1.9% in 2013 with unemployment down to 7.2% in the three months through December.  Yet, if an economic upswing is on its way, neither the government nor the central bank wants anyone to know.  “Neither balanced nor sustainable” is how Mark Carney, the head of the Bank of England, described the UK economic recovery.  The Chancellor, George Osborne, claims that the “recovery is not yet secure”.  A more pessimistic outlook on the UK economy is actually closer to reality.  GDP in the UK is still lower than before the onset of the global financial crisis.

Despite some signs the economy is picking itself up, a fully-fledged return to form is still some way off.  Key drivers of growth are still frozen with UK businesses neither investing nor finding much business in overseas markets.  The economy also scores poorly in terms of long-term prospects with low levels of investment translating into few gains in productivity as well as stagnating wages.

Are you pulling my leg?

The UK central bank is the more diligent of the pair.  It has been working hard to convince people that interest rates will not be rising anytime soon.  The hope is that businesses and households can be convinced to borrow if they feel secure that interest rates will remain at their current low levels.  Mark Carney has tried to use forward guidance to this end but the policy fell flat (as outlined in a previous post).  Downbeat comments on the state of the UK economy are another avenue for soothing concerns over interest rate hikes.

George Osborne seems to be skating off in a different direction.  His remarks on the economy are part of a routine designed to push his austerity program promoted as painful but necessary due to the high levels of government debt.  Austerity did seem to have its merits amid the Eurozone crisis when investors with cold feet were pulling their money out from indebted countries.  Worries about debt levels have eased but the UK government is still sticking with its harsh spending cuts.

Doing more harm than good

The austerity measures are proving harmful in two ways.  Firstly, there is a shortfall in demand in the UK economy which is exacerbated by lower government spending.  The ideal response to weak demand is a fiscal stimulus with the actual benefit to the economy larger than the actual increase in government spending.  Yet, despite the negative effects, the UK government has chosen to do the opposite due to an ideological dislike of large government.

The other negative is that the Bank of England has been left solely in charge of generating an economic recovery.  It is bad enough that the duet has turned into a solo performance but the austerity measures act as a further handicap.  The one-man act has proven tough even for someone with the stellar reputation of Mark Carney but this situation also creates its own problems.

Loose monetary policy has been a factor behind increased asset prices showing up in the property valuations and the stock market.  This has helped to push up consumer spending as households with property or stocks feel wealthier.  Yet only a small portion of the population are benefitting.  Monetary policy by itself is not the route to a balanced or sustainable recovery (as argued in a previous blog).  A change in direction by the government is needed to give more balance or the economic ice may prove thin indeed.

Insights from Asia: More infrastructure for everyone

Infrastructure is like eating vegetables – more is always better (with one exception) 

Infrastructure was on the mind of Your Neighbourhood Economist during a recent trip around Asia.  Roads
in Cambodia were so bumpy that it was often difficult to think about anything else.  Investing in infrastructure is a no brainer for developing countries – it helps the economy run more smoothly by lowering the costs of doing business as well as helping to create jobs.  The same logic also applies to richer countries although it is tougher to decide where to spend any available funds.

Infrastructure – what is it and why is it good?

Infrastructure is easy to spot but hard to define.  Essentially, it is the facilities that are necessary for an economy to function.  Companies need electricity to power their factories and offices, roads to be able to move goods around, and phones and the Internet to communicate with others.  The concept of infrastructure could also be stretched to include the courts and laws which govern business, hospitals to heal sick workers, schools to produce the necessary skills in the workforce, and police to reduce the effects of crime.  However, let’s stick to the basic definition to keep things simple.

A lack of proper infrastructure can get in the way of doing business.  Clogged up roads or an intermittent power supply will create delays which put operations behind schedule.  The extra costs of power generators or the time taken in transporting goods will eat into profits.  A patchy phone or Internet network will hamper access to information needed for key decisions.

Shortfalls in infrastructure are more obvious in developing countries as by definition major parts are still being built.  Construction typically struggles to keep up with rapid growth in economic activity.  The large number of new cars on the road in Phnom Penh was a surprise but the amount of work being done on the roads was not.

In order to generate higher levels of wealth (which will typically mean more new cars), a developing economy needs people to move from working on the land to engaging in more economically productive activities in the cities.  Insufficient infrastructure is an obstacle that can inhibit economic expansion and trap a country at a lower level of income.

