RedEaredRabbit Rises
05/01/2013 1 Comment
The Interest Rate Fallacy
08/12/2012 6 Comments
I wrote recently of The Debt Fallacy – the widely held belief that the financial crisis was caused by government debt. If you read it you’ll recall that it’s fairly easy to prove this as a fallacy because figures for government debt are easily available. Nevertheless it’s a myth that is widely believed because the government puts a lot of effort into propagating it in the knowledge that most people won’t actually check.
Another fallacy that the government often uses hand in hand with this is one regarding interest rates. It goes something like this:
Interest rates on UK debt are low because the markets have built confidence in the UK’s economy because of the austerity measures. If the government were to increase public spending, the markets would lose this confidence resulting in the UK losing its AAA credit rating and interest rates on our debt soaring.
This, ladies and gentlemen, is the Interest Rate Fallacy – the widely held belief that interest rates are low because of the market’s confidence in our economy. To show why this is a fallacy is a little harder than it was with The Debt Fallacy because I can’t just download a graph from the IMF website. So before reading on you might want to get a cup of tea and an exciting type of biscuit, such as a Jammy Dodger.
All settled? Then let’s get started. Before we tackle the fallacy we need to look briefly at what government debt is and why people buy it at all.
How does the government borrow money?
The government borrows money by issuing bonds. A bond is essentially an IOU, which anyone can buy. It will say something like, “I will borrow £100 from you for 10 years and at the end of the 10 years I’ll pay you back your £100. As compensation for you not having access to your cash for 10 years, I will additionally pay you interest at an annual rate of 5% for those ten years.”
Why does someone lend money to the government?
Imagine that I have £100 in cash. I could keep the £100 as cash or use it to buy a bond. Cash is good because I can do useful things with it like buy stuff. However, I need to think about my future and if I want to save money for later rather than spend it now then I would be better off buying a bond because I get paid interest as compensation for me not having access to my money. If I want to spend now then cash is good. If I want to save now then bonds are good.
What determines the interest rate on my bond?
The interest rate on a bond is determined by the rate that savers are willing to accept in compensation for not having access to their cash for the period of the bond. So if I want to invest my £100 for 10 years what are the factors that will influence the rate I am prepared to accept?
Probability of default
If I tie up my money with someone for 10 years then it’s quite important to me that they don’t go bust during that time because if they do I will lose my money. If I am lending to someone risky I might decide to ask for a higher rate of interest in order to compensate me for the risk that they might not be able to repay me.
Demand for bonds vs Demand for cash
If I want to save money and everyone else wants to spend money then I can probably get a high rate on my investment. If there are few savers and lots of spenders in the market (i.e. the demand for bonds is low and the demand for cash is high) then the government will need to offer better rates to attract investors. Conversely if there are lots of people who want to save money and few who want to spend, the government can offer much lower rates knowing that there are still lots of people who will invest anyway.
Expected future short-term interest rates
That’s a mouth full isn’t it?
Short-term rates are set (in the UK) by the Bank of England. These rates determine the rate I can get for investing money for a short period of time.
If I am going to invest for a longer period of time, my expectation of what the Bank of England will do with short-term rates in the future is important. This is all sounding a bit wonkish so I’m going to explain with an example. Imagine the following scenario:
- I live in a country where the government offers two different types of bond
- One lasts for one year
- The other lasts for 10 years
- I have £100 that I would like to invest for ten years
I have a choice:
- Invest my money once in the 10 year bond
- Invest my money ten times (once every year) in one year bonds
If I choose the first option then my money is tied up for ten years at the pre-agreed rate of interest. If I choose the second option then every year when I invest my money again I get whatever the new short-term rate set by the government is. Supposing that short-term rates are 2% but I expect them to rise by 0.25% every year. My expectation of what the second option looks like is this:
| Year | Interest Rate | Value of Savings |
| 1 | 2.00% | £102.00 |
| 2 | 2.25% | £104.30 |
| 3 | 2.50% | £106.90 |
| 4 | 2.75% | £109.84 |
| 5 | 3.00% | £113.14 |
| 6 | 3.25% | £116.81 |
| 7 | 3.50% | £120.90 |
| 8 | 3.75% | £125.44 |
| 9 | 4.00% | £130.45 |
| 10 | 4.25% | £136.00 |
Therefore for me to decide that investing in a 10 year bond is worth it, I need a rate of at least 3.1225%, otherwise I expect to lose money on it.
Conversely, if I expect interest rates to go down then I will be happy with a lower rate for my 10 year investment.
Still with me? Good. Get yourself another Jammy Dodger – you’ve earned it.
Why are interest rates low now?
The government says that interest rates are low because the markets have lots of confidence in our economy because of their austerity policy. Lots of people lap this up as gospel but let’s stop for a moment and think about that. The government is borrowing at the lowest rates in the country’s history at the same time that the economy is in the longest depression in living memory. Would this really be the point in history that confidence in our economy hit an all time high?
Umm… no. So using what we’ve learnt, let’s look at some sensible explanations instead.
Expected future short-term interest rates
Short-term interest rates are very low at the moment. We know why – in reaction to the financial crisis, the Bank of England cut interest rates in an attempt to boost the economy. (They cut them to 0.5% in March 2009 where they have remained ever since.)
