Chancellor and Governor

Later in term we will spend some time thinking about monetary and fiscal policy; these are the two ways in which governments attempt to influence economic activity, wisely or otherwise.  Both are currently in the news regularly; fiscal policy because the Coalition is running a very tight fiscal policy in order to bring down the government deficit, and monetary policy because interest rates remain essentially at zero yet inflation is high.

The current monetary policy arrangements have the Bank of England commissioned by the government to set interest rates to achieve an inflation target of 1-3%.  However, for 20 of the last 30 months, that target range has been missed by the Bank.  Every time the target is missed, the Governor of the Bank of England, Mervyn King, must write a letter to the Chancellor explaining why the Bank has failed in its duty.  The Chancellor usually responds, and these letters, in the interests of openness, are published on the internet.  Here is George Osborne's recent response to King.

The interesting aspect of this letter is that Osborne suggests that by staying the course of the government's very tight fiscal policy, this will help monetary policy to be more effectively conducted because without it, inflation would surely happen.  Of course, there are plenty of counter arguments to this assertion, not least that given inflation is generally imported inflation currently (cost push), then it will not necessarily fall due to domestic actions by governments (unless they can increase the exchange rate).  Furthermore, such a contractionary fiscal policy could yet see the UK returning to a recession (we saw negative growth in the last quarter), in which case again if inflation is imported, there seems little reason why this would make the Bank's job any easier: Inflation will still be high, and the economy in a recession.

Furthermore, whatever the government does with fiscal policy, the Bank can always counteract with monetary policy: Assuming their efficacy, if fiscal policy was loose, then tight monetary policy would suffice to keep economic activity reasonably constant, and equivalently a tight fiscal policy could be counter-balanced with a loose monetary policy (so QE2 and more).

The Bank of England's Big Decision

In about half an hour, the Bank of England will announce its decision on interest rates. Each month, on the first or second Thursday, the Monetary Policy Committee (MPC) of the Bank of England meets to decide on monetary policy. The main tool of monetary policy used by economies around the world currently is the interest rate, and the MPC will decide whether it is going to keep the interest rate on hold for another month at its lowest practical value of 0.5%, or whether it will increase interest rates. It faces a tough decision.

Later in term we'll talk quite a bit about monetary and fiscal policy and we'll start to understand just why this decision is so tough. In any state of the world it is hard to forecast and know what is going to happen in the future and hence know the right thing to do with monetary policy.

Currently the Bank has a problem in that economic growth is negative yet inflation is above its target (of 2%). In an ideal world, the Bank would have one of these two problems to deal with, because they demand conflicting responses. Negative growth demands loose monetary policy, hence low interest rates, in order to stimulate economic activity. But high inflation demands tight monetary policy, hence higher interest rates, in order to keep economic activity in check and thus keep inflation down.

There's another part of this difficult question though which the Bank must factor in: Much of our inflation is imported from abroad, as the pound has lost so much value in recent years. As we've learnt recently, if interest rates did rise here in the UK, it is possible that the exchange rate would appreciate, hence reducing that imported inflation effect.

Either way, we lie in wait for the decision, expected in about 24 minutes...

Monetary and Fiscal Policy

Later in term we cover these two things in detail - for now we just hint at them, and having looked at inflation in yesterday's lecture while thinking also about unemployment and yesterday's surprising GDP growth figures announced by the ONS, last night Mervyn King (Governer of Bank of England) made a speech in Newcastle about the UK economy.

In it he mentioned the problems he faces as the head of the Bank of England, which is in control of fighting inflation: He expects inflation to rise to 5% in 2011, yet the Bank's target is 2% (plus or minus 1% so a range of 1-3%). Yet GDP growth was negative in 2010Q4, and is not expected to perk up any time soon.

The problem is that high inflation would usually be met by the Bank of England with higher interest rates, yet growth is weak: And higher interest rates would hurt growth (we'll study the interest rate transmission channel from interest rates to economic activity later in term).

The fundamental problem is that of the two basic types of inflation covered yesterday, demand-pull and cost-push, the UK is suffering cost-push at the moment: The weak exchange rate imports inflation, and commodity prices are high at the moment - both factors that makes inputs more expensive.

However, as also mentioned, inflation can come simply from expectations becoming reality. If people start expecting higher inflation then they will attempt to build that into their wage settlements, particularly if and when the economy begins to recover. Then with more money in the economy, this will likely translate into higher actual inflation. So the current cost-push inflation may turn into demand-pull inflation, and this is what the Bank of England is seeking to avoid.

It seeks to avoid it precisely with speeches like this, attempting to show us that it knows what it is talking about when it comes to the economy...

GDP Falls!

Those of you keen eagles will have noticed that GDP figures for 2010Q4 were announced today by the ONS, and the figures contained quite a shock: GDP fell in the last quarter of 2010.

After three quarters of positive growth, analysts had expected a small positive number for GDP growth, but numbers plummeted. There have been many concerns since the Coalition implemented its austerity package that it might plunge the UK into a double dip, and hence those worriers appear to be feeling vindicated in voicing their concerns.

However, there are good arguments for why we might have seen such a contraction: We had lousy weather for most of December! Certainly George Osborne has leapt on this explanation to maintain that austerity remains the right path to take. Construction fell particularly strongly in the period, down 3.3%, supporting this view. It's a rather British response to blame the weather, isn't it?!

Yet December was just one month out of three in the quarter. What happened in the other two months? Growth clearly couldn't have been particularly strong in that period.

Do these figures mean we're definitely heading for a double dip? Of course not. The numbers will still be revised (this is the first estimate based on just a third of the available data), although it is unlikely they will be revised up substantially enough that growth would become positive. And it's just one quarter - the working definition for a recession is two quarters of negative growth.

