Transcript Why has the UK recovery been so weak in recent years

Why has the UK recovery been so weak in recent
years?
http://www.theguardian.com/business/2014/jan/21/imf-world-economic-recoveryoutlook-weo
How is the unemployment rate measured?
The unemployed are those people able, available and willing to work at the going wage but
cannot find a job despite an active search for work.
1. The Claimant Count measure includes unemployed people who are eligible to claim the Job
Seeker's Allowance (JSA). The data is seasonally adjusted to take into account predictable
seasonal changes in the demand for labour such as seasonal jobs in tourism, retailing,
building and farming.
2. The Labour Force Survey counts those who are without any kind of job including part time
work but who have looked for work in the past month and are able to start work
immediately. The figure includes those people who have found a job and are waiting to
start in the next two weeks. On average, the Labour Force Survey measure has exceeded
the Claimant Count by about 500,000 in recent years – equivalent to 2.5% of the labour
force. Because the LFS measure is a survey - albeit a large one -there will always be a
sampling error in the data
http://www.economicshelp.org/macroeconomics/unemplo
yment/measuring_unemployment/
Why is the unemployment rate usually a lagging indicator of an economic recovery?
1. Reluctance to hire: Businesses may be reluctant to hire extra workers unless they are
confident that the recovery will be sufficiently strong and sustained
2. Plenty of spare capacity: After a recession, there is plenty of spare capacity, so extra output
can be supplied by using existing workers and capital inputs more intensively – for example
by offering the existing workforce more hours of overtime.
3. Costs of hiring and training: There are extra costs in hiring and training workers, some
businesses find it a struggle to fund the expense of taking more people onto their payroll
4. Weak demand growth: If the growth of demand / output is less than the gains in output per
worker then more output can be supplied with less instead of more people. E.g. output might
rise by 2% but output per person employed could grow by 4%.
This is one of the most important policy issues facing not only the UK
government but policy-makers in many other countries. After rising
sharply over the course of the recession, the youth unemployment rate
(for people under the age of 25) in the EU 27 reached 23.2 per cent of
the labour force in 2013. In some countries it is more than double this.
Youth unemployment rates varied from 7.7 per cent in Germany to
59.2 per cent in Greece in the summer of 2013.
What factors help to explain why youth
unemployment is so high in the UK economy?
http://www.ibtimes.co.uk/bcc-urges-uk-chancellorgeorge-osborne-tackle-youth-unemployment-debt-ukeconomic-recovery-1439569
What factors help to explain why youth unemployment is so high in the UK economy?
1. Limited experience: Most younger workers have limited experience in the labour market,
employers may be reluctant to hire them when older people with direct experience are in
competition
2. Human Capital (skills) Deficit – many thousands of younger people leave school and college
without the necessary basic qualifications and functional literacy needed to find work.
3. Reduced retirement rates limit chances – lower interest rates on savings and reduced
pension incomes are causing many older workers to postpone their retirement
4. Weakness of existing training schemes – with low success rates for getting new labour
market entrants into meaningful and sustained employment.
5. Limited availability of training – even when good schemes exist, young people find that
there are too few opportunities to gain quality work experience.
Analyse some of the consequences of a persistently high rate of youth unemployment
1. Social costs: Crime, Vandalism
2. Lifelong effects on future wages and earnings. It also changes the rewards from investing
time and money in taking A-levels or a degree.
3. Loss of income: a decline in their real living standards and are worse off out of work.
4. Loss of potential national output and a waste of scarce labour resources
5. Young people who cannot find a job may lose the motivation to search for work, this can
have a negative effect on long- run aggregate supply and damage the economy’s growth
potential. This is called a “hysteresis effect”.
6. Outward migration (emigration): When unemployment is persistently high and employment
rates are falling, many people may move country in search of work leading to a decline in
the active labour supply. The numbers of 20-29 year-olds in Ireland fell by 8.8% 2012, as well
as by 4.3% in Spain and by 3.5% in Portugal, as young people emigrated in search of work
elsewhere
7. Persistently high youth unemployment is creating disaffection, social and political tensions
and risks undermining support for democratic systems.
Which policies might be effective in reducing the rate of youth unemployment?