Remember though, that long-term interest rates are determined by what the market expects short-term rates to be in the coming years. One explanation (this is the right one by the way so pay attention) for low long-term interest rates would be that the markets expect The Bank of England to keep short-term interest rates low for the foreseeable future.
Why would the markets expect The Bank of England to keep short-term rates low in the future? Well remember why short-term rates became low in the first place – an attempt to stimulate a weak economy. If the market expects the UK economy to remain depressed in the future they will expect The Bank of England to keep short-term rates low. If they expect a recovery is just around the corner they will expect short-term interest rates to rise and they will demand higher long-term rates in compensation.
Demand for bonds vs Demand for cash
Ok, I said the last one was the right answer but it’s important to consider this point too. The demand for bonds is huge at the moment. Why? Because when the financial crisis struck, people who had spent happily during the good years changed their behaviour dramatically and started saving. We are living in a world of people saving money rather than spending it. Again they are doing that because of a lack of confidence in the economy.
Probability of default
Enough of sensible explanations. Let’s look at a daft one. You’ll recall that people demand higher interest rates if they think that the person to whom they are lending might go bust before their bond matures. Therefore if the markets think that there is a good chance that the UK might go bust within the next 10 years they will demand higher rates for their 10 year bonds.
Let me be absolutely explicit here. There is absolutely no chance of the UK going bust in the next ten years. Despite the least economically competent government that anyone can remember, it is still impossible.
The UK is a large, developed economy whose debt is in a currency that they control. We print our own money – we can’t run out of it. Barring alien invasion, the UK will service its debt next year, the year after, the year after that etc. etc.
What about Greece?
A common comparison, used by George Osborne amongst others, is that Greece has a weak economy that is expected to remain weak but has high interest rates on government debt. They do but there is a difference between Greece and the UK and although George Osborne chooses to ignore it, it is a very big difference. When a country adopts the Euro they give up something very important – control over their currency. The countries that have seen their interest rates rise, Greece, Ireland, Italy, Spain, Portugal all have something in common – their debt is in a currency they can’t control.
But what about Argentina in 1999/2000?
Their debt was in US dollars so the same thing applies. They borrowed in a currency they could not control.
What about Iceland? They weren’t in the Euro and their government debt wasn’t that bad.
That’s true but Iceland’s three major banks had somehow been allowed to build up about €50bn of foreign debt between them. To put that into perspective, that was about 600% (!) of Icelandic GDP. Nice one Icelandic banking dudes.
What if the UK loses its AAA credit rating? Interest rates will soar!
The first thing to mention is that this argument assumes that austerity will prevent any downgrade of the UK’s credit rating. I’ll return to that point though because I want to tell you a few things about credit rating agencies first.
A credit rating agency is a private company that expresses an opinion about a borrower’s likelihood of repaying money they have borrowed from someone else. You will note that the UK currently has a AAA credit rating, which is the highest possible. (Not all agencies use AAA as a code to signify the safest borrower but the UK has the highest rating from all of the major ones.)
For example, the biggest credit ratings agency, Standard & Poors, gives the UK a AAA rating. To understand what that rating means, let’s benchmark it against something else to which Standard & Poors have given a AAA rating.
In the run up to the financial crisis, banks lent money to risky borrowers in the form of subprime mortgages. Those banks would then package up a few thousand of these dodgy mortgages together and sell them on to someone else. Guess what rating Standard & Poors gave to these packages of toxic debt? Yep, AAA!
Reread that last paragraph – the largest credit rating agency in the world gave their highest possible rating to packages of subprime mortgages. I am not a credit rating agency and you are not a credit rating agency but if you and I were forced to form an opinion on the creditworthiness of 2,000 subprime mortgages all mixed together we would probably not come to the conclusion that it was the safest investment possible. The credit ratings agencies did.
If you think I am cherry picking one (albeit hugely damning) example, I’ll give you another. On the 15th September 2008, Lehman Brothers went spectacularly bankrupt. All three of the major agencies rated Lehman Brothers as a low risk counterparty.
So the upshot of this all is that no one actually listens to these people. S&P downgraded the United States from AAA to AA+ last year. Did the markets all panic and think that the US was about to go bust? No. They ignored the discredited opinion of an organisation who thought that subprime mortgages were a good investment and went their about business as usual. Interest rates on US bonds actually went down.
But wouldn’t rates go up if we abandoned austerity?
The last refuge of the “Austerity=Low Interest Rates” cult is always, “Even if your ‘economics’ mumbo-jumbo is right about the reasons for low rates, if we actually took advantage of them and borrowed some more money, those rates would not stay low for long!” I’ll address that now.
Demand for bonds vs Demand for cash
As I’ve mentioned before we are currently in a liquidity trap. In normal times, cutting short-term interest rates stimulates spending. A liquidity trap occurs when we have already cut interest rates as far as they can go but people still want to save. At the moment, no one wants to spend money but The Bank of England have already cut rates to almost zero.
Being in a liquidity trap means that we would need a significant change in behaviour back from saving to spending before it made any difference at all to actual interest rates. The interest rate we would need to get people spending is negative but The Bank of England can’t set a negative rate* so we’re left with demand for bonds far outstripping demand for cash. Being in a liquidity trap isn’t good news but it does at least mean we can increase borrowing without changing the interest rate.