But it ought to be a concern. We learnt last week about the role government spending plays in aggregate demand (how much we all demand of goods in the economy), and as such it ought not to be surprising that as the government reduces G significantly, aggregate demand falls and growth slows. The government is hoping for a strong longer-term impact rather than any short-term impetus with its austerity - it argues private sector behaviour has long been crowded out by high government spending. Later in term we'll assess in more detail crowding out and we'll be better placed to give an assessment of the likely success of the Coalition's economic strategy.

Jobless Growth?

This term you'll learn about the national economy, and then we'll extend ourselves into what economists call the open economy: Considering the national economy in the global context.

We won't be able to go too much into Globalisation, but by implication you'll learn about the economic arguments for Globalisation - along with potentially some arguments against it. It will come too late to be covered in a tutorial unfortunately so later in term I'll provide some discussion questions for you to ponder anyhow.

Nancy Folbre is an economist at the University of Massachusetts, and she has written an article in the New York Times about jobless recoveries and jobless growth.

A jobless recovery is what it says on the tin: An economic recovery (GDP is growing again), but without unemployment falling, or even employment rising. Workers in jobs are becoming more productive, it would seem, instead of more hiring taking place.

The explanation given is Globalisation. The usual dirty word. Apparently this has affected the economic incentives US companies face, meaning that while still being patriotic American companies, they are now forced to locate abroad to produce cheaper to sell the goods back to Americans. Hence the jobs producing the goods go abroad. We get cheaper prices, but not the jobs.

Of course, this very simplistic view is just that, and it ignores most if not all economic theory. It is a protectionist view. We can't really compete with these productive workers elsewhere, and moreover we don't really want to - so we erect barriers and protect ourselves - tariffs, subsidies, etc. But then we end up producing what China could produce cheaper, instead of innovating and creating better jobs producing new and better things that people want to buy (entrepreneurship), and allowing China to produce the things they have a comparative advantage in producing.

Essentially this is populist stuff: Appeal to what people want to hear now, regardless of where it will leave us in the future (substandard goods, mediocre workers molly-coddled by the government, higher prices). The truth is painful: Other countries are able to compete and produce some things America currently produces much more cheaply. It's a hassle to keep on changing and be subject to the pressures of competition. But it's healthy too, since it keeps us on the ball, producing only things that people actually want.

If you are someone prone to economic nationalism like this, it is worth asking the question: What is the difference between thinking about production here vs China, and production in the south of England vs Northern Ireland? Should we stop trading with folk in other parts of the UK? What about other parts of our city? It would be perverse. As Don Boudreaux writes:

This note is inspired by DG Lesvic’s objection to Art Carden’s use of the reductio ad absurdum – an objection that, I confess, I do not share.

Reductios work so well when arguing against proponents of economic nationalism (that is, “protectionists”) because, economically and morally speaking, there is absolutely no difference between Suzy trading with Joe her next-door neighbor and Suzy trading with Jose in Mexico, Josef in Austria, or Javu in China. None.

So when any protectionist argues, based on reason X, for restrictions on trade drawn along national political borders, it’s always enlightening to apply the same argument X to trade restrictions drawn more locally – even as locally as the individual.

Fritz Machlup said in class at NYU back in 1981 that arguments for protectionism, when followed through to their logical conclusion, always ‘prove’ that a person’s right hand should not trade with that person’s left hand.

Inflation Higher

The Office for National Statistics releases data on inflation month by month. We talked a little about inflation yesterday, and will go into much greater detail next week: Inflation is the change in the price level. That's a wonderfully vague definition which you'll have to improve on a little for assignments and the final exam. What price level? Whose price level?

The ONS calculates a number of price indices: Numbers that reflect the level of prices for a collection (or bundle or basket) of goods. Inflation then, according to one of these indices, is the change, year-on-year. So the number announced today was the increase in prices in December 2010 relative to December 2009. We compare year-on-year to account for seasonal patterns that might distort our understanding of what's going on in the economy. Whichever way you look at it, inflation is high.

The Bank of England is set a target of 2% for inflation, yet it was nearly 4%. This creates problems for the Bank of England because inflation is relatively high, yet GDP growth is still fairly embryonic after the recession. Any attempt to curtail inflation by the Bank of England will put downward pressure on economic growth, and hence would not be helpful.

Yet the longer inflation remains higher than target, and particularly with the VAT rise that we've just had at the start of 2011, the more it starts to get built into new wage settlements by workers. If workers are paid more, this will likely lead to higher inflation since consumers have more money to spend while supply levels haven't adjusted.

More next week...

Inflation Higher

The Office for National Statistics releases data on inflation month by month. We talked a little about inflation yesterday, and will go into much greater detail next week: Inflation is the change in the price level. That's a wonderfully vague definition which you'll have to improve on a little for assignments and the final exam. What price level? Whose price level?

The ONS calculates a number of price indices: Numbers that reflect the level of prices for a collection (or bundle or basket) of goods. Inflation then, according to one of these indices, is the change, year-on-year. So the number announced today was the increase in prices in December 2010 relative to December 2009. We compare year-on-year to account for seasonal patterns that might distort our understanding of what's going on in the economy. Whichever way you look at it, inflation is high.

The Bank of England is set a target of 2% for inflation, yet it was nearly 4%. This creates problems for the Bank of England because inflation is relatively high, yet GDP growth is still fairly embryonic after the recession. Any attempt to curtail inflation by the Bank of England will put downward pressure on economic growth, and hence would not be helpful.

Yet the longer inflation remains higher than target, and particularly with the VAT rise that we've just had at the start of 2011, the more it starts to get built into new wage settlements by workers. If workers are paid more, this will likely lead to higher inflation since consumers have more money to spend while supply levels haven't adjusted.

More next week...