Tough decisions lead to neglect of infrastructure

The potential benefits from infrastructure also extend to richer countries.  More developed economies typically already have considerable infrastructure but this requires maintenance as well as extra spending due to shifting economic conditions.   It is far trickier for governments in developed countries to figure out what new infrastructure is worthwhile.  That spending on faster internet connectivity will be beneficial is a given, but it may be less obvious where to allocate the budget for, say, transport infrastructure.

Whether to invest in more roads, better railways, or bigger airports depends on predicting the lifestyles people will adopt in the future.  Ideally, the private sector would take on this burden but the copious amounts of cash along with the risks involved in major construction projects and the long-term scale of such operations are too much for businesses to handle.  Consequently, it is left to governments to determine the best courses of action.

This often results in tough infrastructure decisions being kicked down the road. Despite large budget deficits, the case for ending the neglect of infrastructure seems stronger than ever (following this link for the exception) due to high unemployment and the fact there are few engines of economic growth.  Just like your mother would tell you to eat your veggies, more infrastructure would be good for our economic health.

Japan – Don’t hold your breath

Hopes are high that Japan might be set for an economic reboot but a deeper look at the new policies and politicians involved suggests otherwise.

Your Neighbourhood Economist was once an optimist regarding the prospects for the economy in Japan after having lived there for nine years.  A nascent recovery in the seemingly morbid Japanese economy always seemed to be just around the corner.  It seems as if the economy in Japan is at another possible turning point with a string of new policies that could just do the trick.  The newish Prime Minister has taken on board some bold policies and optimism abounds, but after having been disappointed in the past, Your Neighbourhood Economist is not getting carried away and thinks that another let-down is the more likely outcome.

The despairing state of the Japanese economy is so bad that it makes the Eurozone crisis look like a day out at the beach (where many Europeans will be in August).  Not only is the government debt equal to around 230% of GDP (which makes Greece seem not so bad) but close to half of what the government spends each year is made up from borrowing.  Japan is still dealing with the consequences of perhaps the largest property bubble in history which burst in the late 1980s, but prices for property are still falling over two decades later and share prices are still only around a third of their peak in 1990.  To make things worse, Japan is also in the grip of deflation (falling prices) which typically stops consumers from spending and firms from investing.

Any optimism may seem surprising faced with such problems but the election of a new LDP government headed by Shinzo Abe has sparked hopes of a turnaround.  Abe has prompted a raft of new policies (referred to as the three arrows) encompassing monetary and fiscal policy combined with reforms.  The first two of the arrows have already been unleashed – a 10.3 trillion yen (US$116 billion) stimulus package (fiscal policy) and plans to double the money supply over two years (monetary policy).  The third arrow involves key reforms necessary to revive the economy but only piecemeal policies have been released so far leaving Your Neighbourhood Economist worried that the first two arrows won’t amount to much while the critical reforms will be stifled.

The best policy response to a temporary drop in demand is typically an increase in government spending to make up for the shortfall and keep the economy ticking over.  But this prescription for a fiscal stimulus has been tried over and over in Japan with little avail as the problems are beyond being fixed in this way (for more, see When Keynesian Policies won't work).  Neither does the doubling of the money supply hold much promise.  As shown in other countries with loose monetary policy, companies and consumers have shown that they would much rather pay back debt or hoard extra cash rather than spend or invest it.  So the extra funds from the central bank will only probably show up in the bank accounts and only a small portion of it will likely feed through to the real economy (see Why is the economy still stuck? for more on the poor track record of monetary policy).  An expansive monetary policy tends to be a favoured policy option for governments that are looking for a way to avoid unpopular but crucial measures to shore up the economy (for more detail, see Perils of doing too much).

The best hope for the Japanese economy is the reforms in the third arrow such as joining in on the new Pacific free trade agreement which would open up the economy to more competition from overseas.  The reforms are needed to cut through regulation in many areas which stifle innovation to the benefit of vested interests who resist any changes to this harmful regulation.  This is the nature of politics everywhere but the problem is more pervasive in Japan due to a culture that prizes consensus where making changes in the face of opposition is frowned upon.  The extent to which the Prime Minister is willing to go up against the vested interests is as yet unclear.  The reforms announced in June which were supposed to provide initial targets of the third arrow were disappointing.  While the announcement came at a crucial time ahead of elections (which the ruling LDP party won a sweeping victory), the signs are not good. 

