Monetary Policy – via the currency market

With the banking system clogged up, the European Central Bank is looking for other ways to make monetary policy work

Unconventional - this is a term currently used to describe many new elements of monetary policy such as quantitative easing.  It could also be employed in relation to the manner in which monetary policy works nowadays.  The European Central Bank (ECB) cut interest rates in November 2013 due to concerns about deflation (for more info, see previous blog) but the effects are not expected to work through the banking sector as would normally be the case.  Instead, the unspoken target of the policy change was the value of the euro.  This is stuff that you won’t find in any economics textbook, so how does it work and why is the ECB having to rely on such disingenuous tactics for its policies?

The normal result of a cut in interest rates would be a boost to the economy through an increase in lending with lower borrowing costs convincing more households and businesses to take out loans.  The extra spending that this generates would spur on the economy.  But this policy route is not working at the moment as demand for new loans is weak irrespective of how low interest rates are.  The fall in inflation has prompted growing concerns about deflation and the ECB felt the need for further action to signal its intent to prevent this.

Accordingly, the ECB is targeting another avenue (without stating it outright) to achieve the desired results – the currency market.  Europe has been burdened with a currency which reached a two-year high against the US dollar in October.  This is relevant to the fight against deflation in two ways – a stronger currency hurts the economy by making exports more expensive (and harder to sell overseas) as well as reducing the prices of imports (which adds to downward pressure on prices).  A reversal of this trend, that is, a weaker currency, would then work in Europe’s favour and is one of the few levers available to the ECB.

A lower interest rate helps to drag down the value of a currency by reducing the benefits of holding cash in that currency and providing an extra incentive to sell.  This effect is further magnified by the large amount of cash sloshing around in the global financial system at present.   But it is not so easy - some other central banks (namely the Bank of Japan) are keen on achieving the same results through similar policies and not all countries can have weak currencies.  This has resulted in the coining of the term "currency wars" as countries battle to drive down the value of their currencies.  It all sounds rather dramatic but it is evidence of how things in the system of finance are far from normal.

ECB Rate Cut – what's the point?

The European Central Bank set itself apart with looser monetary policy but how is this likely to make any difference to the economy?

Central banks have been busy recently, whether it be talk of forward guidance from the Bank of England or the tapering of bond purchases by the Federal Reserve.  The exception had been the European Central Bank (ECB) which had been going through a quiet period after monetary policy helped to put paid to the Eurozone crisis in 2012.  Worries about deflation jolted the ECB back into action following data showing that inflation was down to 0.7% in October.  The ECB decided to respond last week by cutting its benchmark interest rate from 0.5% to 0.25%.  But, with interest rates already low, will a further reduction make much of a difference to the economy?

A cut to interest rates is something of an anomaly as the ECB is the only major central bank which has not already lowered interest rates as much as possible.  The recent trimming of its key interest rate follows cuts in July 2012 and May 2013 with the ECB using this drip-feeding of interest rate changes to respond to new data on the economy in Europe.  The focus of policy has shifted from saving the Eurozone from collapse, which was achieved by the ECB taking a stand pledging to do “whatever it takes” to save the euro. Instead, the ECB is looking to boost growth with the hope of staving off deflation.

Lower prices may sound like a blessing to consumers but this fall has the effect of making debt tougher to pay back as selling the same amount of goods generates less money for firms which also means that the government misses out on tax revenues.  Not exactly what a heavily indebted Europe needs at the moment.  This is the reason why central banks will typically adjust policy to achieve inflation of around 2% - better to have a small amount of inflation than succumb to deflation.  Inflation has been decreasing elsewhere as well such as in the UK (see previous blog) due to weak growth combined with a fall in global commodity prices (see Inflation – then and now for more on how inflation works).

The interest rate cut in itself will actually have little effect with households and businesses in Europe not keen on borrowing while the economy is so weak.  Rather it is a signal of intent – the ECB will continue to loosen monetary policy while some central banks elsewhere (the US and, to a lesser extent, the UK) are approaching the beginning of the end of their loose monetary policy.  The key mechanism by which this will be fed through into the economy is likely to be the exchange rate but more on this later…

The ups and downs of UK inflation

Inflation has become delinked from the UK economy but at least it seems to be heading in the right direction

Something seems off.  Inflation figures for the United Kingdom released this week show that inflation dropped to 2.2% during the 12 months up to October.  Inflation had previously been high despite the sluggish UK economy but inflation is now on the way down just as the economy is picking up again according to data released at the end of October showing the fastest rate of economic growth in more than three years.  Any links between inflation and the health of the economy take on extra meaning due to the level of prices being the primary concern of central banks.  So how is the Bank of England likely to react to such mixed data?

