It is commonplace to use cost–benefit analysis (CBA) in assessing public policies, such as whether to build a new hospital, road or rail line. Various attempts in the past few months have been made to use CBA in assessing policies to reduce the spread of the coronavirus. These have involved weighing up the costs and benefits of national or local lockdowns or other containment measures. But, as with other areas where CBA is used, there are serious problems of measuring costs and benefits and assessing risks. This is particularly problematic where human life is involved and where a value has to be attached to a life saved or lost.

Take the case of whether the government should have imposed a lockdown: an important question if there were to be a second wave and the government was considering introducing a second lockdown. The first step in a CBA is to identify the benefits and costs of the policy.

Identifying the benefits and costs of the lockdown

The benefits of the lockdown include lives saved and a reduction in suffering, not only for those who otherwise would have caught the virus but also for their family and friends. It also includes lives saved from other diseases whose treatment would have been put (even more) on hold if the pandemic had been allowed to rage and more people were hospitalised with the virus. In material terms, there is the benefit of saving in healthcare and medicines and the saving of labour resources. Then there are the environmental gains from less traffic and polluting activities.

On the cost side, there is the decline in output from businesses being shut and people being furloughed or not being able to find work. There is also a cost from schools being closed and children’s education being compromised. Then there is the personal cost to people of being confined to home, a cost that could be great for those in cramped living conditions or in abusive relationships. Over the longer term, there is a cost from people becoming deskilled and firms not investing – so-called scarring effects. Here there are the direct effects and the multiplier effects on the rest of the economy.

Estimating uncertain outcomes

It is difficult enough identifying all the costs and benefits, but many occur in the future and here there is the problem of estimating the probability of their occurrence and their likely magnitude. Just how many lives will be saved from the policy and just how much will the economy be affected? Epidemiological and economic models can help, but there is a huge degree of uncertainty over predictions made about the spread of the disease and the economic effects, especially over the longer term.

One estimate of the number of lives saved was made by Miles et al. in the NIESR paper linked below. A figure of 440 000 was calculated by subtracting the 60 000 actual excess deaths over the period of the lockdown from a figure of 500 000 lives lost which, according to predictions, would have been the consequence of no lockdown. However, the authors acknowledge that this is likely to be a considerable overestimate because:

It does not account for changes in behaviour that would have occurred without the government lockdown; it does not count future higher deaths from side effects of the lockdown (extra cancer deaths for example); and it does not allow for the fact that some of those ‘saved’ deaths may just have been postponed because when restrictions are eased, and in the absence of a vaccine or of widespread immunity, deaths may pick up again.

Some help in estimating likely outcomes from locking down or not locking down the economy can be gained by comparing countries which have taken different approaches. The final article below compares the approaches in the UK and Sweden. Sweden had much lighter control measures than the UK and did not impose a lockdown. Using comparisons of the two approaches, the authors estimate that some 20 000 lives were saved by the lockdown – considerably less than the 440 000 estimate.

Estimating the value of a human life

To assess whether the saving of 20 000 lives was ‘worth it’, a value would have to be put on a life saved. Although putting a monetary value on a human life may be repugnant to many people, such calculations are made whenever a project is assessed which either saves or costs lives. As we say in the 10th edition of Economics (page 381):

Some people argue ‘You can’t put a price on a human life: life is priceless.’ But just what are they saying here? Are they saying that life has an infinite value? If so, the project must be carried out whatever the costs, and even if other benefits are zero! Clearly, when evaluating lives saved from the project, a value less than infinity must be given.
 
Other people might argue that human life cannot be treated like other costs and benefits and put into mathematical calculations. But what are these people saying? That the question of lives saved should be excluded from the cost–benefit study? If so, the implication is that life has a zero value! Again this is clearly not the case.

In practice there are two approaches used to measuring the value of a human life.

The first uses the value of a statistical life (VSL). This is based on the amount extra the average person would need to be paid to work in a job where there is a known probability of losing their life. So if people on average needed to be paid an extra £10 000 to work in a job with a 1% chance of losing their life, they would be valuing a life at £1 000 000 (£10 000/0.01). To avoid the obvious problem of young people’s lives being valued the same as old people’s ones, even though a 20 year-old on average will live much longer than a 70 year-old, a more common measure is the value of a statistical life year (VSLY).