The LDP gets the bulk of its support from the vested interests who oppose reforms and has little impetus to rebel against its support base considering that the main opposition party is in disarray.  The LDP has pushed ahead with reforms in the past – most notably under the leadership of Junichiro Koizumi who was Prime Minister between 2001 and 2006.  But Koizumi was a maverick from outside of the party mainstream while Abe is a party stalwart who has already had an unimpressive spell as Prime Minister.  Abe does not seem to be a true believer in the need for reforms as Koizumi was and Abe’s main focus instead seems to be changing the constitution to increase the military might of Japan.  So while it is high time for a turnaround in the fortunes, it does not look like any amount of arrows will slay the beasts sucking the life out of the Japanese economy.

Why is the economy still stuck in a rut?

As the last hope for an economic recovery, monetary policy has proven lacklustre at best and here is why things have not turned out as planned.

It has been more than five years since the onset of the global financial crisis but it still seems as if we are stuck cleaning up the mess.  The task of getting the economy back on track has been made even trickier with policy makers being side-tracked by a number of misadventures such as the Eurozone crisis and the fiscal cliff in the US.  Governments everywhere have been shackled by large debts and central banks have been relied on to save the day.  Despite having a better track record in the past, the inability of central banks to use monetary policy to fix the problems created by the unique circumstances of our current dilemma have prolonged the economic stagnation.  Your Neighbourhood Economist looks at why the central banks had to try new things and why even this fresh approach has not improved the outlook for the future.

Monetary policy had always provided a road map back to economic recovery in the past.  The directions were simple – lower interest rates would help get the economy back on the right path. The theory behind this was that making it cheaper for firms or households to borrow would give the economy a boost at a time when other sources of growth were flagging.  Interest rates could be topped up again once the economy had been kick started with inflation used as a gauge on the strength of the economy (i.e. low inflation suggests weak demand with rising inflation seen as a sign of an overheating economy). 

However, even interest rates close to zero have failed to gain traction amid the consequences of the global financial crisis.  There are two main reasons for this which relate to borrowers and lenders.  On the lending side, banks have shrunk their operations due to chronic uncertainty that pervaded both the financial well-being of the banks themselves and any borrower they might lend to – banks were unsure of the potential for losses on their own books, let alone those of other business which they may lend to.  A wave of new regulations also acted to hamstrung banks who reacted by lending less to lower the level of risk on their balance sheets with other options such as selling shares not available (this problem was most pronounced in Europe – see Another reason not to bank on Europe for more). 

Borrowers too weren't in the mood with many companies and households having already taken on too much debt during the years of cheap credit which led up to the crisis.  Uncertainty was another factor as wage earners worried about their jobs while firms were more concerned with their own survival rather than borrowing to expand their operations.  Rather than borrowing, the opposite was more likely to be the case as consumers paid down their credit cards while firms repaid their debt and kept cash for a rainy day.  A lack of willingness on both sides (lenders and borrowers) meant that more debt was out of the question no matter how low interest rates would be set.  This put pay to conventional notions of monetary policy and required a fresh approach.

Quantitative easing was taken on-board as a possible solution.  This involved central banks buying bonds to provide funding for banks and companies wanting a different source of cheap funding.  The bond buying also lowered the returns on these safer assets and pushed investors to put their money into more risky assets such as buying bonds of struggling countries in Europe like Greece or Spain.  The extra money in the global financial system was expected to help grease the wheels of banking which had seized up.  But little of this additional cash has reached the real economy and has been hoarded by banks or companies or has gone to pump up share prices.

The limited extent to which their policies fed through to the economy prompted central banks to throw more and more funds at the problem with the Federal Reserve in the US buying US$85 billion in bonds each month and the Bank of Japan pledging to double the money supply in two years (for more on this gamble, see All bets are ON).  The acceleration of monetary policy has not driven the economy much faster through the slowdown.  However, even just the notion of an eventual retreat by central banks has caused jitters among investors who have benefited most up to now from the real-world consequences of monetary policy (refer to Caution - Windy Road Ahead to see how monetary set the tone of stock markets).

So the outlook for the stagnating economy is not good.  Governments remained mired in their debt with even relative bright spots such as the recovery in the US economy in peril when factoring in likely cuts to government spending in years to come.  Central banks have dug themselves into deep holes by trying to do too much and even the limited effects of monetary policy will be difficult to maintain (for more on why thus might be the case, see The perils of doing too much).  The result being that problems in the economy such as a shortfall in demand and uncertainty over the future continue to drag on consumer and business sentiment.  All it would take to ignite economic growth again is a commonly held belief that the future will be brighter.  But, considering all of the above, it is proving a hard sell.  

The perils of doing too much

Central banks have been recruited to stave off economic disaster but they may have been forced into overplaying their hand.