There are many policy options – some focus on short term measures to increase the demand for
younger workers. Others seek to tackle structural supply-side weaknesses and failures in the
labour market:
1. Improving the quality of compulsory education and more effective career guidance for
students
2. Interventions to prevent early departure from schools and colleges
3. Increasing the vocational skills of disadvantaged children through training subsidies
4. Increase the number of long-term apprenticeships for the under -25s and pay participants a
training wage to improve their motivation and incentives
5. Cut the national insurance contributions paid by employers when they take on extra younger
workers – this is effectively a wage subsidy
6. Policies to stimulate direct job creation such as infrastructure projects
7. Encouraging business start-ups among young people and also an expansion of social
enterprises working at local level who can offer jobs and work experience
What has happened to UK unemployment in the current recovery phase?
• The data suggests that total employment has recovered since the end of the recession and
that unemployment has not climbed to the heights seen in past recessions. There is also some
evidence that the unemployment rate is less of a lagging indicator of the economic cycle than in
the past.
• One reason why the rate of monthly job losses or redundancies has fallen could be that low
interest rates have reduced the number of business failures. Some commentators have
discussed the existence of “zombie companies” kept afloat by a number of years of cheaper
borrowing costs and who normally have been expected to go under during a recession.
• However - UK unemployment on the LFS measure is still almost 1 million higher than before
the financial crisis and economic output has yet to return to its pre-recession level. The
employment rate has improved but again it remains well below pre-2007 levels.
• One consequence of weak GDP growth but rising employment is that labour productivity has
fallen.
• The number of people working part time because they are unable to find a full-time job has
also increased – this gives rise to the concept of under-employment and suggests that the
official unemployment figures often hide some important effects of a deep recession and slow
recovery.
What factors might speed up the pace of recovery in the UK economy?
1. Strong economic growth in trading partner countries especially the Euro area
2. A recovery in business and consumer optimism feeding through to higher planned spending
3. The effects of the “replacement cycle” i.e. many consumers may have put off buying a new
car or a washing machine for a few years during the recession, but feel that they must now
start replacing their appliances. Businesses likewise might now regard replacing capital as a
priority
4. A stronger than expected rise in house prices bringing about a rise in household wealth
5. Signs that the commercial banking system is expanding the supply of new credit to those
wanting loans including small-to-medium sized businesses
6. An increase in UK export sales if the economy can achieve competitiveness gains such as a
fall in relative unit labour costs
7. Changes to the coalition’s fiscal austerity programme – e.g. lower consumer and business
taxes, slowing down the pace of fiscal deficit reduction
8. The multiplier effects of an increase in infrastructure spending by the private and public
sector –there are plenty of projects to consider including HS2, the London Gateway project
and Cross Rail
http://www.lse.co.uk/FinanceNews.asp?code=d2f75za9&headline=BoEs_Carney_sa
ys_UK_economys_spare_capacity_may_be_more_than_15_pct
Why might productive capacity remain idle? How can this be measured?
Economic growth is the continuous improvement in the productive capacity to satisfy the
demand for goods and services, resulting from increased production scale, and improved
productivity (innovations in products and processes).
Productivity capacity is determined by the supply-side potential of an economy. This is
determined by:
•
•
•
•
The quantity of factor inputs available
Changes in total factor productivity e.g. of labour and capital
Changes to the state of technology
Business formation, improvements in the management of factor resources
Estimates are calculated by the OECD each year for the trend rate of growth of real GDP – this
is perhaps the best measure of year-on-year changes in productive capacity. These estimates
are shown in the next chart:
How is the output gap measured? Why might it remain sizeable for an extended period?
• The output gap tells us how close current output (GDP) is to long-term potential output.
• A negative output gap is when actual GDP is less than potential GDP. Some factor resources
such as labour and capital machinery are under-utilized; the main problem is likely to be higher
unemployment. More people out of work indicate an excess supply of labour, which causes
downward pressure on real wage rates.
• A positive output gap is when actual GDP is greater than potential GDP. Some resources
including labour are likely to be working beyond their normal capacity e.g. making extra use of
shift work and overtime. The main problem is likely to be an acceleration of consumer price
inflation.
http://www.youtube.com/watch?v=jXZQw51UiHc
What are the problems in estimating the size of the output gap?
