The issue of the state of the public finances has dominated much economic-thinking in 2010. This is not just a UK issue, it is a global issue; deteriorating public finances have led to governments around the world making some often very difficult fiscal policy choices. For instance, here in the UK we are continuing to debate the issues arising from the Comprehensive Spending Review which presents the government’s spending plans for the next few financial years. Over in Ireland concerns have resurfaced about the ability of the Irish to finance its burgeoning stock of public debt (see articles below). The fragility of the Irish banking system has meant that interventions by government have been needed to support financial institutions which, some estimate, will see net borrowing by the Irish government this year rise to the equivalent of over 30% of Ireland’s Gross Domestic Product.
The International Monetary Fund’s World Economic Outlook Database is a rich source of information for anybody looking to make international comparisons of public finances. Being able to extract key messages from data and to make economic sense of them is a crucial skill for an economist. But, in doing so it is important that we have an understanding of some of the terms being used by those presenting the data. In this case, to help you undertake your own study of the size of government expenditures, revenues, deficits and debt for countries around the world, we provide a short overview of some of the terms relevant to understanding public finances and illustrate them with reference to a sample of countries.
The IMF’s public finance figures relate not to the whole of the public sector but to general government and thereby exclude public corporations. The general government’s budget balance is presented in both national currency and relative to its Gross Domestic Product. The latter is very useful when making comparisons across countries. A negative figure indicates net borrowing, i.e. expenditures exceed receipts, while a positive figure means that government is a net lender, i.e. receipts exceed expenditures. Forecasts are available for 2010, but, naturally, can be rather unreliable, given that the fluidity of economic events means that they are subject to sizeable revision – Ireland being a case in point.
If we look at the period from 1995–2009 as a whole, the UK was a net borrower with a deficit equivalent to around 2¾ of GDP. Ireland, in contrast, averaged close to a balanced budget with some sizeable surpluses, such as in 2006 when it ran a budget surplus equivalent to 5.2% of GDP. Some countries, such as Australia (0.5% of GDP), averaged budget surpluses over this period. But, the UK’s deficit was not especially large by international standards. From 1995–1999, the USA ran a deficit equivalent to 4.5% of GDP, Greece 5.7% of GDP and in Japan, where several fiscal stimuli have been attempted to reinvigorate the economy, 5.9% of GDP. Nonetheless, the UK’s predicted deficit for 2010 of in excess of 10% of GDP does place it towards the higher end of the deficit-scale, though by no means at the very top!
Another budget balance measure is the structural balance. This attempts to model government expenditures and receipts so as to be able to predict what the budget balance would be if the economy was at its potential output, i.e. that output level when the economy’s resources are being used at normal levels of capacity utilisation. At the moment, for instance, many countries are experiencing a negative output gap, with output below its potential. This puts upward pressure on expenditures, largely welfare expenditures, but also depresses receipts, such as those from taxes on income or spending. The UK is estimated to have run a structural budget deficit equivalent to 2.6% of potential GDP from 1995–2009. With the fiscal measures to support the economy this is forecast to be as high as 7.9% in 2010. Japan is estimated to have run a structural deficit over the period from 1995–2009 equivalent to 5.4% of potential GDP, while in Greece it is estimated at 6.1%.
Another commonly referred to budget balance measure is the primary balance. The primary balance excludes any interest received on financial assets held by government, and, more significantly, interest payments made by the government on its stock of debt. This measure gives us a sense of whether governments are able to afford today’s spending programmes. The UK ran a primary deficit between 1995 and 2009 equivalent to 1% of GDP, while in America and Japan respectively the primary deficit averaged 2.6% and 4.8% of GDP. Interestingly, because of the size of debt stocks in many countries the exclusion of interest makes a notable difference to this fiscal indicator. For instance, Greece typically ran a primary surplus equivalent to 0.9% of GDP.
Budget balances are flows, whereas debt is a stock concept. In other words, budget deficits and surpluses can add to or reduce the stock of debt. Figures are available both on gross debt and net debt. The latter is net of financial assets, including gold and currency reserves. The UK’s average stock of gross debt to GDP between 1995 and 2009 was 45.2% of GDP, but this has risen to over 75% in 2010. In fact, by international standards our public-debt to GDP ratio remains favourable. In Greece, gross public-debt to GDP is predicted to be around 130% of GDP this year, but as high as 225% in Japan.
Finally, consider an interesting case: Sweden. By international standards its public expenditure to GDP share is high, averaging 54% between 1995 and 2009. But, it ‘balances the books’ with a small average budget surplus of 0.2% of GDP and a primary surplus of 0.8% of GDP. Its stock of debt has been falling even in recent times and stands at only a little over 40% of GDP. In 2010, despite the prediction of a small overall budget deficit of 2.2% of GDP, it will continue to run a structural surplus of 0.4% of potential GDP. Hence, Sweden demonstrates nicely the danger of assuming that, in some way, public expenditure necessarily translates into government deficits and, in turn, stocks of public debt.
