Inflation – More friend than foe

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

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

I’ll be back (as the good guy)

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

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

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

More inflation now to save the future

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

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

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

Stock Markets – Calm for now

Following a rising stock market is an easy way to make money but share prices can only defy gravity for so long

Something strange is in the air among investors – a pervading sense of calm.  Volatility in financial markets has dropped off while stock prices are near record highs.  These conditions seem out of place at a time when there are a number of reasons to be jittery - the economic recovery is far from assured and central banks are set to raise interest rates.  The buoyancy of the financial markets says more about the habits of investors than the actual state of the economy. 

One defining feature of investing is that it can be easier to make money by following trends rather than fighting against market momentum.  The only problem is that the trends become a force in themselves and can push prices too far either up or down.  This effect can only be temporary as markets must revert back to normality at some point.  This leaves investors caught between making money when times are good and making a getaway before profits are wiped out.  This day is drawing closer.  Your Neighbourhood Economist can’t predict when it might happen, only that a reckoning is likely to be just around the corner.

It’s complicated

Financial markets are notoriously hard to read.  Theory tells us that the prices of shares are based on a combination of all available relevant information.  Yet one of the most pertinent reasons for buying or selling is the past price movements.  Financial assets are one of the few things that we buy more of as the price rises and are more likely to sell when the price falls.  This can often override other considerations such as whether a company is expected to see its profits grow in the future.  Base instincts such as greed and fear can also take over and distort our investment decisions.

The tech boom and bust just over a decade ago was a classic example of this.  Investors threw money into start-ups whose ability to generate revenue was questionable.  You did not even have to believe that the Internet would revolutionize business, just that others would and that these others would keep buying so that you could make a tidy profit and sell up.  Thus, prices often deviate from what shares in a company might actually be worth depending on the likelihood that someone else might be willing to pay more for the shares sometime in the future. 

This is not to say that money cannot be made by holding onto shares in profitable and well-managed firms.  Yet such an investment policy will only work out in the long term with the timing of when to buy and sell also being crucial.  The bulk of investors, however, are not trading in shares over the long term.  Professional investors looking after other peoples’ money tend to actively buy and sell to take advantage of short-term trends.  This proactive approach is also used justify (and amplify) their considerable fees despite often being unable to outperform market benchmarks.

Actually, it's even more complicated

Gauging where shares might be heading is further complicated by the current expansive monetary policy.  An abundance of cash in the financial system means that people wanting to buy financial assets are never far away.  Pushing share prices to unrealistic values is just one example of how monetary policy is creating problems.  Policy makers need consumers in an optimistic mood to get spending up and creating extra wealth through the stock market is one of the few ways of getting us in a more cheerful mood.  It can only provide a short-term boost and might work in the opposite direction when this policy is reversed.  The jolt from the inevitable interest rate hike which is likely to disrupt the market calm may result in more than just some investors losing their easy gains.

Economic Recovery – Reasons to be Pessimistic

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

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

Why so glum?

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

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

Grumpy for a reason

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

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

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

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

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.

Economics – more religion than science?

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

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

In Markets We Trust

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

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

Believing in false idols

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

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

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

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

Measuring the Economy – A Knotty Problem

A change in focus is needed to make a real difference when measuring economic growth

Measuring the economy can be a bit like estimating the length of the proverbial piece of string.  Even pinning down what to measure before taking out your tape measure is tricky.  What is measured takes on even more importance when it is tied into government policy which aims to make us all better off.  This is a sobering thought at a time when improvements according to the traditional yardstick of GDP often fail to make a difference to the lives of many of us.  Changing what is used as a gauge for economic improvement can have significant consequences for the outcome of economic policy.

Being strung along by GDP

Rising inequality is a hot topic among economists at the moment.  Data shows that the wealth of the rich has increased considerably faster than for the less well-off over the past few decades.  Much of this can be attributed to the forces of globalization - a shortage of

skilled workers in the global marketplace has pushed up their pay while the opening up of countries such as China has resulted in a glut of low-skilled workers which has depressed their wages.  Technology has also added to this trend with computers reducing the clerical and administration work that had been a source of jobs for middle class workers.

Some see inequality as a necessary part of a capitalist economy with industrious people earning more due to their own hard work.  Others point to the social costs of inequality such as higher crime and more health problems and call for more policies to stem this trend.  The lack of advances in the earning power of a large portion of the population will inevitably have serious political consequences such as the rise of populist movements or a growing mistrust of capitalism among young people.  The issue is all the more urgent as it comes at a time when Western countries are struggling to maintain their place at the top of the global pecking order.