A problem with VSL or VSLY measures is that they only take into account the quantity of years of life lost or saved, not the quality.

A second measure rectifies this problem. This is the ‘quality of life adjusted year (QALY)’. This involves giving a value to a year of full health and then reducing it according to how much people’s quality of life is reduced by illness, injury or poverty. The problem with this measure is the moral one that a sick or disabled person’s life is being valued less than the life of a healthy person. But it is usual to make such adjustments when considering medical intervention with limited resources.

One adjustment often made to QALYs or VSLYs is to discount years, so that one year gained would be given the full value and each subsequent year would be discounted by a certain percentage from the previous year – say, 3%. This would give a lower weighting to years in the distant future than years in the near future and hence would reduce the gap in predicted gains from a policy between young and old people.

Conclusion

Given the uncertainties surrounding the measurement of the number of lives saved and the difficulties of assigning a value to them, it is not surprising that the conclusions of a cost–benefit analysis of a lockdown will be contentious. And we have yet to see what the long-term effects on the economy will be. But, at least a cost–benefit analysis of the lockdown can help to inform discussion and help to drive future policy decisions about tackling a second wave, whether internationally, nationally or locally.

Articles

Questions

  1. What are the arguments for and against putting a monetary value on a life saved?
  2. Are QALYs the best way of measuring lives saved from a policy such as a lockdown?
  3. If the outcomes of a lockdown are highly uncertain, does this strengthen or weaken the case for a lockdown? Explain.
  4. What specific problems are there in estimating the number of lives saved by a lockdown?
  5. How might the age distribution of people dying from Covid-19 affect the calculation of the cost of these deaths (or the benefits or avoiding them)?
  6. How might you estimate the costs to people who suffer long-term health effects from having had Covid-19?
  7. What are the arguments for and against using discounting in estimating future QALYs?
  8. The Department of Transport currently uses a figure of £1 958 303 (in 2018 prices) for the value of a life saved from a road safety project. Find out how this is figure derived and comment on it. See Box 12.5 in Economics 10th edition and Accident and casualty costs, Tables RAS60001 and RA60003, (Department of Transport, 2019).

In the current environment of low inflation and rising unemployment, the Federal Reserve Bank, the USA’s central bank, has amended its monetary targets. The new measures were announced by the Fed chair, Jay Powell, in a speech for the annual Jackson Hole central bankers’ symposium (this year conducted online on August 27 and 28). The symposium was an opportunity for central bankers to reflect on their responses to the coronavirus pandemic and to consider what changes might need to be made to their monetary policy targets and instruments.

The Fed’s previous targets

Previously, like most other central banks, the Fed had a long-run inflation target of 2%. It did, however, also seek to ‘maximise employment’. In practice, this meant seeking to achieve a ‘normal’ rate of unemployment, which the Fed regards as ranging from 3.5 to 4.7% with a median value of 4.1%. The description of its objectives stated that:

In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee’s assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.

The new targets

Under the new system, the Fed has softened its inflation target. It will still be 2% over the longer term, but it will be regarded as an average, rather than a firm target. The Fed will be willing to see inflation above 2% for longer than previously before raising interest rates if this is felt necessary for the economy to recover and to achieve its long-run potential economic growth rate. Fed chair, Jay Powell, in a speech on 27 August said:

Following periods when inflation has been running below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2 per cent for some time.

Additionally, the Fed has increased its emphasis on employment. Instead of focusing on deviations from normal employment, the Fed will now focus on the shortfall of employment from its normal level and not be concerned if employment temporarily exceeds its normal level. As Powell said:

Going forward, employment can run at or above real-time estimates of its maximum level without causing concern, unless accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of our goals

The Fed will also take account of the distribution of employment and pay more attention to achieving a strong labour market in low-income and disadvantaged communities. However, apart from the benefits to such communities from a generally strong labour market, it is not clear how the Fed could focus on disadvantaged communities through the instruments it has at its disposal – interest rate changes and quantitative easing.