The output gap is the difference between actual and potential GDP. Potential output is the
maximum amount of goods and services an economy can turn out when it is most efficient—
that is, at full capacity. But it is difficult to get precise measures of both actual GDP and
productive capacity:
1. Actual GDP might be under-recording income, spending and output – for example, the size
of the shadow economy linked to non-payment of taxes, and the value of output of goods
and services that don’t have a precise market value.
2. The level of potential output and, hence, the output gap cannot be observed directly.
3. The trend growth of output depends in part on how many years’ worth of data is used in the
calculation. Statisticians claim that estimating the trend in a series of data such as GDP is
especially difficult near the end of a sample – just at the time when the value of the
estimated output gap is of most interest to policy-makers.
4. One way of measuring the amount of spare capacity in the economy is to use producer
surveys. These surveys ask questions about skilled labour shortages and other factors that
might be limiting production. But there is inevitably sampling error and firms may interpret
questions differently.
5. The underlying structural relationships in the economy often change over time. Some
industries might be in decline (heavy manufacturing for example) whilst others are rising fast
(creative services, cloud computing, additive manufacturing) – but the official data on GDP
by value added of output might be failing to pick these changes up accurately.
Thus it is hard for the Bank of England and others to get a precise measure for the output gap –
the extent to which they rely on survey evidence and can have a big bearing on interest rate
decisions.
Other measures of capacity pressure in the
economy include:
• Total employment
• Surveys of capacity utilization
• Surveys of labour shortages
• Data on average hours worked and average
hourly earnings
What is meant by hysteresis? What are some of the main causes of hysteresis?
• The dictionary definition of hysteresis is “the lagging of an effect behind its cause.” In
mainstream macroeconomics it has become common to explain hysteresis as a tough problem
caused by a deep recession and persistently high unemployment.
• For example, a long-term unemployed worker loses skills and motivation and so finds it hard
to re-enter the labour force. Indeed, some “discouraged workers” may leave the labour market
and become economically inactive.
• In the autumn of 2013, 8.9 million people of working age was either not looking for work or
not available for work – these are the economically inactive – and this accounts for over a fifth
of the population of working age in the United Kingdom.
Hysteresis can also be caused by:
1. Businesses failing / closing down leaving depressed areas and regions
2. Other businesses making deep cuts in investment to a level insufficient to replace worn out
plant and machinery
3. Commercial banks that lose money in a recession and become strict with their lending to
businesses and households – leading to a significant contraction in loan finance for the business
sector
4. A deep recession can cause lower tax revenues which might then result in less investment in
and maintenance of key public services and a fall in the quality of a nation’s infrastructure
Why might hysteresis be a result of sustained cyclical weakness?
1. When demand and output remain weak – largely because of low private sector spending –
businesses are left with spare capacity and planned investment remains weak
2. If capital investment slumps. It may fall below the rate needed simply to replace obsolete
machinery – the average age of the remaining capital stock will rise
3. Out-dated machinery and long term unemployment hurts a country’s global
competitiveness affecting export performance and the overall balance of trade.
http://blog-imfdirect.imf.org/2012/07/19/mind-the-gap-policies-to-jump-start-growth-in-theu-k/
Assess the possible consequences of hysteresis effects on the UK economy.
An ageing capital stock will hit labour productivity and global competitiveness:
• Persistently high unemployment contributes to a flat economic recovery – in December 2012,
UK output per capita remained 14 % below its pre-crisis trend and 6 percent below its pre-crisis
level
• Hysteresis effects in the labour market (linked to long term structural unemployment) will be
a drain on government finances (more welfare claims and less tax revenue)
• There is the risk of human capital flight – for example a brain drain of younger (often skilled)
workers who move country in search of better employment opportunities
• The loss of talented workers who cannot find employment in hysteresis-affected countries can
hamper the pace of research and innovation, a country can become less dynamically efficient
• Hysteresis reduces an economy’s productive capacity and permanently depresses potential
GDP
• If hysteresis contributes to higher unemployment and lower productivity it can cause an
increase in the non-accelerating inflation rate of unemployment (NAIRU) making it harder to
achieve price stability at a socially acceptable rate of unemployment
Identify some of the factors causing a downward trend in inflation since 2011
Inflation is caused by demand-pull and cost-push factors together with the effects of
administered prices and changes in inflation expectations. Having peaked at over 5% in the
autumn of 2011, consumer prices inflation (CPI) has been falling since and has been dropping
back towards the central 2% target. In December 2013, inflation in the UK was 2.1%.