Probability of default
What would happen if the markets thought the UK was about to go bust and everyone tried to sell their bonds all at once? (Yes, I know the idea of the UK going bust is stupid but people use this argument a lot so I should address it.) Unlike Greece, Ireland, Spain, etc we have a flexible exchange rate. If the markets suddenly decided to start offloading UK government debt interest rates would not actually rise. What would happen is that the pound would just devalue** and interest rates would stay the same.***
Summary
So as we’ve seen interest rates are low because everyone wants to save rather than spend and the markets expect short term interest rates to be low for the foreseeable future because they expect the economy to remain weak.
We’ve also seen that credit ratings agencies’ opinions are not worth listening to. Despite the government claims that austerity is the barrier against a downgrade, I fully expect the UK to be downgraded next year. And you know what? If that happens the markets won’t give a toss and long term interest rates will remain low.
If you have read this whole post down to here then well done – treat yourself to another Jammy Dodger. You know now what determines interest rates on government bonds and you know that it has the opposite to do with everyone being happy about our economy. The sad reason for low interest rates is simply that the markets expect our economy to remain bad for a long time yet.
And to be honest, who could really blame them?
RedEaredRabbit
* They could in theory make interest rates negative but then people would just hoard cash instead of investing it. (You’d get a better return by keeping cash under your mattress than lending it out.)
** Although a devaluation in the pound sounds bad it would actually boost the economy. When the pound is weak then foreign goods and services become more expensive. Also our goods and services become cheaper for foreign investors. This means more money being spent on UK goods and services, both by us and our friends overseas.
*** I brushed over the reason for this because it would have doubled the size of the already too big blogpost. If you’re interested in why this is the case read this.
The Debt Fallacy
27/11/2012 27 Comments
Because this blog has a strong political theme, it might surprise you to learn that I don’t watch Question Time very often. Partly this is because I’m usually in bed by the time it comes on, but if it were called “Answer Time” and the politicians were forced to give proper answers to the questions I would probably be compelled to stay up late once per week and watch it. Instead it is generally an hour of politicians indulging in their favourite pastime of evading, misrepresenting and misleading and to be honest, I get enough of that already.
Still, I did watch some of it a few weeks ago and noticed that in pretty much every answer the Conservative or Lib Dem gave they managed to blame having to take lots of “difficult decisions”, such as cutting benefits for poor people and cutting taxes for rich people, on…
The mess we inherited from the Labour government
The government seems to believe that this is some kind of carte blanche to do whatever they want without any accountability; a Get Out of Jail Free card that they never have to give back. It isn’t though. It’s the political equivalent of saying, “OH MY GOD, WHAT’S THAT BEHIND YOU?” then running away when you turn around. That particular favourite phrase is not what I am going to spend time talking about because no one believes it anyway. Despite the government’s best efforts, no one is actually dumb enough to agree that they don’t need to be accountable for their policies.
They did come up with another favourite line, however, that narks me even more than this one because a lot of people do actually believe it. When someone mentioned government spending they said something like this:
It was the irresponsible spending of the last government that got us into this mess in the first place…
And the thing that annoyed me more than them wheeling out this spin-doctor nonsense for the thousandth time was that no one else on the panel directly challenged it. If I’d been on the panel, (I was on holiday so they had to go with Steve Coogan as the non-politician), I would have directly challenged it. I would have directly challenged it because it isn’t true. It is a lie and when politicians say it they are lying. This, ladies and gentlemen is The Debt Fallacy, the widely-held belief that UK government debt caused the financial crisis.
Before we delve into what actually did cause the “mess”, let’s see why this is a fallacy by looking at UK government debt between 1997 when Labour took office and 2007 when the financial crisis started. (Source IMF)
National Debt of G7 Countries as % of GDP
Yes, not only was borrowing significantly lower in every single year than everyone else in the G7, it was actually lower in 2007 than when Labour took office ten years earlier. Staunch Conservatives will no doubt be hugely disappointing that there is no marked increase in UK government debt in that graph. Don’t worry, just for you I’ve done another one for just the UK with the previous five years under John Major added in. Now you can see a government who did oversee a marked increase in the national debt. I’m nice like that. Don’t mention it.
UK National Debt as % of GDP
So you can see why the government’s claim about a debt-fuelled spending binge is a lie. This level of public debt clearly didn’t cause the financial crisis. So what did?
The cause is actually fairly simple. Banks make profits by borrowing money and then investing it. Their profit comes by getting a higher return on their investments than they have to pay on to the people from whom they borrowed the money. For example if I put £100 in a bank account the bank might pay me 1% interest and then invest that £100 in in a scheme that makes them 5%. Simple enough.
Banks though, like any other businesses, want to compete against one another – they want to make the biggest profits for their shareholders and show everyone that they are the best bank. This is what caused the crisis.
Over time, banks became increasingly competitive and concerned themselves more with trying to make the biggest profit and less with the risks associated with what they were doing. With the £100 I put in my bank account they could invest it in something safe and make 5% or they could invest it in something risky and make 10% or 15% or 25%! The more risky the investment the more return it could yield. No bank was going to invest in something risky if its likely return was less than a safer alternative and so risk equalled reward. Competition between banks, all vying for the biggest profits, led to riskier and riskier investments and nowhere was this more prevalent than housing. It became possible for people to borrow crazy amounts of money to buy a house, even if they had poor credit worthiness. This irresponsible lending fuelled housing bubbles all over the world. Here’s how Florida house prices changed in the four years prior to the financial crisis.