Assessment

Modern monetary theorists (see blog MMT – a Magic Money Tree or Modern Monetary Theory?) will welcome the changes, arguing that they will allow more aggressive expansion and higher government borrowing at ultra-low interest rates.

The problem for the Fed is that it is attempting to achieve more aggressive goals without having any more than the two monetary instruments it currently has – lowering interest rates and increasing money supply through asset purchases (quantitative easing). Interest rates are already near rock bottom and further quantitative easing may continue to inflate asset prices (such as share and property prices) without sufficiently stimulating aggregate demand. Changing targets without changing the means of achieving them is likely to be unsuccessful.

It remains to be seen whether the Fed will move to funding government borrowing directly, which could allow for a huge stimulus through infrastructure spending, or whether it will merely stick to using asset purchases as a way for introducing new money into the system.

Articles

Speeches

Questions

  1. Find out how much asset purchases by the Fed, the Bank of England and the ECB have increased in the current rounds of quantitative easing.
  2. How do asset purchases affect narrow money, broad money and aggregate demand? Is there a fixed money multiplier effect between the narrow money increases and aggregate demand? Explain.
  3. Why did the dollar exchange rate fall following the announcement of the new measures by Jay Powell?
  4. The Governor of the Bank of England, Andrew Bailey, also gave a speech at the Jackson Hole symposium. How does the approach to money policy outlined by Bailey differ from that outlined by Jay Powell?
  5. What practical steps, if any, could a central bank take to improve the relative employment prospects of disadvantaged groups?
  6. Outline the arguments for and against central banks directly funding government expenditure through money creation.
  7. What longer-term problems are likely to arise from central banks pursuing ultra-low interest rates for an extended period of time?

For the majority of people, a house (or flat) is the most valuable thing they will ever own.

It is important to understand the role that house prices play in the economy and how much of an impact they have.

The Bank of England monitors changes in the housing market to assess the risks to the financial system and the wider economy. The housing market employs large numbers of people in construction, sales, furniture and fittings, and accounts for a sizeable percentage of the value of GDP. The market is closely linked to consumer spending and therefore is a crucially important sector of the economy.

The concepts of supply and demand can be applied to understand house price changes and the impacts on the economy.

What is the housing market?

The housing market brings together different stakeholders, such as homeowners who are selling their properties, people seeking to buy a property, renters, investors who buy and sell properties solely for investment purposes, contractors, renovators and estate agents, who act as facilitators in the process of buying or selling a property.

In the UK, two-thirds of households own the property in which they live, and the remaining third of households are renters, split fairly equally between private and social renting. We can thus divide people into:

  • Homeowners – either outright owners or with a mortgage;
  • Private renters – people renting from private landlords;
  • Social renters – people renting from local authorities and housing associations.

There are many determinants of demand and supply in the housing market, many of which are related to demographic factors. Such factors include the size of the market, rate of marriages, divorces, and deaths. However, factors such as income, availability of credit, interest rates and consumer preferences are also important.

Why is the housing market important for the economy?

Changes in the housing market are always given such importance due to the relationship house prices have with consumer spending. Changes in house prices and the number of sales affect how much money people have to spend. Given that household spending accounts for two-thirds of Britain’s total economic activity, any changes in consumption is likely to have a major impact on the wider economy. Observing the housing market helps us to assess the overall demand for goods and services.

When house prices increase, those consumers who own their own homes have now become better off as their houses are worth more. This ‘wealth effect’ increases the confidence of homeowners, which in turn increases consumption. Some of these homeowners will decide to acquire additional borrowing against the value of their home. The borrowing is then spent in the economy on goods and services, thereby increasing aggregate demand and GDP.

However, when house prices decline, homeowners lose confidence as their home is now worth less than before. This becomes a major issue if prices have decreased enough to make their house worth less than the remainder of the unpaid mortgage – known as ‘negative equity’. Homeowners will therefore reduce their consumption and will be less likely to undertake any new borrowing.