The global financial crisis has propelled central banks into prominent roles in fighting off recession while politicians have been slow to act.  Being the last remaining stalwart against economic disaster, central banks had to go further and do more than would have ever been previously conceivable due to their limited range of policies.  Even though the efforts of central banks have some effect in keeping the global economy afloat, the jury is still out with regard to the distortions left behind by the actions of central banks as well as their new roles as backstops for the global economy.

Most central banks have been given independence over the past few decades due to the notion that this will aid them in their central goal of reigning in inflation.  The theory behind this is that politicians would be tempted to use the tools of monetary policy – setting interest rates and the level of money supply – to boost economic growth and their re-election chances to the long term detriment of the economy.  So independent economists at central banks were given the reigns of monetary policy and a target for inflation of typically around 2% to ensure that a safe pair of hands would be in charge.  The typical cycle of monetary policy involved interest rates rising during periods of strong economic expansion to keep lending in check while a weaker economy prompted cuts to interest rates in order to make borrowing easier. 

The global financial crisis that struck in 2008 involved what could be deemed to be a perfect storm.  Politicians had got caught up in the bubbly state of the economy and government spending got out of hand backed by tax revenues that were later found to be just a temporary fill-up.  This was not just confined to a few countries but the Bush administration in the US, the Labour government in Britain, and many countries in Europe were running large budget deficits at a time when common sense would have suggested putting money away during the good times.  So when the banks got themselves into trouble and required help from tax payers, government finances were already stretched and there was nothing left in the coffers to bail out the economy. 

A crisis of confidence hit the global economy with spending by consumers and investment by companies being cut back due to the chronic uncertainty of whether the banking sector was going to collapse.  Your Neighbourhood Economist would argue, with a good dose of hindsight, that the typical Keynesian policies of an increase in government spending would have been the best response to the global slowdown with government making up for the shortfall in demand from elsewhere.  Government spending could have made up for the shortfall in demand, but the mismanagement of government finances meant that this option was not available.

Monetary policy was always going to be a struggle (a bit of hindsight coming in useful here too) as the activities of the central banks during recessions, such as boosting lending, are generally transmitted through the financial system.  Yet, banks everywhere were fighting for their own survival instead of being concerned about the tinkering of central banks in the background.  The weak translation of monetary policy into positive effects on the actual economy has resulted in the extent of the actions of the central banks having to be ramped up to have an effect.  The most obvious example of this is the recent announcement by the Japanese central bank that it plans to double the money supply in Japan which would be beyond belief even just a few years ago (for more, see All bets are ON). 

Even though the worst seems to be over, central banks are still in a difficult situation in terms of getting out of the role of being the guarantors of the economy.  The massive scale of their involvement in the economy will make an orderly retreat fiendishly difficult due to possible economic hiccups in the future and uncertainty over how the economy will respond.  Even if this Herculean task is pulled off with minimal problems, a new precedent has been set where central banks will now ride to the rescue if the economy goes bad. 

This situation is made worse by politicians who have shown themselves to only look short-term in their focus when dealing with such problems as the Eurozone crisis in Europe or the fiscal cliff in the US.  The expanding responsibilities of central banks may find them overextending themselves to the detriment of the good work they have achieved so far such as keeping a lid on inflation.  Central banks have overachieved during the global financial crisis considering their initial remit but should not have to be relied on to save the day.  Economists are not meant to be super heroes.

Recessions, Ice creams, and the UK economy

The UK economy is set for a triple dip recession but it may not be the last.

Children love ice cream cones but a chocolate coating makes it even better.  Ice cream can be covered in chocolate not once but twice and a double-dip ice cream cone was a real treat.  It is a pity that recessions don’t work the same way.  This is particularly true in the case of the UK which may be in the midst of a triple-dip recession after real GDP fell in the last three months of 2012.  Even worse than this is that the fear that a weak UK economy may dip into negative growth a few more times this decade. 

A double-dip recession is a relatively common flavour of recession.  It occurs when an economy rebounds after a recession but the ensuing growth is not strong enough to be sustained and the economy weakens again before an upward trajectory is finally achieved.  The reasoning behind such a growth path is that businesses and households will hold back on spending during a recession due to heightened cautiousness and uncertainty about the future but spending will pick up again once the economy seems to be improving.  If the delayed burst of spending is premature or small in size, the boost to the economy is only temporary and growth stalls until the economy has worked through the issues that caused the first recession.