Florida House Prices (Q4 2002 = 100)
In just four years they increased by almost 80% and people’s wages were definitely not increasing at anything like that rate. In short it was unsustainable. There is a useful principle in economics called Stein’s Law after the late American economist Herbert Stein and I wish more people had paid attention to it in the pre-crisis years. It says simply this:
If something can’t go on forever, it will stop.
Stop it did and we all know the rest. In hindsight it’s easy to look back at this and say that the banks were lending irresponsibly but much harder to say why they didn’t they realise it at the time. The only explanation I can offer is that they were too concerned with out-performing one another and not concerned enough about the risks involved until it was too late. Like a gambling addict who’s had a good night but doesn’t know when to quit, the banks didn’t want to think about Stein’s Law.
Essentially the positions they took on the housing market assumed that:
- House prices always go up
- Mortgage defaults are pretty rare
On the first point the banks thought, “Even if this individual doesn’t repay their 120% mortgage, the house will be worth more than that in a couple of years, so where’s the risk?”
On the second point they seem to have committed a really basic error in their probability calculations. Imagine I have lent to 5 risky individuals. The chances of any one of them defaulting on their mortgage is 5%. Therefore the risk of all of them defaulting on their mortgages is:
5% x 5% x 5% x 5% x 5% = 0.00003125%
But those of you who remember your GCSE maths will recall that you can only multiply probabilities together like this when they are independent. For example if the probability of a person having a beard is 20% and the probability of someone being female is 50% the probability of a lady having a beard is not 10%. (Unless of course you work in a circus.)
Similarly, the chances of individuals defaulting on their mortgages are not independent. When an economic downturn occurs, unemployment rises, incomes drop and lots of people all suddenly can’t repay their mortgages at the same time.
Banks, in their bid to out-profit each other, took huge positions on the housing market. They were betting that economies would grow and house prices would go up. It had been so long since the economy had been through a really serious downturn that they had forgotten the lessons of the past. The resulting crisis shows that so confident were they in endless economic prosperity, that none of them had a Plan B in the event of a downturn. The global economy isn’t like that though and if economic history has taught us anything it is that bad things have always eventually found a way to happen and by the time the banks spotted the bubble was about to pop it was too late.
Banks weren’t just lending irresponsibly on mortgages though. People took cheap loans and were able to borrow more than ever before on their credit cards. Banks were so desperate to lend that they offered amazing deals to secure our credit card debts. Fee-free transfers, interest-free balances for 12 months etc etc and the same thing happened – all of a sudden lots of people were unable to make repayments at the same time and the banks had no fallback.
This had a short term effect of making the banks insolvent and governments world-wide were forced to bail them out. While this solved the short-term problem there was another problem that almost six years later remains unsolved.
When economies around the world turned bad, people were left with mortgage debt, loan repayments and credit card bills that were ridiculously high. Those lucky enough to keep their jobs switched overnight from not worrying about their personal debt to worrying only about their personal debt. The thousand pounds they had on their credit cards was no longer something they could kick into the long grass and assume they would just pay it off later. Seeing their friends and co-workers losing their jobs made the risk of redundancy a reality.
This shock led to a very sudden and very dramatic change of behaviour. People moved almost overnight from spending to reducing their debt. Even those who had avoided running up debt became very worried about how little they had tucked away for the hard times and moved from spending to saving.
In the economy your spending is my income and my spending is your income. When everyone stops spending at the same time the consequences can be catastrophic. I say “can be” because a responsible government could plug the gap by increasing public spending but in most cases they didn’t, hence it was catastrophic, hence the depression. (I like saying “hence”. I think it makes me sound all knowledgable.)
So that’s how it happened and that’s the real reason we are in a depression and it had nothing to do with UK government debt at all.
There is a good argument that the previous Labour government should have spotted what the banks were up to and should have done something to address it. Although the banks caused the crisis, the previous government was asleep on the job while this was going on. If the current government were pushing that argument they would have a valid criticism but they aren’t because although it is the truth, it doesn’t pin all of the blame on the previous government.
Politics aside, the years before and since the crisis really are a shameful and embarrassing period in economic history. A first year economics student taking their first macroeconomics module will learn that government spending increases economic growth and that it works best of all when the economy is suffering from a lack of demand. They will learn that my spending is your income and your spending is my income. They will learn that if your spending disappears my income does too. They will learn about economic cycles – the economy will go down as well as up, so plan for it.
Sadly these are lessons that the current government has either not learned or has simply chosen to ignore. Simple enough as those lessons are, it’s sadly far more convenient for them to just propagate The Debt Fallacy.
RedEaredRabbit
A Letter To America
05/11/2012 Leave a comment
From checking the stats on this blog I see that after the UK, the second highest readership is in the United States. In fact, I get more hits from the US than from positions 3 – 12 in the list combined. (Australia, Canada, India, Ireland, Spain, France, Germany, The Netherlands, Sweden and New Zealand, if you’re interested.)
Tomorrow, my second highest contingent of readers will be going to their voting booths to decide whether Obama or Romney is their next president. So, American readers, this post is for you.