Reasons :
1. Lower fuel prices as world crude oil prices have dipped – there has been a significant
slowdown in economic growth in many of the faster-growing emerging market economies
2. Continue weak growth of wages / average earnings – at a rate well below inflation
3. An appreciation in the sterling exchange rate – making import prices cheaper
4. A fall in the world prices of many commodities – for example – global wheat prices dropped
43% in the year 2013 and rubber prices have halved from mid-2011 through to the end of
2013
5. The continued large negative output gap means that the economy is operating well below
capacity and there are few demand-pull inflationary pressures. Many businesses are
reluctant to raise their prices when consumer demand in particular remains weak. Energy
companies have appeared to be a notable exception to this!
http://www.bbc.co.uk/news/10612209
What is meant by an inflation target and why might a 2% inflation target be justified?
An inflation target is a set aim of monetary policy that seeks to keep inflation at a low positive
rate. The Bank of England has a CPI inflation target, which is currently 2 per cent.
The widely held view is that accelerating inflation can bring economic and social costs that are
harmful for macroeconomic performance and for society as a whole. Sum of these are
summarised below:
• Income redistribution: Higher inflation has a regressive effect on lower-income families and
older people in society. This happen when prices for food and domestic utilities such as water
and heating rises at a rapid rate.
• Falling real incomes: With millions of people facing a cut in their wages or at best a pay freeze,
rising inflation leads to a fall in real incomes.
• Negative real interest rates: If interest rates on savings accounts are lower than inflation,
people who rely on interest from their savings will be poorer. Real interest rates for millions of
savers have been negative for at least four years
• Cost of borrowing: High inflation may also lead to higher interest rates for businesses and
people needing loans and mortgages as financial markets protect themselves against rising
prices and increase the cost of borrowing on short and longer-term debt. There is also pressure
on the government to increase the value of the state pension and unemployment benefits and
other welfare payments as the cost of living climbs higher.
• Business competitiveness: If one country has a much higher rate of inflation than others for a
considerable period of time, this will make its exports less price competitive in world markets.
Eventually this may show through in reduced export orders, lower profits and fewer jobs, and
also in a worsening of a country’s trade balance. A fall in exports can trigger negative multiplier
and accelerator effects on national income and employment.
• Business uncertainty: High and volatile inflation is not good for business confidence partly
because they cannot be sure of what their costs and prices are likely to be. This uncertainty
might lead to a lower level of capital investment spending.
• Risks of wage inflation: High inflation can lead to an increase in pay claims as people look to
protect their real incomes. This can lead to a rise in unit labour costs and lower profits for
businesses
Having a positive inflation target of 2% seeks to lock in a degree of price stability for an
economy. There is an upper limit of 3% and a lower limit of 1% in part because persistent price
deflation can also be a problem.
http://www.nber.org/digest/apr98/w6126.html
Identify some of the set-backs that might happen in the Euro Area
1. The economy of the Euro area might slide back into another recession without having fully
recovered from the previous downturn – the recession that lasted eighteen months in the
single currency area was the deepest that Europe has suffered in over forty years.
2. Another sovereign debt crisis might engulf many of the highly indebted countries inside the
single currency area, especially those on the periphery of the area such as the PIIGS
(Portugal, Italy, Ireland, Greece and Spain).
3. Another banking crisis such as occurred in Cyprus might erupt damaging the confidence of
savers.
4. Another recession in the Euro area might bring about a period of price deflation which
would be hugely costly for countries, businesses and consumers with large unpaid debt.
http://money.cnn.com/2014/01/22/news/economy/europe-economy-risks/
Distinguish between trade and financial links
• Trade links are the trade flows in goods and services between the Euro area and other
countries including the UK:
o 10% of all of the imports coming into the Euro area are from the UK. 8.5% of Euro area
imports come from the USA and 12% from China. So an economic downturn in the Euro area
would hit exports from these countries and risk the economic recovery process in the UK
and USA in particular
o Over 50% of total UK merchandise trade in goods and services is with Euro area countries
• Financial links cover capital flows between the Euro area and the UK:
o Short term banking flows / foreign exchange trading
o Portfolio flows such as capital moving into and out of stock markets, property and bonds
o Direct capital flows such as major investment projects made by Euro area businesses in the
UK and vice versa
o The City of London remains the euro’s main financial centre - More than 40 per cent of
worldwide euro foreign-exchange is handled in London, a bigger share than the 18 countries
of the euro area combined
Distinguish between public and private sector debt
• Public sector debt is owed by central and local government and by public (state-owned)
corporations. The total level of accumulated public sector debt is also known as the
national debt. Debts owed by state-owned banks form part of the national debt.
