Interest Rate Hike – not expecting the worst

People tend to fear the worst but higher interest rates may not mean interest rates that are actually that high

Some things that people normally dread as not so bad in reality – such may be the outcome with the upcoming hikes in interest rates.  Interest rates are set to levels which relate to the strength of the underlying economy (as reflected in the level of inflation).  But the pressure to push up interest rates is likely to be limited considering that the long-term prospects for the economy are a bit grim.  On top of this, there is a growing range of policy tools that central banks can use instead of interest rates to manage the economy.  So when higher interest rates do come, like a visit from the in-laws, it may not be as painful as had been expected.

Inflation not so scary

One of the main jobs of central banks is to set interest rates so as to keep inflation low.  This is because inflation in itself is seen as having a negative influence as well as being a sign that an economy might be overheating.  Inflation comes about as firms increase prices typically when their costs are rising or when demand is strong.  Yet, neither is the case at the moment.  Stagnating wages, which is the largest expense for many firms, mean that higher costs are not likely to translate into higher prices. Sluggish consumer spending is prompting some firms to cut prices so as not to lose customers.

This is more than just the result of a sluggish economic recovery as shown by growing concerns about the long-term prospects for the economy.  Investment by businesses continues to remain weak despite record low interest rates.  The expanding operations of companies would help to fuel gains in productivity which further feed into higher wages.  But, with firms not wanting to spend and consumers not likely to get their hands on much extra cash, economic activity is expected to remain subdued.  Austerity measures are a further damper on the economy as governments rush to sort out their finances.

The most glaring reason to not expect any trouble from inflation is prices have barely budged despite everything that has happened over the past decade.  Inflation has remained subdued (mostly 5% or (much) lower) despite a surge in bank lending in the lead up to the crisis or central banks printing billions in new cash in more recent times.  The only time inflation popped up on the radar of policy makers during the depth of economic recession in 2011 due to high commodity prices (more on that later).

This time is different

Not only is inflation expected to remain low but influences over monetary policy are also likely to act to keep interest rates low.  For starters, the potential for a slower pace of economic growth will make it difficult to justify central banks raising interest rates.  Calls for a hike to interest rates at the Bank of England (which is likely to go first among the larger central banks) may be premature considering low inflation and the stuttering economic recovery. 

Monetary policy is also developing so that central banks have more options available to them to deal with inflation and other negative aspects of a buoyant economy.  The most promising of these are macroprudential measures such as caps on mortgage lending and other controls on banks.  These will enable central banks to rein in overheating parts of the economy without having to increase interest rates.

There have also been changes to inflation itself.  As mentioned above, any inflation recently has tended to come from outside sources such as commodity prices rising in global markets in line with growing demand in emerging markets.  Higher interest rates can only have an effect when a rise in prices is due to factors within the economy itself.  So if inflation is due to external causes, central banks will likely hold off increasing interest rates.

Hope for the best

So, there is likely to be no rush to increase interest rates, and when the inevitable does happen, interest rates are not actually going to rise by that much.  This is welcome news for places where buoyant property prices have push new home owners to take on large mortgages relative to their income.  Higher interest rates still have the potential to stall an economic recovery that is still fragile.  But if central banks wait for the right timing, the eventual interest rate hikes may be like going to the dentist expecting to have some teeth pulled but instead just getting a clean and a lollipop.  

Economic Recovery - Downgraded

Amid talk of economic recovery, we may not get back to living the life we had in the past

Being downgrading can be tough – no one likes having to get by with less – but this is what we might have to put up with regard to the economy.  Life was much easier around a decade ago when we were enjoying the perks of strong and steady economic growth.  But the upgrade was likely temporary when considering that it was funded with a borrowing binge that was unsustainable.  With wages likely to continue to stagnate for years to come, we may not have it so good again for a long time.

Anything but first class

Gains in wages are typically the main route to the good life for most of us.  Bigger pay packets at the each of the month give us more money to spend.  This money goes back into the economy to create a virtuous cycle helping create a healthy economy so that wages to rise again in the future.  The main avenue through which wages rise is higher output per worker.  This involves people being put to more productive use whether through raising their levels of skills, working together with machines or computers, or doing business in a better way.  The economy usually operates to ensure that this happens automatically as businesses, which want to maximized their profits, will try and make the most of their staff. 

Yet, the past few years, if not the past few decades, have shown us that the tendency for higher wages is not something that we can take for granted.  This is because the two forces of globalization and technology have made life tougher for many people in richer countries.  The sectors of the economy which typically supported the middle class with stable and steady jobs have been eroded.  Jobs such as those in manufacturing along with clerical work have been either moved to countries where labour is cheap or increasingly carried out by machines or computers. 