The Romney campaign has focused primarily on the terrible job Obama has done with the economy. The Republican plan is benefit cuts for poor people, tax cuts for rich people and generally cutting public spending wherever possible. Might this work? Well we have a good test case in the UK. In contrast to Obama we have done all of these things in the pursuit of economic growth. I’ll be frank, it hasn’t gone well. While Obama has presided over 13 consecutive quarters of economic growth, the UK is currently celebrating one consecutive quarter of economic growth. While the US economy is bigger than it has even been before, the UK economy is smaller than it was five years ago. On the economy, Obama wins.
Of course, it doesn’t stop there.
Romney on abortion, when asked whether he’d support a bill to ban all abortions:
I’d be delighted to sign that bill.
Romney on equality for gay couples:
I’m going to want to see a marriage limited to a man and a woman. I don’t want to see civil union either.
Romney on Obama voters:
There are 47 percent who are with him, who are dependent upon government, who believe that they are victims, who believe the government has a responsibility to care for them, who believe that they are entitled to health care, to food, to housing, to you-name-it — that that’s an entitlement. And the government should give it to them. And they will vote for this president no matter what. These are people who pay no income tax. My job is not to worry about those people.
Romney on Obama’s ethnicity:
My dad, as you probably know, was the governor of Michigan and was the head of a car company. But he was born in Mexico and had he been born of Mexican parents, I’d have a better shot at winning this. But he was unfortunately born to Americans living in Mexico. He lived there for a number of years. I mean, I say that jokingly, but it would be helpful to be Latino.
No one has ever asked to see my birth certificate. They know that this is the place that we were born and raised.
Romney on why public health care is bad:
I like being able to fire people who provide services to me.
Romney on climate change:
My view is that we don’t know what’s causing climate change on this planet. And the idea of spending trillions and trillions of dollars to try to reduce CO2 emissions is not the right course for us.
Tomorrow, America you have an opportunity to vote for someone who has not only, for the first time brought in health care for the poor in the wealthiest country in the world, he has also massively outperformed Europe in economic growth. He hasn’t done enough on climate change but at least he doesn’t deny its existence.
Tomorrow, America you also have the other option of voting for the climate-change denying, economy-destroying, tax-cuts-for the-wealthy-pursuing, health-care for-the-poor-withdrawing, gay-rights-denying, Mr. Mitt Romney.
It’s up to you but we’re all watching.
America, it’s your call.
RedEaredRabbit
Obama vs Cameron
02/11/2012 1 Comment
Last night’s question time had a bit of a US election theme and Conservative MP, Kwasi Kwarteng couldn’t resist taking a stab at Obama for not pursuing a policy of austerity. Because Obama hadn’t gone for austerity like we had in the UK, the US economy was now in a mess etc. etc.
It’s an all too familiar noise from the government but is it actually true?
Here’s a graph showing how the US and UK economies have grown over the past four years:
US vs UK GDP (2008Q3 = 100)
(The green diamond is when Obama came to power and the purple diamond is when Cameron came to power.)
It’s fairly clear from that graph that the US economy has far out-performed the UK economy in the last few years. If you compare just the time since David Cameron came to power things look even worse:
US vs UK GDP (2010Q3 = 100)
If the performance of the US economy is a failure then I would love some of their failure over here.
It makes me wonder why politicians say things like this. Why, as an austerity pursuing government, would you even bother bringing up this subject when talking about the United States? Of course they still have problems but it’s an economy who didn’t pursue full out austerity and who massively out-performed our own who did.
One possibility is that when politicians say things like this they just hope none of us will check the actual facts and find out they’re telling lies. Worrying as that possibility is, I think the reality is even more scary:
This government is so far down the road of austerity that the truth just isn’t important any more.
RedEaredRabbit
Good News
24/10/2012 2 Comments
Today David Cameron gave a strong hint that the GDP figures to be released tomorrow will be “good news”. As Jonathan Portes quickly pointed out, someone in the know even hinting at the figures before they are released is illegal. David surely knows this and it is a sign of the pressure he is under over the economy that he has blurted this out today.
When the GDP figures are bad the government says things along the lines of, “Things are worse than we thought, this is even more of a reason to pursue austerity!” And when they are good tomorrow they’ll say, “Austerity is working!” So whatever is going on they’ll say austerity is the right policy because they’re in too deep now to say anything else. But will these “good news” figures really mean a good economy?
GDP figures are always quoted relative to the previous quarter. The previous quarter was an absolute disaster so doing well in comparison to that is not necessarily good news. As I wrote three months ago:
We will almost certainly do better in Q3 – it is virtually impossible for us to repeat a quarter that bad. And when we get a recovery in Q3, the government will be saying it is advocation of their policy.
Q3 being better than Q2 isn’t that important. If the economy had been in free fall it would be important but the economy hasn’t been in free fall, it has been in depression and as I’ve mentioned on here before, the results in an individual quarter don’t tell us much at all. The important thing is not whether Q3 was better than Q2 – it is the longer-term trend, i.e. how much longer we have to wait until the economy returns to a healthy level?
Whatever the numbers are tomorrow it will certainly not represent an advocation of austerity – the expiry date on that fallacy is long passed and, in a depression longer than The Great Depression of the 1930s, it would be fairly ridiculous to claim it had worked.
The question we should be asking now is not, “When will the economy be bigger than it was in the second quarter of 2012?” A much better question would be, “When will the economy be bigger than it was at the start of 2008?”