Inflation typically moves in line with the economy – increasing during boom times and falling when times are bad.  But as mentioned above, this relationship does not always hold as economic growth in places other than Western countries, such as China and other emerging markets, can affect prices for global commodities, a situation which was not always the case (for more on this, see Inflation – Then and Now). The strength of the Chinese economy explains how inflation in the UK could briefly exceed 5% near the end of 2011 while the economy was struggling.

Although the main goal for the Bank of England is to maintain price stability which involves keeping inflation close to around 2%, the high inflation in 2011 was not seen as a problem on the basis that the factors behind the higher inflation were judged to be temporary (and this turned out to be correct).  More persistent inflation typically comes with more sustained periods of economic growth as increased wealth pushes up demand and results in rising prices.

Accordingly, it may be a good omen that lower inflation has come at a time when the fortunes of the economy are beginning to brighten.  It will give the Bank of England more leeway to keep interest rates lower for longer.  However, it is not clear whether inflation will continue to fall – energy suppliers are planning to hike energy prices while the government will be keen to limit higher fuel bills.  Energy costs will also be dampened by China no longer experiencing the rampant economic growth of the past decade.   At least inflation will be one less thing that the Bank of England will need to worry about with the tricky prospect of interest rate rises on the horizon.

Wonga - Do we need to be saved?

Politicians are questioning our ability to make the right choices but that is not the real problem.

Criticism of Wonga recently reached a new nadir with the rather ridiculous claim by Ed Miliband, the Labour Party leader, that children have been “targeted” throughTV ads.  There does seem to be something unethical about a firm which charges almost 6,000% interest on loans.  However, this hasn’t prevented Wonga from prospering.  With wages stagnating for many people, there is strong demand for extra cash at times of need even if it does come with a big chunk of interest payment.  Yet, many in the media have been critical of a culture of borrowing with Wonga as the new pied piper (see my previous blog on Wonga).  Are Wonga’s loans useful in times of trouble or a snare for the unwary?

One of the key elements of a capitalist economy is that firms will sell any product where profits can be made.  This drive for profits pushes companies to innovate and create things that we didn’t even know we wanted.  The short-term loans from Wonga are one such product allowing quick access to cash that was not previously available.  Their popularity suggests that many find such loans useful, but it also prompts concerns that people are not making the smartest financial decisions.  Politicians among others target the source of supply (the firms offering the loans) rather than the source of the problem which is too complicated to deal with.

This paternalistic way of thinking is the basis for government action on a range of our “bad habits” from smoking (where policies have worked out for the best) to alcohol and fast food (which have been controversial).  Government policies such as these which try to modify the behaviour of adults sometimes seem like a replacement for a decent education system.  The world is growing in complexity and we are faced with an increasing range of choices at the same time as education is becoming increasingly focused on test results.  This leaves teachers with little time to teach important life skills such as a healthy diet or financial literacy.  Politicians could do us all a favour by asking the bigger questions rather than jumping on the latest bandwagon – if only there was a way to improve the behaviour of politicians.

Wonga – the new bad boy of finance?

Wonga has been grabbing headlines for the wrong reasons but who is really to blame?

It is not a good time for finance firms of any guise to be making too much money at the moment.  So the British short-term lender Wonga attracted the wrong type of attention when it announced record profits of 65 million pounds for 2012.  Everybody from Ed Miliband, the Labour Party leader, to the Archbishop of Canterbury have lined up to vilify Wonga for making money out of people who have fallen on hard times.  Wonga, who offer loans of small amounts for a period of up to 30 days, have hit back with a slick new promo video telling the stories of some of its customers.  Is Wonga as bad as they say or is the recent controversy just a bit of name calling to grab some headlines?

Among the numerous criticisms, perhaps the most commonly heard are to do with the eye-wateringly high interest rates which work out at 5,853 percent (as stated clearly on the website).  Yet the short periods of borrowing mean that interest payments are typically small compared to the amounts involved - a typical loan of 200 pounds for 15 days incurs fees and interest of just over 36 pounds.  But 200 pounds would explode out to over 10,000 pounds over 12 months so any mishaps which delay repayment have the potential to spiral out of control and result in massive debts.