• Private sector debt is owed by private businesses and households. Companies may
have borrowed to finance investment (corporate sector debt); households have loans for
example credit card debt and mortgages on properties.
• Financial debt is also part of the private sector – this is the outstanding (unpaid) debts
of banks and financial corporations - for example the level of bad debts on loans to
businesses and to the housing market.
Why is a high level of private sector debt a problem for the UK economy?
1. Debt acts as a constraint on future spending power. Millions of households in the UK are
saddled with many thousands of pounds of debt and the interest payments on this debt
reduces their effective disposable income.
2. Banks have a high level of debt and this restricts their willingness and ability to make fresh
loans to businesses and households who want to borrow.
3. The economy is at risk with such a strong debt-to-GDP ratio
a. If price deflation appeared, then falling prices and incomes would make the debt problem
even worse especially in real terms .
b. If and when nominal interest rates begin to increase then a large number of households –
especially mortgage payers are at risk and might struggle to make their repayments. This
could cause another recession in the housing market.
http://www.debtbombshell.com/
Analyse how “commodity price volatility also
remains a risk for both inflation and growth.”
1. Changes in food, metal and mineral prices affect the short run costs of many businesses – for
example food processors, car manufacturers, plastics companies and transportation industries.
This will lead to shifts in short-run aggregate supply (SRAS) and a change in the trade-off
between growth and inflation. A rise in commodity prices for example causes an inward shift of
SRAS, a rise in the general price level and a contraction in real national output (other factors
remaining equal)
2. The UK economy is a net importer of many commodities. So for example, an increase in the
international price of gas, rubber or coffee will cause our import bill to rise, worsening the
current account of the balance of payments. And this decline in net trade will have a
deflationary effect on aggregate demand.
3. Volatile prices for important commodities can also affect the incentives for exploration,
research, investment and eventual supply of substitute commodities e.g. the shift towards
renewable energy, lighter materials and alternatives to crude oil such as shale gas.
http://money.stackexchange.com/questions/9
293/why-are-the-prices-of-some-commoditiese-g-oil-more-volatile-than-others
Identify some of the economic policies used to “bolster demand”
1.
a.
b.
c.
d.
Expansionary monetary policy – including:
Ultra low nominal interest rates (0.5%)
Quantitative easing (QE) currently worth £375bn
A depreciation of the exchange rate
Measures to stimulate bank lending such as funding for lending
2. Fiscal policy measures
a. Cuts in corporation tax / specific tax incentives such as lower tax rates for shale gas
exploration and production
b. Increased spending on infrastructure
c. Incentives for bringing private sector money into government projects
How does quantitative easing work?
• When policy interest rates are at zero or close to zero, there is a limit to what
conventional use of monetary policy can do
• In March 2009 the BoE started quantitative easing for first time.
• The main aim of QE is to support aggregate demand and avoid a recession becoming a
deflationary depression
• The Bank of England uses QE to increase the supply of money in the banking system
and encourage them to lend more at cheaper interest rates
• The Bank does not print new £10, £20 and £50 notes instead it uses money created by
the central bank to buy government bonds .
http://www.youtube.com/watch?v=rcPEkmstDek
Has quantitative easing been effective in supporting an economic recovery?
• There are doubts about the effectiveness of quantitative easing – bank lending has
struggled to recover since the end of the recession. At the end of 2013, the QE
programme totalled £375bn
• One effect of quantitative easing has been to reduce the interest rate (or yield) on
long term government borrowing. Lower long term interest rates may have been helpful
for some businesses looking to fund major investment projects using new corporate
bond issues.
http://www.bbc.co.uk/news/business-24614016
To what extent are inflation expectations and nominal wage growth linked?
• Expectations of inflation are what people expect to happen to the rate of inflation in the
future.
• If inflationary expectations climb higher, then there might be a pick-up in pay claims so that
real wages are protected
To what extent does a low wage growth and stable inflation expectations allow a further
expansion of monetary policy?