IMF World Economic Outlook Database
World Economic Outlook Database International Monetary Fund
Articles
Ireland warns jump in borrowing costs very serious Telegraph (12/11/10)
Ireland’s cost of borrowing soars after dramatic sell-off Telegraph, James Hall, (11/11/10)
Imperative Budget is passed – Lenihan RTE News (12/11/10)
Lenihan welcomes EU move to calm markets RTE News (12/11/10)
Irish crisis demands new EU response Financial Times , Mohamed El-Erian (12/11/10)
Britain backs EU rescue missions for debt-ridden Ireland Guardian , Phillip Inman and Patrick Wintour (12/11/10)
Questions
- The IMF’s figures relate to general government. What do you understand by the term general government and how does this differ from the public sector?
- What does net borrowing indicate about the government’s budget balance? What if it was described as a net lender?
- What do you understand by the term structural budget balance? How is this concept related to the business cycle?
- What is measured by the primary balance? Would you expect this to be higher or lower than its budget balance? Explain your answer.
- How does gross debt differ from net debt?
- What factors do you think affect investor confidence in buying government debt?
- Japan’s stock of gross debt is about 225% of GDP while that in Greece is 130%. Does this mean that Japan should have greater problems in financing its debt? Explain your answer.
The latest mortgage approval numbers from the Bank of England continue to demonstrate the fragility of the UK housing market and, in particular, waning levels of activity. The 47,474 approvals in September was the lowest number since February. The downward momentum in approvals has gained pace in recent months. The number of approvals in Q3 was 2.9% lower than in Q2 and was 11.5% lower than in Q3 of last year. All of this provides evidence that housing demand is weakening.
Tight credit conditions have affected the supply of mortgages for some time and, as a consequence, negatively impacted on the number of house buyers. This is likely to be especially true for potential first-time buyers who have no housing equity with which to help purchase property. But, the marked downward momentum in mortgage approvals is reflecting a weakening in housing demand.
So what explains this weakening of housing demand? In part, it is likely to be current economic conditions. But, expectations of future economic conditions are crucially important in determining activity levels in the housing market. With concerns about future economic growth it would be no surprise if households are feeling more than a little cautious about their spending plans and about their household finances. Economic uncertainty amongst households does not bode well for activity levels in the housing market. If this line of thinking is right we can expect mortgage approvals numbers to remain subdued for some time to come.
Articles
Drop in mortgages sparks concerns over house price falls The Herald, Ian McConnell (30/10/10)
Housing dip feared as mortgage approvals stall Guardian, Mark King (29/10/10)
UK mortgage approvals decline Irish Times (29/10/10)
Net mortgage lending slumps to just £112 million Independent, James Moore (30/10/10)
Mortgage approvals lowest since Feb Reuters (29/10/10)
Data
Mortgage approval numbers and other lending data are available from the Bank of England’s statistics publication, Monetary and Financial Statistics (Bankstats) (See Table A5.4.)
Questions
- What variables do you think will affect the demand for mortgages?
- What variables do you think will affect the supply of mortgages by lenders?
- What do you understand by housing and mortgages being complementary products? Why might the complementary relationship between housing and mortgages be stronger for first-time buyers?
- If housing demand weakens, would we expect house prices to fall? Are there circumstances when a weakening of demand might not translate into lower house prices? Illustrate your answer using demand and supply diagrams.
The governor of the Bank of England, Mervyn King, made an important speech in New York on 25th October. The Governor’s speech was a wide-ranging discussion of the banking system. At the heart of it was a fundamental economic concept: market failure. The market failure that King was referring to stems from the maturity transformation which occurs when banks borrow short, say through our savings or wholesale funds from other financial institutions, and then lend long as is the case with mortgages. Of course, the positive outcome of this maturity transformation is that it does allow for funds to be pooled and this, in turn, enables long-term finance, something which is incredibly important for business and households. However, King believes that banks have become too heavily reliant on short-term debt to finance lending. Indeed he went so far as to describe their levels of leverage as ‘extraordinary’ and ‘absurd’. He argued that such a system can only work with the ‘implicit support of the taxpayer’.
In elaborating on the market failure arising from maturity transformation in today’s financial system, King notes
…the scale of maturity transformation undertaken today produces private benefits and social costs. We have seen from the experience of first Iceland, and now Ireland, the results that can follow from allowing a banking system to become too large relative to national output without having first solved the “too important to fail” problem.