The combination of austerity measures and loose monetary policy in most countries is not doing much to address this issue and may be making the situation worse.  Cuts to government spending disproportionately hurt the less well-off while the wealthy have benefitted as quantitative easing has driven up stock prices.  These policies are based on the premise that creating growth in the overall economy will benefit us all.  But the data shows that, for example, while GDP in the UK is expected to reach its previous 2008 high this year, it will take a few more years for average earnings to recover lost ground. 

A different piece of string

The overall size of the economy is becoming increasingly difficult to measure.  So it might be better to focus more on the bit that matters most to people – what they earn and can spend.  Using median (real) earnings as a gauge of the economy would mean that economic growth would be more tangible for more people.  It is also a more simplistic measure which would require less manipulation although it would require some adjustments (to take into account changes in what we spend our money on and whether those goods change in price).

It would be a simple alteration that would have major implications for economic policy.  The welfare of normal people would be the central focus with other related issues such as unemployment also taking on greater importance.  Yet, this would not be a license for wages to rise inexorably as businesses would suffer and any artificially manufactured gains would only be temporary.  On the other hand, measures to help companies, such as lower corporate taxes, would also need to have a positive effect on wages. 

Increasing the median wage would have a more profound effect on the health of the economy and would involve more than simply boosting spending through an increase in debt.  Making progress on this goal would require more long-term policies such as investment in education and reskilling workers in declining sectors.  Lifting earnings would be hard work but the positive results would be genuinely worth the effort.

Banking – Let Financing Flourish

Banks have had to prune back their lending but other forms of finance have found space to blossom

Spring is in the air as a dark winter for the banking sector has allowed new forms of financing to take root.  A range of financing options has sprung up to service businesses left out in the cold by banks.  This is more than just a temporary reprieve from the current dearth of funds from banks.  It could instead be part of a bigger shift whereby banks are no longer the main source of lending.  This development appears to be a good thing for the economy but the full ramifications will only become clear with time.

Diversification in financing

Banks had long been the big trees in the financial jungle.  Their network of branches spread far and wide and claimed the bulk of the chances to provide funds to the economy.  Few opportunities filtered through to other forms of funding, which remained small in comparison.  The global financial crisis has opened up the possibility of change with banks having been poisoned by toxic debt.  Access to credit all but withered away after the crisis cut down a few banks and clipped many others.

The problems in the banking sector are mostly self-inflicted.  There is a glut of cash available for loans but banks are too concerned with their own survival to be in a position to facilitate lending.  A range of companies have sprouted up between the cracks to provide the funding needed to nourish the economy.  These new firms have been labelled as the shadow banking sector and tap into money from a range of sources such as pension funds and businesses outside of the finance sector, as well as from people like you and me through peer-to-peer lending sites. 

The diversity of routes for lending solves one of the problems with the banking sector.  Deposits were not enough to provide banks with all the money that was needed in the lead up to the global financial crisis.  Instead, banks sucked up funds from the money markets where it was possible to borrow for a few months.  This is not an issue when funds flow freely but the money dried up when the crisis struck.  On the other hand, the money being put to use by the new firms comes via an assortment of different arrangements and many, such as pension funds, are willing to offer up cash for longer periods.

When more is better

The growth of the many new sources of financing seems to be positive.  As in nature, higher levels of biodiversity help to build a more robust funding ecosystem.  Such funding operations are still just saplings.  Yet, there is the potential for a future forest of financing options.  Some parts of the new setup may even grow to rival the lending capabilities of banks.  This has only come about through the irony of banks jeopardising their long-term prospects and opening up opportunities for others due to their need to lend less to ensure short-term survival.

There is a further benefit in that any shrinking of banking operations should be beneficial over the long term.  This is because the current rules for banking mean that banks have too much scope to get themselves into trouble.  Not all is rosy however, with some of the new firms facing criticism from the public despite seemingly meeting a genuine need (such as Wonga).  The new range of financing options may also include potential problems lurking under the surface.  But this could be somewhat accommodated by central banks and other regulators broadening their oversight. 

The flowering of new funding options may be one of the few bright spots in the aftermath of the global financial crisis and could help to ensure that the economy won’t have to go through a drought in finance again.