The vast majority of homeowners will have taken out a mortgage in order to purchase their home. Mortgages are the largest source of debt for households in the UK. More than 70% of household borrowing is mortgage debt. Half of all homeowners who live in the house they own are still paying off their mortgage. Therefore, households might suddenly hold back on their spending during times of uncertainty because they start to worry about repaying their debts. This has a knock-on effect on the rest of economy, and a small problem can suddenly become a big one.

In addition to affecting overall household spending, the buying and selling of houses also affects the economy directly. Housing investment is a small but unpredictable part of total output in the economy. There are two different ways in which the buying and selling of houses impacts GDP.

The first is when a new build is purchased. This directly contributes to GDP through the investment in the land to build the house on, the purchase of materials and the creation of jobs. Once the homeowners move in they also contribute to the local economy: i.e. shopping at local shops.

The second is when an existing home is bought or sold. The purchase of an existing home does not have the same impact on GDP. However, it does still contribute to GDP: i.e. from estate agents’ and solicitors’ fees and removal costs to the purchase of new furniture.

Why house prices change: demand and supply

Demand: the demand for housing can be defined as the quantity of properties that homebuyers are willing and able to buy at a given price in a given time period. Factors affecting the demand for housing include:

  • Real incomes: If real incomes increase the demand for housing increases due to a rise in the standard of living.
  • The cost of a mortgage: If there is a rise in interest rates in the economy, mortgage interest rates are likely to rise too. This makes the cost of financing a loan more expensive and therefore will see a decline in demand.
  • Availability of credit: The more lending banks and building societies are willing to provide, the more people will borrow and spend on housing and hence the higher house prices will be.
  • Economic growth: When the economy is in the recovery and boom stages of the business cycle, wages rise. This will increase the demand for houses.
  • Population: When the population increases or if there is an increase in single-person households, demand for housing increases.
  • Employment/unemployment: The higher the level of unemployment in an economy, the less people will able to afford housing.
  • Confidence: If consumers feel optimistic about the future state of the economy, they will be more likely to go ahead with purchasing a house, thereby increasing demand. House prices tend to rise if people expect to be richer in the future.

Supply: The supply of housing can be defined as the flow of properties available at a given price in a given time period. The supply of housing includes both new-build homes and existing properties. Factors affecting the supply for housing include:

  • Costs of production: The higher the cost of production, the fewer houses are built, reducing the supply of housese coming to the market. Example of costs include: labour costs, land for development and building materials.
  • Government policy: If the government increases taxation and/or reduces subsidies for new house developments, there will be fewer new houses built.
  • Number of construction companies: Depending on their objectives, the more construction companies there are, the more likely there is to be an increase in the supply of housing. The construction industry accounts for around 7% of UK GDP.
  • Technology and innovation: With improved technology and innovation in the construction industry, houses become cheaper and easier to build, thus increasing the supply.
  • Government spending on building new social housing: The government has the ability to influence the supply of housing by increasing spending on new social housing.

Price elasticity of supply

The supply of new housing in the short run is price inelastic. The main reason for this is the time it takes to build a new home. The production of a house can take many months, from the planning process to the project’s completion. Supply also relies on access to a skilled labour force and the availability of certain construction materials.

Because of the inelastic supply, any changes in demand are likely to have a significant effect on price. This is illustrated by the diagram, which shows a larger proportionate increase in price than quantity when demand increases from D1 to D2.

The current UK housing market

Despite the current economic climate and the effects of the lockdown restrictions on consumers, house prices have increased, and sales have now resumed. Rightmove, which advertises 95% of homes for sale, states that the housing market has seen its busiest month in more than 10 years in July. During the summer, the housing market usually sees a lull in activity. However, since the easing of lockdown, there has been a flurry of activity from buyers and sellers. Since July 2019, house prices have increased by 1.7%, according to the Nationwide Building Society.

London estate agency, Hamptons, states that homeowners are now bringing forward their moving plans as the experience of lockdown has encouraged them to seek more space. The mortgage market is also very favourable right now in terms of interest rates, and rental demand is continuing to surge across the UK.