This has led to a polarization of the work force between high and low skilled areas with a shrinking middle ground.  At one end of the spectrum are bankers, IT experts, and professionals whose knowledge and training ensure a high level of pay.  The rest of the workforce is left with menial jobs such as taxi drivers, shop assistants, and delivery personal only because these are jobs that can’t be shipped overseas.  On top of this, austerity measures in many countries also mean that public sector workers are also suffering.

No route out

With many of us now competing with machines or overseas workers, our bargaining has been considerably diminished.  So while wages rises is a perk that many are missing out on, profits for many businesses have never been higher.  Profitable firms could be the agents of economic growth by expanding their operations and investing in more equipment.  Yet, with weak wages crimping consumer spending, most companies prefer to hoard their cash until the economic recovery is more robust.   What seems like a common sense strategy for each firm has added up to a prolonged slump for the economy as a whole.

The government could step into the breach and provide the investment in worker training or infrastructure to boost productivity.  Yet, the infiltration of pro-market economic theory has pushed the government to the sidelines of the economy.  Even the wealth that had been created in the boom years before the crisis was only benefiting a small portion of the economy.  One example is the finance sector that was creating wealth that mostly went to those working in finance rather to the economy as a whole.  Building a road or new schools creates benefits now and in the future while repackaging of loans only generates money for a lucky few working in banking.

Stuck with a second class economy

Workers have been battling with the consequences of globalization and technology for decades but could rely on debt in the past to enjoy some of the high life.  But like an ever expanding credit card balance, this spending spree was never built to last.  To make things worse, even politicians got involved.  The US government with Bush junior in charge slashed tax rates while the Labour government spent lavishly on the UK public sector around the turn of the century. 

Government finances had been boosted by economic growth fuelled by debt but this was a luxury that would prove fleeting.  Now government is like the rest of us in having to cut back.  Without many goodies going around, voters are likely to become increasing tetchy.  Politics is also getting ugly with constructive policy making likely to go out the window.  Low interest rates and more debt have been offered up as a way out but this creates even more problems in the absence of economic growth.

Something special will be needed to get both consumers and businesses to hope for something better.  Yet, the grim realities of life mean that this may not happen anything soon.  Like being in a long haul flight in economy class, we might be stuck here for a while.  

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.

Economists crash but don’t burn

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

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

Set for a fall

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

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

No so clever after all

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

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

Skipping over the lesson of the tale

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

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

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)

Time to rethink the role of Government

While their reputation has suffered at the hands of economists, it is time for governments to show that they have wised up

It must be tough being repeatedly told that you are stupid but that is what governments have had to put up with.  Mainstream economic theory tells us that markets know best and clumsy governments only get in the way.  But the global financial crisis has highlighted that financial markets are not smart enough to be left to their own devises.  This is just one of several areas where it would be wiser to bring back government as a power for good.

The Invisible Hand was always seen the clever one

Economists like to think that markets are the smartest thing around.  Markets refer to not just places where anything from sausages to shares are sold, but also to the economic system where numerous companies compete to offer goods or services.   The clever thing about markets is that prices and output can change to reflect demand from consumers and this helps to determine the best allocation in an economy.  The best bit is that this optimal outcome is not based on decisions made in one controlling body but market information gleaned from the individual decisions of consumers and firms. 

This belief stems all the way back to the father of economics, Adam Smith, who argued over three centuries ago that the private actions of individuals in the market would work for the public benefit.  Governments, on the other hand, are seen as more of a heavy hand in the economy.  Governments get in the way by creating red tape that strangles business and misallocating resources by dishing money out to favourite sectors.  Examples of misspent money abound as do unworthy recipients of taxpayer cash.  

Yet, all economists would also agree that some government actions are needed for markets to function properly.  Basics such as national defence and policing are essential for any business to operate and can only be provided by governments.  Companies also rely on a supply of workers with some degree of education as well as communication and transport infrastructure.  So while some level of government intervention is necessary, the extent to this is something that is defined by politics.   

The trend started by Thatcher and Regan has been for an increasingly shrinking role for government in the economy.  Economic theory was enlisted to make the case for smaller government which came as a backlash against decades of expanding government.  Much of the initial cases for privatizations and deregulation were justified due to numerous areas where government had overextended itself.  Yet, faith in markets and distrust of government has become so embedded in politics that cases where more government might be good are dismissed.  Governments are so timid in their actions that much of policy to do with the economic recovery has been outsourced to central banks (which creates its own problems).

Who looks stupid now?