Investments by companies in new factories or equipment are essential for an economy to return to sustainable growth.  But such investments fluctuate considerably depending on the business mood and companies will delay or terminate investment plans if the economy is not strong enough for the companies to earn a suitable return.  So growth will remain feeble with short periods of weak recovery followed by similarly short and shallow recessions.  Such is the background behind the triple-dip recession and why the third consecutive recession in the UK may not be the last.  This weak business cycle with minimal investment in the UK will continue until business confidence is revived.

 

What makes the state of the economy after a deep recession in the UK different from the plain vanilla type is the hard-to-digest problem of a banking crisis and the bitter tonic of austerity measures.  In the build-up to the global financial crisis, the UK economy was more reliant on its banking sector than most other countries.  High wages earned by employees in the finance sector helped boost spending and a willingness by banks to lend fuelled a real estate boom.  The excesses of the finance sector in the good times amplify the problems that need to be sorted when times turn bad.  The result in this case is that the UK economy is currently suffering from weak consumer spending and a decline in lending by banks.  Reregulation of banking activities has added further complication to sorting out the finance sector. 

The effect of the banks adding to the swings in the economy is further heightened through the government.  The buoyant finance sector provided extra income for the government when the economy was booming.  Not only did this boost of funds to the government quickly dry up after the global financial crisis but the government also had to use up valuable resources to step in to rescue the banking sector.  Having already spent the cash bonus, the government is now having to take money out of the economy in a manner which is the opposite of a fiscal stimulus through its austerity measures.  This is also not a problem that will be easy to sort out and government cut backs are expected to continue through to 2018.

Considering that a “triple-dip recession” is relatively new term, what comes next?  A quadruple-dip recession?  Even if the UK economy manages to survive without slumping to two consecutive quarters with negative growth (the common definition of a recession), years of slow growth are ahead.  The worst case scenario is Japan.  The extent of the economic stagnation in Japan is not measured in the number of recessions but in the number of decades for which there has been no substantial growth.  Japan also suffered a property bubble which triggered a banking crisis but on a larger scale.  Yet, like Japan, the UK still has a lot to do, such as finding the right balance between regulations and increasing lending at banks along with government measures to boost the economy.  Until this happens, hopes for recovery are likely to melt away like an ice cream cone on a hot day.

Winning the Ugliness Contest

Once popular with all the investors, the United Kingdom is beginning to fall out of favour as the diet of austerity measures proves to be too harsh.

A beauty contest is all relative.  It is not hard to be the prettiest when everyone else is ugly.  Such was the fate of the British economy during the Eurozone crisis.  It was not in the best shape but it still looked attractive compared to the turmoil in Europe and this lured in investors who snapped up bonds issued by the government.  But, with the worst of the Eurozone crisis now over and Europe no longer being shunned, it is the United Kingdom that is the object of attention for all of the wrong reasons.

The economy in the United Kingdom did see some benefits from the debt crisis across the English Channel in Europe.  The United Kingdom was seen as a haven in troubled times when investors needed to find somewhere secure to put their money.  As a result, the interest rates on government debt dropped below 2.0% to record lows (for more on this, see Not All Investors in Bonds Have Lost Money).  This has provided some relief as, even though slightly separated from the Eurozone and its troubles, the United Kingdom was in a spot of bother of its own with government debt of 82% at the end of 2011 climbing to 89% 12 months later.

But now that Europe is not the mess it was, the United Kingdom does not hold the same allure and its faults are starting to show through.  The austerity measures which have been introduced to tackle the budget deficit are sapping life out of the economy as money goes toward paying off government debt.  Following a decline in real GDP in the last three months of 2012, Britain is set to make headlines of the wrong sort with a triple-dip recession on the cards if the economy remains weak.  The dismal state of the economy means that Moody’s stripping UK government debt of its illustrious triple A rating last week was not much of a surprise as the reasons for the downgrading – the sluggish economy and high debt levels – were obvious to all.  But the attention on the ugly side of the UK economy is adding to the calls for more to be done to stimulate economic growth.

The coalition government in the United Kingdom which is headed by the Conservative Party has been adamant in its stance that reducing the debt is the best way to perk up the economy.  But this has been increasingly called into question as the theory behind such policies has stumbled in the face of the economic realities.  Studies done by the IMF also show that cuts to government spending have more of a negative impact on the economy than previously thought (for more detail, see Time for Plan B?).  The downgrading of the debt will add to pressure for a change in tact as it may prompt investors to move their money elsewhere and interest rates on government debt will rise as a result.  The higher cost of borrowing will increase the government expenses and eat into the savings the government has made through its austerity measures.  The weaker economy will also reduce the tax revenue for the government adding to its woes. 