In the speech, King considers a range of remedies to reduce the risks to the financial system. These include: (i) imposing a tax on banks’ short-term borrowing which could, to use the economic terminology, help internalise the external cost arising from maturity transformation; (ii) placing limits on banks’ leverage and setting capital requirements as outlined in the recent Basel III framework (for a discussion on Basel III see Basel III – tough new regulations or letting the banks off lightly?; (iii) functional separation of bank activities to safeguard those activities critical to the economy. King argues that whatever remedies we choose they should be guided by one fundamental principle: “ensure that the costs of maturity transformation – the costs of periodic financial crises – fall on those who enjoy the benefits of maturity transformation – the reduced cost of financial intermediation”.
Mervyn King’s speech makes considerable reference to our banks’ balance sheets. So to conclude this piece we consider the latest numbers on the liabilities of British banks. At the end of each month, in its publication Monetary and Financial Statistics, the Bank of England publishes figures on the assets and liabilities of Britain’s banking institutions or ‘MFIs’ (monetary and financial institutions). The latest release showed that British banks had total liabilities of some £8.15 trillion at the end of September 2010. To put it into perspective that’s equivalent to around 5½ times the country’s annual Gross Domestic Product. Of this sum, £3.75 trillion was classified as Sterling-denominated liabilities, so largely reflecting operations here in the UK, while £4.39 trillion was foreign currency liabilities reflecting the extent of over-seas operations.
The Sterling liabilities of our financial institutions are dominated by two principal deposit types: sight deposits and time deposits. The former are deposits that can be withdrawn on demand without penalty whereas time deposits require notice of withdrawals. Sterling sight deposits at the end of September totalled £1.16 trillion (31% of Sterling liabilities and 80% of annual GDP) while time deposits totalled £1.52 trillion (40% of Sterling liabilities and 105% of annual GDP). The next largest group of deposits are known repos or, to give them their full title, sales and repurchase agreements. Repos are essentially loans, usually fairly short-term, where banks can sell some of their financial assets, such as government debt, to other banks and this can help to ease any shortages in funds. Sterling-denominated repos totalled £197.8 billion at the end of September (8% of Sterling liabilities and 21% of annual GDP).
To conclude, the growth in our banking system’s liabilities has been pretty staggering. Compared with today’s liabilities of nearly £8.15 trillion, liabilities 13 years ago totalled £2.35 trillion. So over this period the banks’ liabilities have risen from a little below 3 times Gross Domestic Product to over 5½ times GDP. That is certainly worthy of analysis.
Mervyn King’s speech
Banking: from Bagehot to Basel, and back again The second Bagehot lecture, New York City (25/10/10)
Articles
Mervyn King mobilises his tanks Independent, Ben Chu (26/10/10)
Get tougher on banks, says banking governor Mervyn King’ Daily Mail, Hugo Duncan (26/10/10)
Mervyn King attacks ‘absurd’ bank risk BBC News (26/10/10)
Mervyn King says banking must be reinvented BBC News blogs: Peston’s Picks, Robert Peston (26/10/10)
Data
Data on banks’ liabilities and assets are available from the Bank of England’s statistics publication, Monetary and Financial Statistics (Bankstats) (See Table B1.4.)
Questions
- What do you understand by the terms: (i) market failure; and (ii) maturity transformation?
- What is the external cost identified by Mervyn King arising out of maturity transformation?
- What does it mean to internalise an external cost? Can you think of examples from everyday life where attempts are made to do this?
- Consider the various ‘remedies’ identified by Mervyn King to reduce the riskiness of our financial system. (You may wish to download the speech using the web link above).
- Distinguish between the following deposits: (i) time deposit; (ii) sight deposit; and (iii) repos.
It looks like being a busy time for economic commentators for many, many months as they keep an eye on how the economy is progressing in light of the squeeze in public spending and impending tax increases. Inevitably these commentators – including us here on the Sloman News Site – will be watching to see how the private sector responds and whether or not, as is hoped, private sector activity will begin filling the void left by the public sector.
Of course, the largest group of purchasers in the economy is the household sector. So, in the short term at least, they will be crucial in supporting the total level of aggregate demand. The effects of any rebalancing of aggregate demand as the public sector’s role is reduced will be more painful should the real growth in household spending slow or even go into reverse. As consumers we are well aware that our spending depends on more than just our current income. For instance, it is affected by our expectations of our future incomes and by our general financial position. In essence the latter reflects our holdings of financial assets and liabilities (debt) and any wealth we may be lucky enough to hold in valuables such as housing.
So, do we have any clues as to how the financial position of households might be impacting on our spending? Well, the latest numbers from the Bank of England on Housing Equity Withdrawal (HEW) offer us an important insight in to the extent of the fragility felt by households as to their financial position. These numbers show that households increased their stake in housing by some £6.2 billion in the second quarter of 2010. At least two questions probably spring to mind at this point! Firstly, what is HEW and, secondly, what has this got to do with spending?