•The annual growth of wages is one of the factors taken into account by the Monetary Policy
Committee at their monthly meetings to determine the policy interest rate.
•If wage inflation is at moderate levels then the Bank will be less worried about the risk of costpush inflation.
•Slow wage growth will also hold back the ability of households to spend money on goods and
services.
What is meant by a “balanced budget fiscal expansion?”
This concept has become a major topic of conversation in the debate over the
economic effects of fiscal austerity in many countries in the European Union and
beyond. Put simply, a balanced budget fiscal expansion occurs when a change in
government spending is matched by an equal change in taxation so that
there is a neutral effect on the annual fiscal deficit but with the hope that real
national income will expand. Central to the concept is that the fiscal multiplier effects
of say a £10bn rise in government spending are higher than the negative multiplier
effects of an equivalent £10bn rise in taxes.
http://www.economicshelp.org/blog/5634/ec
onomics/balanced-budget-fiscal-expansion/
What factors affect the size of the fiscal multiplier effect?
1. Design: i.e. the important choice between tax cuts or higher government spending. Evidence
from the OECD is that multiplier effects of increases in spending are higher than for tax cuts
or increased transfer payments.
2. Who gains from the stimulus? If tax reductions are targeted on the low paid, the chances are
greater that they will spend it and spend it on UK produced goods and services.
3. Financial Stress: Uncertainty about job prospects, future income and inflation levels might
make people save their tax cuts. On the other hand if consumers are finding it hard to get
fresh lines of credit, they may decide to consume a high percentage of the boost to their
disposable incomes
4. Temporary or permanent fiscal boost: Expectations of the future drive behaviour today ...
Most people now expect taxes to rise further in the coming years. Will this prompt a higher
household saving and a paring back of spending and private sector borrowing?
5. The availability of credit: If fiscal policy works in injecting fresh demand, we still need
the banking system to be able to offer sufficient credit to businesses who may need to
borrow to fund a rise in production (perhaps for export) and also investment in fixed
capital and extra stocks.
6. The response of monetary policy: The multiplier effects of a fiscal stimulus depend in
part on what happens to policy interest rates and the exchange rate (we cannot look
at fiscal and monetary policy in isolation!). Would a rise in government spending and
borrowing lead to higher interest rates? That might dampen the expansionary effects.
Or would the Monetary Policy Committee be prepared to keep nominal interest rates
low even if there were signs of stronger economic growth and recovery.
What is economic re-balancing?
Economic re-balancing describes changing the balance of demand, output and jobs in different
parts of the economy. For example – attempts to achieve:
1. Re-balancing away from consumption and imports towards exports and business investment
2. Re-balancing away from dependence on the housing market towards manufacturing industry
as a source of new economic wealth
3. Moving away from debt-fuelled consumer demand towards a higher level of private saving
including occupational pensions and other long-term savings schemes
4. Re-balancing away from dependence on financial services towards a greater role for
manufacturing and a range of emerging potentially fast-growth industries such as life
sciences and creative services
5. Improving the level of regional balance i.e. encouraging more investment and jobs in areas /
regions of the economy with persistently higher unemployment and lower incomes
6. Re-balancing the economy away from high levels of government spending, taxation and
borrowing towards a great share of national output and income flowing from the private sector
Policies to promote rebalancing
What is fiscal consolidation?
• Fiscal consolidation is a policy aimed at reducing annual government deficits and the
national debt accumulation. It is also known as fiscal austerity or a tightening of fiscal policy.
• The UK coalition government has a deficit-reduction policy with the emphasis on cutting
government spending in real terms and a series of tax increases.
Explain what is meant by a high structural deficit?
• A structural budget (fiscal deficit) is when the government has to borrow a large amount
each year even when the size of the deficit has been adjusted for the stage of the economic
(business) cycle.
• In a recession, tax revenues drop and state spending on items such as welfare rises, making
the deficit higher. The structural deficit adjusts for these effects.
Outline some of the key fiscal risks from a high budget deficit
When a county is running a high budget deficit some of the risks are that:
1. The Government may have to offer higher interest rates on the new debt that it issues. At the
moment, the annual yield or interest rate on ten year UK government bonds is around 3%.