So why would people risk this in the first place?  A bit of extra cash when we are short might save us even more money than the cost of the loan when caught in a spot of trouble or might stop us from missing out on a big night out with friends just before payday.  The choice to borrow or not to borrow is one that each of us is free to make (with full disclosure of charges from Wonga).  What the long line of Wonga critics are instead condemning is the fact that so many people are choosing to take out loans through firms such as Wonga.

Wonga is a symptom of and not a cause of a society that spends at will and may not always have money left at the end of the month in case of emergencies.   Life was not always so free and easy - access to any extra cash used to be limited to only those on good terms with their bank managers.  But new ways of getting cash, such as credit cards and short-term loans, have provided money to the masses.  We should be thankful to have it if we need it but better management of our finances might mean that we would be thankful not to need it.

Generational Differences - Rise of the Socialists

Young people have a different view on the world than older generations who have made the most from capitalism

Youth is the one thing that most people would want – a chance to live it all over again – but it is not an easy time to be young at the moment.  Young people are facing the toughest job market in decades after having gone through an education system which has been neglected for years with more money being spent on pensions instead.  So it may not be surprising that youngsters are not as keen on capitalism as older generations.  And this is not just part of a rebellious phase but rather a response to an economic system which is geared to benefit long-time members to the detriment of new-comers. 

To start with, let’s look at the job market.  Unemployment rates remain stubbornly high in most countries with developed economies but the proportion of young people without jobs is typically substantially higher.  For example, more than half of younger workers in Spain and Greece are unable to find work.  Joblessness not only has temporary effects such as a loss of income but studies have shown that youngsters who enter the market when the economy is sluggish often earn less over their lifetimes.  The current situation for young people goes beyond this to talk of a “lost generation” who may become disillusioned with the job market and remain disengaged even when employment prospects improve.

This situation is made worse by a system fronted by labour unions geared to protecting the jobs of existing workers who come from an older generation.  This trend has been most damaging in Europe where the efforts of unions have resulted in a two-tier labour market.  Older workers have secured themselves stable jobs due to rules resulting in high redundancy costs whereas younger workers are typically employed on short-term contracts which are first to be terminated when job cuts are needed.  The rise of globalization also means that new-comers to the workforce are competing for jobs with workers in China and India as well as people in their hometown. 

This increased competition for jobs along with automation of work using computers and other new technologies has taken away many of the administration jobs that were the mainstay of work for the older generation.  Better paying jobs are increasingly limited to jobs requiring higher levels of education but this too is an area where young people have been short-changed.  Education is faced with spending cuts and students are being asked to bear a substantial portion of the costs as countries deal with high levels of debt as well as demands from older workers for lower taxes.  The irony of this situation is that spending on pensions and medical bills for the elderly is on the rise at the same time as education is suffering from cutbacks – societies are spending money on the old rather than investing in a new generation.

The housing market provides further evidence of the different fortunes of the older and younger generations.  Trying to get onto the property ladder is only getting tougher for first-time buyers whereas existing owners of property are benefitting from higher prices.  House prices have been surging in some places despite the economic doom and gloom as governments in many countries have even been bringing in measures to push up prices for real estate as a means to revive economic growth (which is why a rebound in UK house prices is not all good news).

With lower pay in less stable jobs (or unemployment) awaiting many youngsters, they are likely to be the first generation in a long time that will end up worse off than their parents.  The older generation must take part of the blame with many elements of the economy set up for their benefit – a seemingly obvious outcome in a world defined through competition where everyone from companies to political parties are battling it out.  The spoils from winning in this competitive environment are on the wane in wealthier countries as global economic rebalancing shifts more wealth to China and other countries on the rise (which is part of A New Inconvenient Truth).

Youngsters have experienced the harsher side of a market economy and it is no surprise that they see the current system as not working in their favour.  Surveys show a growing distrust of capitalism and increasing support for social spending among young people.  The disillusionment of young people has also extended to politics so it is later generations which vote and give direction to the policies of government.  But it seems obvious that changes beckon as the younger generation with their different experiences and views on the world take over the levers of power.  Marketing experts have been quick to jump on changes in habits of different age groups such as Generation X or Y.  Politics may see similar changes coming with the rise of a new generation – it will be interesting to see what world they will build for themselves.

Debt Ceiling: Once more unto the breach

Politics in the United States is starting to cause more problems than it solves as compromise still seems far off.