And I promise you this much – that ain’t going to happen tomorrow.
RedEaredRabbit
Unemployment
17/10/2012 Leave a comment
Really quick post. I saw a lot of government ministers today giving themselves massive pats on the back because of our brilliant unemployment figures. Down 50,000 they say!
That may be the case but we need to put this into perspective. This is the graph from today’s ONS report and the bit circled in red is the bit they are all getting over-excited about:
UK unemployment (source ONS)
While any decrease in the rate of unemployment is good, this is way too slow, especially considering that many of the extra jobs seem to be coming from people moving from previous full-time employed to now part-time employed.
It really does take an incumbent government to think that graph looks like anything other than a disaster.
I’m not going to be popping the champagne just yet.
RedEaredRabbit
It’s the Economy, Stupid.
10/10/2012 Leave a comment
Today I listened to David Cameron’s Conservative Party Conference speech on the wireless. Below is a transcript of what he said about the economy and (roughly) what I said back at the radio.
– – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – –
David Cameron: To help our people rise, then – number one – we need an economy that creates good jobs. We need businesses, of every size, in every type of industry, in every part of the country – investing and taking people on.
RedEaredRabbit: Sounds good.
DC: There are some basic things they need to do that. Low interest rates so they can afford to take out a loan. And confidence that it’s worth investing – because the customers will be there, whether at home or abroad. Getting the deficit down is essential for both.
RER: No it isn’t. Throughout the last few years when we have had a large deficit and interest rates have been the lowest in living memory. I would also argue that confidence in the economy comes from people seeing sustained economic growth and job creation, neither of which we have.
DC: That’s why our deficit reduction plan is not an alternative to a growth plan: it’s the very foundation of our growth plan.
RER: I realise it’s the foundation of your growth plan but two and a half years in it has yielded precisely no growth. That doesn’t suggest it’s a particularly good growth plan.
DC: Now I know you are asking whether the plan is working.
RER: No I’m not. I know the answer to that.
DC: And here’s the truth: the damage was worse than we thought, and it’s taking longer than we hoped…yes it’s worse than we thought, yes it’s taking longer, but we are making progress. Thanks to the grit and resolve of George Osborne, we have cut a quarter off the deficit in the past two years.
RER: I’m confused. In 2010 you said that if we didn’t cut spending the deficit would, by this time, only have reduced by 25%. You said this would be disastrously slow so you needed to cut spending to do it much faster. You’ve cut the deficit by the amount you said would be disastrous but have additionally killed the economy in the process. Is that good now?
DC: That’s helped to keep interest rates at record low levels, keeping mortgages low. Leaving more money in your pockets. Giving businesses more confidence to invest.
RER: I’ll take these one by one.
- Interest rates are low because the economy is screwed
- If you think people have more money in their pockets you are even more out of touch than I thought
- Businesses are not investing. I have no idea where you got that idea from.
DC: Now, the Labour politicians who got us into the mess say they have a different way out of it. They call it Plan B and it goes like this: “We should stop worrying about deficit reduction, borrow more money and spend it to boost the economy.”
RER: Ah, those bastards are using “macroeconomics”. I think though, you’re giving them a bit too much credit by suggesting they invented it.
DC: Right now, while we’ve got a deficit, the people we’re borrowing money from believe that we’ll pay it back – because we’ve set out a tough plan to cut spending and live within our means. That’s why our interest rates are among the lowest in the world…
RER: They believe we’ll pay it back because we are a large developed economy whose debt is in its own currency. We have never been at any risk of default. See my previous point on interest rates.
DC: If we did what Labour want, and watered down our plans, the risk is that the people we borrow money from would start to question our ability and resolve to pay off our debts. Some may actually refuse to lend us that money.
RER: No they wouldn’t. People are queuing up to lend us money. In an era where banks are risky and Eurozone economies borrowed in a currency they can’t control the UK has been and will always be a safe bet.
DC: That would hurt the economy and hit people hard.
RER: So your plan is to cut out the middle-man and do this yourself?
DC: If you have a mortgage of £100,000, just a 1 per cent interest rate rise would mean an extra thousand pounds to pay each year.
RER: I don’t know if you’ve looked at mortgage rates offered by banks recently. They bear no relation at all to the rate at which the UK government can borrow.
DC: Labour’s plan to borrow more is actually a massive gamble with our economy and our future.
RER: Whereas at least with you we know we’re fucked.
DC: And it would squander the sacrifices we’ve already made.
RER: You have sacrificed jobs and growth. Wouldn’t squandering those disasters be quite good?
DC: We’re here because they spent too much and borrowed too much.
RER: No, the banks caused the crisis, it had nothing to do with government borrowing at all.
DC: How can the answer be more spending and more borrowing?
RER: Are you familiar with the book, “Economics for Dummies”?
DC: I honestly think Labour haven’t learned a single thing.
RER: As opposed to your “learning” government who has blindly pursued an economic policy that has continually delivered the opposite of what they said it would?
DC: When they were in office, their answer was always borrow more money.
RER: Actually their borrowing level in 2007 on the eve of the crisis was almost exactly the same as their borrowing level they took on in 1997 and was fairly flat throughout. The numbers are not hard to find.
DC: Now they’re out of office it’s borrow more money.
RER: Ha, those fools! Pursuing their “macroeconomics” again!