2. This will increase the cost of servicing debt, which for the UK government amounted to over
£40bn in 2013. This interest burden has an opportunity cost for less spent on interest
payments could free up financial resources for extra spending on priority public services
such as health and education
3. A sizeable increase in the national debt (accumulated government borrowing) is likely to
cause higher taxes in the future. This will be a drain on economic growth in the medium
term because it will squeeze lower the disposable incomes of tax payers and leave less
money for private sector expansion. This gives rise to what is termed “crowding out effects.”
4. It might be considered unfair if the rising tax burden falls more heavily on future generations
of tax payers rather than people who benefit from government spending now.
What is meant by a bold monetary stimulus?
A bold monetary stimulus describes a combination of measures that together form an
expansionary monetary policy designed to stabilise confidence, demand and output in a
recession and debt-hit economy.
One of the features of the handling of monetary policy in many advanced countries (including
the USA and the UK) in response to the global finance crisis has been the willingness of central
banks to run loose monetary policies in a bid to prevent one or more economies falling into a
persistent deflationary slump.
Since 2008 in the UK we have seen:
1. Policy interest rates (set by the Bank of England) drop from 5.5% in 2007 to 0.5% in March
2009 –they have stayed at that rate ever since
2. The introduction of quantitative easing (QE) starting in the spring of 2009 and worth £375bn
(as of Jan 2014)
3. Special measures aimed at boosting the ability and willingness of the banking system to
finance investment for the business sector such as Project Merlin and the Funding for Lending
project
4. A significant depreciation in the external value of the pound / sterling – depreciation
represents a competitive boost for export sectors and for businesses in the UK that face
competition from imports for the spending of domestic consumers.
Analyse how a bold monetary stimulus can help support the economy
A bold monetary stimulus is designed to:
• Support business and consumer confidence
• Increase the effective disposable incomes of households with debts such as mortgages
• Increase demand for interest-sensitive products such as household appliances and new
vehicles
• Help to bring about a depreciation in the exchange rate as hot money flows are reduced
• Lower the cost of businesses borrowing money to fund their survival or investments
http://www.telegraph.co.uk/finance/comment
/jeremy-warner/10691038/Has-Britainsmonetary-policy-started-a-future-crisis.html
Why might a monetary stimulus have a limited effect on economic activity / recovery?
A number of reasons have been put forward to explain why cutting interest rates in the
aftermath of a credit crisis and deep recession may have a limited effect on economic activity
(broadly defined as a recovery in real GDP and an expansion of employment, profits and
investment).
1. The unwillingness of commercial banks to lend – most banks have become risk-averse and
they have cut the size of their loan books and making credit harder to obtain – this has been
notable for many small and medium sized businesses needing loan finance to fund their
expansion / investment
2. Low consumer confidence – people are less prepared to commit to major purchases such as
a new car or other household appliance because the recession has made people risk averse.
Weak expectations lower the effect of rate changes on consumer demand – i.e. there is a
low interest elasticity of demand.
3. Huge levels of private sector debt still need to be paid off including over £200bn on credit
cards. A report from the Money Advice Service published in 2013 found that nearly nine
million people across the UK are living with serious debt problems.
4. Falling or slow-rising asset prices make it unlikely that cheap mortgages will provide an
immediate boost to the housing market. Property prices in much of the UK have remained
fairly static until well into 2013 although London has seen very strong growth fuelled by
population increases and demand from overseas investors.
5. High loan costs for some borrowers - although official policy interest rates have been close
to zero since March 2009, the rate of interest charged on loans and overdrafts has actually
increased –indeed it is a fact of life that the cost of borrowing using credit cards and bank
loans is a high multiple of the policy rate. Much media attention has been focused on the
growth of the pay-day loan industry many of whose members charge interest rates on loans
well above 100% as an annual percentage rate.
6. The benefits of a weaker exchange rate have been dampened because of slow demand
growth in many of the UK’s major export markets including the ongoing economic crisis in
the Euro area.
Taken as a whole, when a monetary stimulus has a limited effect on economic activity / recovery
then conventional monetary policy can appear to be ineffective in lifting an economy out of a
deep recession.
This was recognised by John Maynard Keynes in his crucial work in developing an understanding
of how a collapse in private sector confidence and demand can bring about a state of almost
semi-permanent recession. He developed the idea of a liquidity trap.