With the economy not looking so good in comparison to elsewhere, the government and the central bank will have a harder task to win over the confidence of investors and to come up with a suitable regime of policies to keep the economy in reasonable health.  One consolation is that the constantly changing political and economic situation in various countries struggling with the consequences of the global financial crisis means that the time that the UK economy spends in the spotlight may be short.  In the same week, an indecisive election result in Italy makes it likely that it will be dragged out in front of the international media as the new candidate for the winner of the ugliness contest. 

Central Banks: Doing more harm than good?

Central banks are working overtime to kick start the global economy but monetary policy is being relied on to do too much and may just be creating more problems.

With the global economy in a slump and monetary policy not gaining much traction, it seems natural for there to be doubts about the ability of central banks to manage fluctuations in the economy.  But it is not just an issue of whether monetary policy is working or not, but the questions extend further to whether the actions of central banks have intensified the swings in the business cycle.  Your Neighbourhood Economist has started to wrestle with his own concerns as even more creative monetary policies seem to be having little effect but the finger for blame should not be pointed at central banks.

The standard format of monetary policy revolves around the setting of interest rates.  The desired effect of any policy intended to lower the interest rates is to spur investment by making borrowing cheaper.  This basic policy format was deemed to be sufficient to deal with previous recessions over the past few decades and helped to build up a sense of infallibility that bolstered the reputation of central bankers such as Alan Greenspan.  But the extent of damage to the economy resulting from previous recessions, such as following the plunge in tech stocks in 2000 and 2001, was superficial in comparison to the global financial crisis.  As such, tinkering with the interest rates was enough to get the economy moving again in the past but interest rates close to zero have had little impact this time around.

The critical functions of finance having stalled in the aftermath of the current crisis with banks holding back from lending due to heavy losses in the finance sector coupled with new restrictions on their activities.  It is typical for recessions resulting from a banking bust to be longer and deeper so central banks have delved into a range of unconventional policies such as quantitative easing to kick start the economy.  The money supply has swelled up as central banks have been printing bundles of cash and providing banks with cash to splash out on lending.  Yet, the larger money supply has not fed through to make any substantial effect on the economy.  The surplus money sloshing around has been flowing into the non-productive parts of the economy such as asset prices rather than into businesses which produce assets and liabilities. 

It is this excess money that can jump around the global economy and cause unnecessary volatility.  Central banks act in a way to maintain this surplus cash in the global financial system due to a bias in their policies regarding periods of strong and weak economic growth.  Interest rates are slashed with further measures rushed out when the economy is on the slide but central banks are less aggressive in resetting interest rates to appropriate levels when growth takes off.  Furthermore, the perceived receptiveness of the economy to oversight by the central banks during only mild fluctuations in the economy has increased the faith in monetary policy to shield the economy from shocks.  So, when the economy is booming, the prices of real estate and share prices soar due to the excessive confidence of investors and households who think that the good times will last.  Spending by household increases while debt rises and savings drop off as people think themselves to have more money in these assets despite some of the rise in wealth being transient. 

Banks also act to extenuate the inflation of asset prices by increasing lending to further fuel this boom in property and the stock market while clamping down on new loans when things turn bad.   The finance sector was even more of a culprit in the build-up to the current banking bust due to new innovations when banks thought they could offload lending risks to other parties.  However, this just resulted in an underestimation of risk which blew up in many bankers’ faces during the crisis.  Support from governments and central banks for the finance sector adds to the reasons why banks would want to make bigger bets when economic growth is perky. 

Too much has been expected of monetary policy and this is having adverse effects on the economy.  Central banks have been given oversight of the long-term health of the economy while politicians can pander to the preferences of voters (see More Power to Economists for reasons why this is the case).  The absence of better management of government finances over the past decade has resulted in only limited options in terms of fiscal policy.  Increases in government spending would have been a more appropriate response to the current slowdown in economic growth as cash would have been fed into the real economy rather than just sitting in the vaults of banks as has been the case with the current monetary policy. 

As such, central banks have over extended themselves trying to kick start the economy.  There may be follow on effects from this as the huge quantities of money currently being printed by central banks are likely to exacerbate the trend of excess liquidity in the global financial system as it will be hard to mop up the extra cash once the economy starts moving again.  There are many villains in the tale of the missing economic growth – central banks may be seen as one of them but it is only because monetary policy is being called on to save the day when all else has failed.