DC: I sometimes wonder if they know anything about the real economy at all.
RER: If only they could know all that you do because you’re really good at it.
DC: Did you hear what Ed Miliband said last week about taxes?
RER: No? Did he think it was the plural of taxi?
DC: He described a tax cut as the government writing people a cheque.
RER: Oh.. he got it right. That’s not nearly as funny.
DC: Ed… Let me explain to you how it works.
RER: Time to dispel the macroeconomics witchcraft.
DC: When people earn money, it’s their money. Not the government’s money: their money. Then, the government takes some of it away in tax. So, if we cut taxes, we’re not giving them money – we’re taking less of it away. OK?
RER: Ah.. you’re not giving them money, you’re taking less of it away. Got it. Ed probably hadn’t realised he could make tax-cuts for rich people sound that nice when he said it.
DC: And while we’re on that – who suffers when the wealthy businessman goes off to live in Geneva?
RER: His new neighbours?
DC: Not him – he’s paying about half the tax he would do here…
RER: Well I for one have stopped feeling sorry for the poor and the unemployed now. That rich businessman is clearly the victim. Also, did you know that women are allowed to be successful business people now?
DC: …it’s those who want to work who suffer because the jobs aren’t being created here.
RER: Oh, I see! The jobs aren’t being created here because the rich aren’t rich enough. And all the time I thought it was because of that depression you created.
DC: We promised that those with the broadest shoulders would bear the biggest burden and with us, the rich will pay a greater share of tax in every year of this Parliament than in any one of the thirteen years under Labour.
RER: Yes, but I don’t think cutting the poor’s tax burden by making them all unemployed was what they had in mind.
DC: We remember who busted our banks, who smothered our businesses
RER: Yes, the banks busted themselves, which led to an economic disaster that smothered our businesses.
DC: …who wracked up our debts, who wrecked our economy…
RER: Really glad you’re finally going to have a go at the banks.
DC: …who ruined our reputation, who risked our future…
RER: You tell those banks, David!
DC:…who did this?
RER: I seem to recall it was something to do with the banks.
DC: Labour did this.
RER: Damn. I honestly thought you were going to get something right then.
RedEaredRabbit
The Blame in Spain
07/10/2012 Leave a comment
As you are no doubt aware, the Eurozone is going through a bit of a tough time at the moment. While the economy in Germany has remained resilient throughout the crisis, many other Euro members have not been as lucky. Take Spain for example. Here’s how Spanish unemployment compares with German unemployment during the crisis:
Spanish and German Unemployment Rates (Source IMF)
Yes, it’s awful but we all know how this happened, right? The Spanish government borrowed far beyond its means during the good years, running up huge debts and when the economic crisis hit they couldn’t afford to pay it off. How do we know this? Well, Angela Merkel told us. Anyway, it’s easy enough to prove – the IMF database has everything we need. So let’s grab the data and see how terribly irresponsible Spanish government borrowing was during the good years of the Euro:
Spanish and German Debt:GDP Ratio (Source IMF)
Oh. So if Spain was doing the precise opposite of plunging itself deeper into debt, what exactly is going on?
At the moment Spain is a deeply ill patient and Germany is her self-appointed doctor. Not only has Germany (as we’ve just seen) misdiagnosed the cause of the problem but they have also prescribed austerity as the cure.
I’ve talked before about the fallacy of attempting to solve a depression with austerity and we need not go through those details again to know why it is a fallacy. What I do want to think about though, is why Germany has been so quick to misdiagnose the cause of Spain’s problems and for four years has chosen not to look at the numbers in the graph above.
There is a theory about this but to understand it we first need to travel back in time to the 28th of June 1919.
On that day in history, Germany and The Allies marked the end of war by signing The Treaty of Versailles. The treaty, amongst other things, laid out the reparations that Germany would have to pay The Allies in compensation.
At the time that the treaty was signed the British economist John Maynard Keynes described the reparations not as a compensation but as a “deliberate impoverishment”, and went on to predict (rather chillingly) that they would lead initially to mass poverty and then on to vengeance and another war.
When the reparations began, Germany soon didn’t have enough Marks to buy the foreign currency needed to make the repayments so they printed more Marks. Each time they did this the value of the Mark decreased, so that the next time they went to the printing press, they had to print more Marks than last time. Inflation turned into hyperinflation and the value of the Mark fell off a cliff and then kept going in spectacular fashion.
At the end of The First World War, one US dollar was worth about nine Marks. By the end of 1923, one US dollar was worth 4.2 trillion Marks. Inflation was so high that prices were doubling every two days. Saving money was a pointless exercise, so people spent it as soon as it was in their hands. Workers were paid hourly so they could hand the money to their families to go out and spend immediately while they could still get something for it. If someone went to the pub intending on having a couple of beers, they would buy their two beers on entry for fear that otherwise the second would be more expensive by the time that they came to order it. To help to put this into perspective, here’s a fifty billion mark postage stamp.
A 50 Billion Mark Postage Stamp (Milliarden means Billion)
Living through such a period is almost unimaginable for us and it is little wonder that the current generation in Germany have such an inherent fear of inflation. A leader who would even give a hint of allowing some of it would immediately become deeply unpopular.
So how, you may ask, does this have any bearing at all on the current crisis in the Eurozone? Sadly, the solution that is needed, inconvenient as it may be, is German inflation.