Government policy does not always work out as hoped.  But bureaucrats are not alone in making mistake – just think of Enron or BP.  Yet, the most obvious example of where government involvement has been missed is the finance sector.  Deregulation over the past few decades let loose forces that even the banks themselves were not smart enough to understand.  Banks messed up in terms of the seemingly common sense notion of putting long-term survival ahead of short-term profits.  

More proactive government policy would have gone a long way to preventing many elements of the crisis and is something that we should apply now with the benefit of hindsight.  But the notion that more government is good can also be applied elsewhere.  Transport infrastructure has been neglected amid the trend for smaller government while other areas such as R&D and training for workers could do with more government input.  Governments which are not willing to take an active role in the economy leave voters feeling frustrated and opens the way for the rise of populist parties.

This is not an argument to re-establish government dominance over the economy.  A bigger government need not involve significantly higher taxes and large welfare payments.  But, there are parts of the economy where action is needed to ensure the public good and only government can respond to this.  While politicians on the right need to be more accepting of the positive effects of government, it is up to left-wing parties to make a better case about the good that government can achieve.  It is time that we were all smarter in the way they think about government.  

Central Bank – Emperor's New Clothes

With the myth of its power having been shattered, central banks need to get nasty to win back respect

Central banks are looking a bit naked as if stripped of their power.  Previously, central bankers such as Alan Greenspan were held in awe and ruled over the hearts and minds of investors.  This position of power stemmed from the perceived ability to soothe the fire-breathing financial markets.  Yet, the global financial crisis and its aftermath have shown this to be but a myth.  Part of the problem was that central banks wanted to be liked and keep investors onside.  With its generosity proving its downfall, the naked emperor may need to stop being so nice.

Pretenders to the throne

This fall from grace has happened swiftly.  The powers of central banks reached their peak just before the crisis hit.  Quick to blow their own trumpet, economists talked of a “Great Moderation” – a prolonged period of steady and stable economic growth coupled with low inflation.   Central banks had also shown themselves willing to step in during moments of strife and prop up the stock market.  This won them a strong following among investors who could be sure that central banks would send in the cavalry if there was trouble. 

The proverbial crown slipped and fell dramatically with the global financial crisis.  Not only were central banks proved to be not suitable guardians of the economy but their capacity to rally at times of trouble was limited.  Low interest rates and quantitative easing offered little respite from the plague eating away at the economy.  The potency of central bank policy has been eroded as its primary source of power, the ability to print money, does not mean much in a world awash with money.

The problem was exacerbated by central banks not having the freedom to act as their almighty reputation might suggest.  Part of this was due to internal restraints such as a chronic (but misplaced) fear of inflation.  Such worries about rising prices keep central banks from unleashing their full firepower when faced with crisis.  In addition to this, politics also often acts to stifle central banks.  Germans’ heightened aversion to inflation has kept the European Central Bank from doing more.  The Federal Reserve has also had to be mindful that its actions did not draw ire from Republicans who are typically hostile to any government intervention. 

Cursed by hubris

It also became obvious with hindsight that central banks may have built their dominance on a dubious myth.  The “Great Moderation” may have just resulted from good luck rather than good management.  It is easy to keep inflation down when cheap goods are flooding in from China while money was cheap as China was sending a considerable portion of its earnings as reserves and sending it back to the US.  Yet, the misplaced belief in the rule of central banks over the economy lead to ignorance of risks that central banks thought they had slayed. 

Central banks were happy to live off this aura while also being generous in its dealing with investors.  Yet, this kindness turned out to have a cruel twist with the support shown by central banks to financial markets sowing the seeds of crisis.  Although lauded at the time, the reign of Alan Greenspan has instead been shown to be like a king trying too hard to please his subjects.  Over this period, the Federal Reserve kept interest rates too low while investors made merry amid a booming stock market.   

Better to be feared than loved

The unruly nature of financial markets coupled with the flood of cash sloshing around in global finance means that a guiding hand is needed more than ever.  Having been knocked from their high towers, central banks have to restore some assembly of order in a world where the pull of its ability to print cash is diminished.  It may be best to follow the words of Machiavelli, a renaissance philosopher who theorised on power struggles in Medieval Italy, in that it is better to be feared than loved. 

In this vein, if it was a need-to-be-loved that got central banks, and the rest of us, into trouble, it might be time to get nasty.  Taking a harsh line against any potential distortions in the economy (using macroprudential policies) would win more respect than being too friendly.  To rule with a firmer fist seems a better fit at a time when the consequences of financial excesses are so pertinent.  This would help to usher in a more peaceful period if combined with greater regulation to keep the banking sector from getting out of hand.  More stability may even get investors to appreciate the value of tough love.