The increase in activity in the market has also been helped by the announcement of a stamp duty ‘holiday’ until March 2021. This sees the threshold above which stamp duty is paid rising from £125 000 to £500 000. Estate agency, Savills, has also seen an increase in the number of new buyers registering with its service, more than double the number registered in July 2019. It is thought that, along with the tax savings from stamp duty, people’s experiences in lockdown have made them evaluate their current living space and reconsider their housing needs.

However, given the that the economy is experiencing its deepest recession on record, there is concern about just how long the market can resist the economic forces pulling prices down.

Historically, a drop in house prices has been both a cause and a consequence of economic recessions. During the 2008 financial crisis, house prices fell by about 30%. As previously mentioned, for the majority of people, a house is the most valuable thing they will ever own and therefore consumers are extremely interested in its value. Consumer confidence is one of the key factors affecting the demand for housing. If consumers feel pessimistic about the future state of the economy, they will be less likely to go ahead with purchasing a house, thereby decreasing demand. Britain’s Office for Budget Responsibility, the country’s fiscal watchdog, forecasts that during this downturn prices will fall 5% this year and 11% in 2021.

Various government schemes put in place to help during lockdown are starting to come to an end. The main one – the furlough scheme, which replaced 80% of eligible workers’ incomes – comes to an end in October. It is forecast that labour market conditions will weaken significantly in the quarters ahead, with unemployment predicted to rise for the rest of the year. If these predictions materialise, it would likely dampen housing activity once again.

Conclusion

Fluctuations in house prices and transactions tend to amplify the volatility of the economic cycle. Therefore, it is crucial that we understand what influences such changes. Understanding how supply and demand factors influence the housing market can enable key stakeholders to make better predictions about future activity and plan accordingly. The current market has seen a growth since the easing of restrictions but there is concern that this has been powered by pent-up demand. Therefore, the outlook for house prices is uncertain and the full effects of an economic downturn are yet to be realised.

Articles

Questions

  1. Explain why the supply of housing is inelastic in the short-term.
  2. Given that the elasticity of housing supply in the UK is low, what policies could be introduced to ensure that house building is more responsive to changes in market demand?
  3. If unemployment does increase as predicted, explain what impact this would have on the demand in the housing market and house prices? Use a supply and demand diagram to aid your answer.
  4. Explain how changes in house prices affect the government’s key macroeconomic objectives.

Share prices are determined by demand and supply. The same applies to stock market indices, such as the FTSE 100 and FTSE 250 in the UK and the Dow Jones Industrial Average and the S&P 500 in the USA. After all, the indices are the weighted average prices of the shares included in the index. Generally, when economies are performing well, or are expected to do so, share prices will rise. They are likely to fall in a recession or if a recession is anticipated. A main reason for this is that the dividends paid on shares will reflect the profitability of firms, which tends to rise in times of a buoyant economy.

When it first became clear that Covid-19 would become a pandemic and as countries began locking down, so stock markets plummeted. People anticipated that many businesses would fail and that the likely recession would cause profits of many other surviving firms to decline rapidly. People sold shares.

The first chart shows how the FTSE 100 fell from 7466 in early February 2020 to 5190 in late March, a fall of 30.5%. The Dow Jones fell by 34% over the same period. In both cases the fall was driven not only by the decline in the respective economy over the period, but by speculation that further declines were to come (click here for a PowerPoint of the chart).

But then stock markets started rising again, especially the Dow Jones, despite the fact that the recessions in the UK, the USA and other countries were gathering pace. In the second quarter of 2020, the Dow Jones rose by 23% and yet the US economy declined by 33% – the biggest quarterly decline on record. How could this be explained by supply and demand?

Quantitative easing

In order to boost aggregate demand and reduce the size of the recession, central banks around the world engaged in large-scale quantitative easing. This involves central banks buying government bonds and possibly corporate bonds too with newly created money. The extra money is then used to purchase other assets, such as stocks and shares and property, or physical capital or goods and services. The second chart shows that quantitative easing by the Bank of England increased the Bank’s asset holding from April to July 2020 by 50%, from £469bn to £705bn (click here for a PowerPoint of the chart).

But given the general pessimism about the state of the global economy, employment and personal finances, there was little feed-through into consumption and investment. Instead, most of the extra money was used to buy assets. This gave a huge boost to stock markets. Stock market movements were thus out of line with movements in GDP.