During the good years of the Euro, Spain’s economy did well. Adoption of the single currency led to huge capital inflows from German banks to Spanish banks. The German banks’ perceived risk of lending lots to Spanish banks (and the Spanish banks’ perceived risk of borrowing lots from German banks) reduced significantly (and erroneously) once they were all using the same currency. The German banks thought that since they were both on the same currency now, lending to Spain was like lending to Germany. The Spanish banks eagerly accepted the German loans and invested them in the Spanish housing bubble (they didn’t call it a bubble at the time). As more and more money passed from Germany to Spain the bubble grew, Spanish wages increased and Spanish prices increased.
This is how relative Spanish and German prices changed throughout this period:
German and Spanish Price Inflation (Source IMF)
And this is how relative Spanish and German labour costs changed throughout this period:
German and Spanish Unit Labour Costs (Source OECD)
As you can see, during this time the cost of Spanish workers became much higher relative to their trading partners in the north. When the financial crisis hit and demand dropped off, this left Spain with a deeply uncompetitive economy. Production of goods and services for export to Germany, France and other economies in the north is simply too expensive now.
This is the primary problem that needs to be solved in order for Spain to recover and you might note, it has nothing to do with government spending.
So now we understand the problem, what’s the solution? Well, one solution would be Spanish deflation but deflating your way to competitiveness is extremely difficult because it means everyone taking pay cuts and people don’t really like taking pay cuts. The Spanish government could start by cutting the wages of all public sector employees (and deal with the riots) but how do you convince the private sector to do the same? Also, Spanish deflation effectively increases their debt burden*, which means it’s pretty unworkable in any case.
There is another option – inflation in Spain (and Italy, Portugal, Ireland**) that is low relative to the Eurozone as a whole. The Eurozone economy is dominated by Germany so essentially this means German inflation. We’re not in any way talking hyperinflation but something like inflation of 1% in Spain and say 5% or 6% in Germany would start moving things back toward competitiveness.
With the horrors of 1920s hyperinflation still ingrained in German minds, Angela Merkel will have no easy task in pushing such a policy through and her current policy of blaming the problem on Spanish government spending in the good years and prescribing austerity as the cure has certainly helped to maintain her popularity with German voters.
Sadly though, Angela Merkel being popular won’t be enough to save the Euro.
RedEaredRabbit
*Although Spain’s debt wasn’t high during the good years it is high now due to their economy collapsing. It’s important to understand the the high debt was caused by the crisis rather than the other way around.
** You might have noticed I didn’t mention Greece. They actually did borrow beyond their means for a sustained period and relative deflation is not sufficient to save them. From what I can see they are pretty much done for.
Taking the Hard Road
02/09/2012 4 Comments
I was thinking the other day that GCSEs aside, the past couple of months have been quite good for the government. They have not introduced any new stupid policies, nor have they been forced to scrap any existing ones. Compared with the year they have had this seemed quite promising. Then I remembered that they had been on summer holidays for six weeks.
Anyway, today, with the holiday coming to an end, it was time for David Cameron to reappear with another broken light bulb taped to his forehead. The new policy is planning deregulation which will make it easier to build houses in rural areas such as the Green Belt area around London. This, in his own words, is the problem he is trying to solve:
A familiar cry goes up, “Yes we want more housing; but no to every development – and not in my back yard.” The nations we’re competing against don’t stand for this kind of paralysis and neither must we.
The construction sector, according to Cameron, is paralysed due to a lack of places to build houses.
There is no doubt that the construction sector, along with the rest of the economy, is depressed but once again, the government is failing to understand the problem. Example time.
Imagine that Susan runs a shop that sells television sets. Susan opened her business in 2003 and her business grew nicely for four years. In 2007 she tried to get planning approval to double the size of the shop by building an extension on the park next to her. Demand was high for her televisions and by expanding she could sell even more televisions. Her application was rejected though and she had to make do with the floor space she had.
Then in 2008 the economic downturn happened and her sales dropped off a cliff. All thoughts of expanding the business disappeared and instead she had to downsize, making two of her staff redundant and cutting the number of televisions she held in stock.
Then in 2012 the council comes back to her:
Council: About that planning application you filed in 2007 – the rules have changed and you can expand your shop now!
Susan: No thanks. Things aren’t too good with my business right now.
Council: You’d be helping the construction sector.
Susan: <click>
Council: ….Hello? ….Hello?
In a depression, the problem Susan has isn’t that she doesn’t have enough shop space, it is that people are not buying televisions. Increasing the number of televisions she has in her shop won’t help if she can’t sell the few she already has. Similarly, the problem that the construction sector has is the number of people who want to have houses or extensions built has also dropped off a cliff. When people don’t want to pay for new houses or new extensions, there is no benefit in making more land available to build on – the construction industry will only build more houses when they can see there is a demand for them.
Cameron’s policy demonstrates that he either doesn’t understand the relationship between supply and demand or he believes that the construction sector suddenly fell off a cliff in 2008 because they ran out of land to build on and it happened at the same time that the rest of the economy fell off a cliff by coincidence.
I’ve talked a lot on here in the past about how to solve the problem with demand and it’s really not that complicated. But as Cameron boldly pointed out in his article:
At every turn we are taking the hard road over the easy path
Yes David, we certainly are.
RedEaredRabbit 