Politicians are not usually seen in the best light.  Even in that context, the partial shutdown of the federal government in the United States is exasperating, so much so that Your Neighbourhood Economist was not even going to bother to comment.  The situation leading to the shutdown brings to mind kids in a playground fighting over a toy with everyone losing out after all of the toys are put away.  However, behind all the antics and posturing, there are bigger themes at play which is even more depressing.

October is marked with a number of dates which gradually ramp up the economic stakes.  The month began with the US government having failed to pass legislation for its spending budget for the 2014 fiscal year which starts on 1^st October.  While the bulk of spending by the government, such as benefits for the elderly or unemployed, is not affected, a significant portion of money doled out by the government must first be ratified by Congress before being spent.  As a result, not passing the budget resulted in a partial shutdown of the federal government with around 800,000 out of 2.8 million public employees being sent home without pay.  The parts of government affected include bodies such as the Environmental Protection Agency and the Food and Drug Administration, meaning that many procedures such as permits for certain business activities will not be processed.  NASA will also mostly shutdown as will many of the tourist sites overseen by Federal government employees.

But the partial government shutdown is just a precursor to something more threatening – the government running out of money to pay its bills.  While such an outcome may sound preposterous, it stems from the current budget deficit (with the government spending more than it receives) and the need to borrow to make up the shortfall.  The total amount of debt that the US government can take on is also something that requires approval from Congress.  With the government having racked up a string of budget deficits in the aftermath of the global financial crisis, the amount of borrowing has been steadily rising.  More debt is needed but the government has reached the debt ceiling which was raised in 2011 and is expected to run out of money by around 17^th October.

The stakes are higher if no deal can be done with regard to the debt ceiling.  While the partial shutdown of government can be seen as a bit of a nuisance, a government cash shortage could have global ramifications if it means that the government misses an interest payment on its bonds and thereby triggers a default.  Given that US government bonds are akin to another form of currency in the financial system, a default has the potential to bring the global financial system to its knees. 

In spite of this, the financial markets, while on edge, have not panicked - negotiations regarding the raising of the debt ceiling are still on-going, and even if a deal cannot be brokered, the effects are still unclear.  There are other sources of income such as money from taxes so the government will be able to keep up with some outgoing payments.  But that in itself creates another dilemma – which, if any, payments to forgo.  Investors would hope that debt payment would take priority over, for example, the payment of pensions.  Despite the potential consequences to the international financial system, it would take a brave politician to cut off pensions for old people.

Considering what is at stake, the consensus view is that the politicians will sort themselves out before the government is forced into making such choices.  Your Neighbourhood Economist would like to assume that this will be the case.  But the two main political parties have been squabbling for number of years with the situation getting worse rather than showing any signs of improvement.  Over the past few years, there have been skirmishes over a previous increase of the debt ceiling in 2011 as well as the negotiations regarding the fiscal cliff less than 12 months ago (for more on this, see Winning the election was the easy part) and one of the key obstacles to compromise is growing in strength – that being the so-called Tea Party portion of the Republican Party.

The Tea Party is the radical anti-government element of the Republican Party which is not afraid to be aggressive in pushing for a reduction in the size of government among other policies.  Its members in Congress are targeting large concessions from Obama to raise the debt ceiling – a position which is further fortified by Obama having conceded little in previous showdowns.  Perhaps the biggest concern is that the anti-government fervour of the Tea Party will translate into a view that the debt ceiling is an effective way of slashing government spending irrespective of the costs involved.

The Tea Party has found growing support among Americans disillusioned with the role of the government.  It is part of the rise of populist movements that can also be seen in Europe which rail against mainstream policies, such as an opposition to immigration.  The multi-party political systems in Europe can include such movements as separate parties which often struggle to get the necessary level of support to make it into government.  The political system in the United States only has two political parties and the Tea Party essentially controls a large portion of the Republican Party.  With voting districts in the United States having been shaped over the years to produce safe seats for either the Republicans or the Democrats, Tea Party candidates in Republican seats are typically better at whipping up support enabling them to win out over more moderate candidates. 

The Republican Party as a whole has increasingly felt the need to pander to this radical fringe which has brought a heightened level of conflict to US politics, within the Republican Party itself as well as between the two major parties.  Its unique system of democracy has been a key element behind the successful rise of the United States to global dominance.  But with the country’s place at the top of the global pecking order no longer assured (as described in A New Inconvenient Truth), it would be ironic if its political system was central to its downfall.