Confidence

Stock market prices do not just reflect the current economic and financial situation, but also what people anticipate the situation to be in the future. As infection and death rates from Covid-19 waned around Europe and in many other countries, so consumer and business confidence rose. This is illustrated in the third chart, which shows industrial, consumer and construction confidence indicators in the EU. As you can see, after falling sharply as the pandemic took hold in early 2020 and countries were locked down, confidence then rose (click here for a PowerPoint of the chart).

But, as infection rates have risen somewhat in many countries and continue to soar in the USA, Brazil, India and some other countries, this confidence may well start to fall again and this could impact on stock markets.

Speculation

A final, but related, cause of recent stock market movements is speculation. If people see share prices falling and believe that they are likely to fall further, then they will sell shares and hold cash or safer assets instead. This will amplify the fall and encourage further speculation. If, however, they see share prices rising and believe that they will continue to do so, they are likely to want to buy shares, hoping to make a gain by buying them relatively cheaply. This will amplify the rise and, again, encourage further speculation.

If there is a second wave of the pandemic, then stock markets could well fall again, as they could if speculators think that share prices have overshot the levels that reflect the economic and financial situation. But then there may be even further quantitative easing.

There are many uncertainties, both with the pandemic and with governments’ policy responses. These make forecasting stock market movements very difficult. Large gains or large losses could await people speculating on what will happen to share prices.

Articles

Questions

  1. Illustrate the recent movements of stock markets using demand and supply diagrams. Explain your diagrams.
  2. What determines the price elasticity of demand for shares?
  3. Distinguish between stabilising and destabilising speculation. How are the concepts relevant to the recent history of stock market movements?
  4. Explain how quantitative easing works to increase (a) asset prices; (b) aggregate demand.
  5. What is the difference between quantitative easing as currently conducted by central banks and ‘helicopter money‘?
  6. Give some examples of companies whose share prices have risen strongly since March 2020. Explain why these particular shares have done so well.

The LSE’s Centre for Economic Performance has just published a paper looking at the joint impact of Covid-19 and Brexit on the UK economy. Apart from the short-term shocks, both will have a long-term dampening effect on the UK economy. But they will largely affect different sectors.

Covid-19 has affected, and will continue to affect, direct consumer-facing industries, such as shops, the hospitality and leisure industries, public transport and personal services. Brexit will tend to hit those industries most directly involved in trade with Europe, the UK’s biggest trading partner. These industries include manufacturing, financial services, posts and telecommunications, mining and quarrying, and agriculture and fishing.

Despite the fact that largely different sectors will be hit by these two events, the total effect may be greater than from each individually. One of the main reasons for this is the dampening impact of Covid-19 on globalisation. Travel restrictions are likely to remain tighter to more distant countries. And countries are likely to focus on trading within continents or regions rather than the whole world. For the UK, this, other things being equal, would mean an expansion of trade with the EU relative to the rest of the world. But, unless there is a comprehensive free-trade deal with the EU, the UK would not be set to take full advantage of this trend.

Another problem is that the effects of the Covid-19 pandemic have weakened the economy’s ability to cope with further shocks, such as those from Brexit. Depending on the nature (or absence) of a trade deal, Brexit will impose higher burdens on trading companies, including meeting divergent standards and higher administrative costs from greater form filling, inspections and customs delays.

Papers

Articles

Questions

  1. Referring to the LSE paper, give some examples of industries that are likely to be particularly hard hit by Brexit when the transition period ends? Explain why.
  2. Why have university finances been particularly badly affected by both Covid-19 and Brexit? Are there any other sectors that have suffered (or will suffer) badly from both events?
  3. Is there a scenario where globalisation in trade could start to grow again?
  4. Has Covid-19 affected countries’ comparative advantage in particular products traded with particular countries and, if so, how?
  5. The authors of the LSE report argue that ‘government policies to stimulate demand, support workers to remain in employment or find new employment, and to support businesses remain essential’. How realistic is it to expect the government to provide additional support to businesses and workers to deal with the shock of Brexit?