The Effectiveness of Monetary Policy – The Keynesian Liquidity Trap:
• In normal circumstances it is possible to boost demand by cutting interest rates. But
there is a level below which interest rates cannot go and at that point monetary policy
may become powerless. Moreover, even if interest rates can be lowered this may have no
effect if people cannot or will not borrow. This is known as the liquidity trap.
• At this point, aggregate demand can only be boosted by the Government borrowing
more, either to spend directly or to give to others via tax cuts or the like.
• In other words, we need a targeted Keynesian fiscal stimulus. Keynesians believe that
the size of the fiscal multiplier effect is higher for government spending than for tax cuts.
What are the automatic fiscal stabilisers? Why do they matter?
Automatic stabilizers refer to how fiscal policy can influence the rate of GDP growth in the short
term and thus help to counter swings in the business cycle.
• During phases of high GDP growth, automatic stabilizers reduce the growth rate and avoid the
risks of an unsustainable boom and accelerating inflation. With higher growth, the government
will receive more direct and indirect tax revenues and there will be a fall in unemployment so
the government will spend less on unemployment and other welfare benefits. In some cases, a
government may actually run a budget surplus during a sustained boom which acts as a net
leakage of demand from the circular flow.
• In a recession, because of lower real incomes and a contraction in employment, people and
businesses pay less tax, and government spending on welfare benefits will increase. The result is
an automatic increase in government borrowing with the state sector injecting extra demand
into the circular flow.
Recent evidence from the OECD suggests that a government allowing the fiscal automatic
stabilizers to work through fully might reduce the volatility of the cycle by up to 20 per cent.
Analyse how infrastructure spending financed by temporary tax rises might cause an
expansion of real GDP for a country such as the UK
The British government recognises the importance of infrastructure spending and has
already published several National Infrastructure Plans with many £ billions of pounds
earmarked for projects although few have yet to get off the ground or reached completion.
Keep in mind too that for many of the projects mentioned below, the government is
seeking a combination of public and private investment money.
Examples of infrastructure investment include:
o 2nd Forth Road Bridge
o Argyll wind farm array
o Cross Rail
o High Speed Rail project
o London Gateway Port
o London’s new super sewer
o Nuclear power plants e.g. the proposed one
at Hinkley Point
http://www.ibtimes.co.uk/tfl-create-1000-jobs-1bnlondon-crossrail-bombardier-train-contract-1435306
The hope is the infrastructure spending creates strong multiplier effects leading to a
significant effect on real GDP, employment and incomes.
• Many projects can be relatively labour intensive such as road widening, housing
and environmental improvement schemes
• Supply-chain businesses will benefit from producing and selling the raw materials
and components needed to deliver big projects
• There ought to be an accelerator effect on planned investment e.g. an increased
demand for capital machinery such as earth-moving equipment
Well planned targets also have longer-run economic benefits:
1. Improvements in the capacity of our transport systems
2. Stronger energy security
3. Facilitates improved geographical mobility of labour
4. Better logistics and transport systems can – in the long run – help to reduce prices
for consumers
5. Greater resilience to the effects of volatile weather
6. Increased labour productivity from more efficient transport, telecommunications
and logistics
7. Infrastructure makes the economy more attractive to future flows of inward FDI
8. We need better infrastructure to cope with forecast population growth - the Office
for National Statistics forecasts that the UK population will grow to over 73 million
people by 2035.
What are the counter-arguments to the “balanced budget fiscal expansion” view?
Fiscal conservatives argue that strong action is needed to lower the deficit both in absolute
terms and also as a share of GDP. They argue that the economy will benefit in the medium term
if government finances are brought under control:
1. Lower borrowing means that the UK economy will retain a high credit rating and this will
mean lower interest rates on government debt and newly-issued corporate bonds.
2. Less interest paid on debt frees up more money to be reinvested in key public services such
as health or education.
3. Reducing the debt opens up the possibility of consumer and business tax cuts – a strategy
that free market economists support as a way of stimulating fresh growth in the private
sector.
4. Tighter control of government spending / a lower fiscal deficit makes it more likely that the
Bank of England will be able to keep policy interest rates lower, again helping the economy
to recover more strongly.
5. Some economists have claimed that economic growth tends to be lower on average among
countries with government debt/GDP ratios above 90%.