Let’s begin by defining Housing equity withdrawal (HEW). HEW occurs when new lending secured on dwellings (net lending) increases by more than the investment in the housing stock. Housing investment relates largely to the purchase of brand new homes and to major home improvements, but also includes house moving costs, such as legal fees. When HEW is negative, new secured lending is less than the level of housing investment. In other words, given the level of investment in housing, we would have expected new mortgage debt to have been greater. This means that households are increasing their housing equity.
This brings us to answering our second question – the ‘so what question’. As with all the choices we make, there is an opportunity cost – a sacrifice. By increasing our equity in property and using housing as a vehicle for saving we are using money that cannot be used to fund current consumption or to purchase financial assets.
As we have already noted, the Housing Equity Withdrawal (HEW) figures for Q2 2010 show that households increased their stake in housing by some £6.2 billion. This is equivalent to a little over 2½% of disposable income in the period and income that, as we have also said, could have helped to boost aggregate demand through spending. And, there is another concern for those hoping that households will help support aggregate demand in the short term: negative HEW is not new. In fact, HEW has been negative since the second quarter of 2008, the exact same quarter that the UK entered recession. The magnitude of negative HEW over these past 9 quarters is equivalent to £44.2 billion or 2.1% of disposable income.
Of course, these latest HEW figures are figures from the past. What we are ultimately interested in, of course, is future behaviour. But, it might be that the prolonged period over which British households have been consolidating their own financial position – just as the public sector is looking to do – suggests that households are in cautious mood. So the question for you to debate is how cautious you think the household sector will remain and, therefore, how much households will help support aggregate demand in the months ahead.
Articles
Mortgage equity still increasing, Bank of England says BBC News (1/10/10)
Homeowners pay down loans Independent (2/10/10)
Paying off mortgages is a priority Telegraph, Philip Aldrick (3/10/10)
Homeowners pay off £6.2 billion in mortgage debt Guardian, Phillip Inman (1/10/10)
Families pay off £6bn mortgages Express, Sarah O’Grady (2/10/10)
Data
Housing equity withdrawal (HEW) statistical releases Bank of England
Questions
- What do you understand by aggregate demand? And what do you think a ‘rebalancing’ of aggregate demand might refer to?
- What do you understand by the term housing equity withdrawal?
- What is the opportunity cost of positive housing equity withdrawal (HEW)? What about the opportunity cost of negative HEW?
- What factors might help to explain the nine consecutive quarters of negative HEW?
- List those items that you might included under: (i) household financial assets; (ii) household financial liabilities; and (iii) household physical assets. Using this information, how would you calculate the net worth of a household?
- Let’s think about the spending of households. Draw up a list of factors that you think would affect a household’s current spending plans. Given your list, what conclusion would you draw about the strength of household spending in the months ahead?
Some numbers are a newspaper editor’s dream! One such number this week was -3.6%. This was the fall in house prices in September reported by the Halifax (part of the Lloyds Banking Group). This certainly helped to alert a large audience to the downward momentum in house price growth that has been underway since about the start of the summer. While the Nationwide Building Society reported a 0.1% rise in September it is significant that both Halifax and Nationwide estimate that across the three months to September house prices actually fell by around 0.9%. In other words, the average UK house price fell by 0.9% in the third quarter of the year.
The annual rate of house price inflation, as the name suggests, compares house prices with the same point in time a year ago. The impact of the house price falls in the third quarter has been to reduce the annual rate of house price inflation to around the 3% mark. While the annual rate is still in positive territory, an obvious concern is how long this will be the case. Well, we can expect the annual rate to fall further because the UK saw strong house price growth in the final quarter of 2009 – the Nationwide estimates this to have been 2.2%. If I (Dean) was to throw my hat in the ring and hazard a guess as to the annual rate of house price inflation in the final quarter of 2010, I’d be inclined to say that it would be around the zero mark. If my crystal ball is found to be right, it would mean that house prices will end 2010 no higher than they finished 2009.
Now this is going to surprise you, but there has been considerable agreement amongst economists as to the reasons behind the recent house price falls. In short, it has been shifts in housing demand and supply. The evidence, such as that from estate agents, points to increases in houses prices during the second half of 2009 and the early part of this year as having induced additional housing supply. This means that estate agents saw instructions to sell increase strongly. People felt a little more confident about putting their property on the market and there was also a recovery in the volumes of new homes constructed.
So far, so good, you might think. But, as this year has moved on growing uncertainty about the economic environment and the on-going difficulties facing many potential buyers, especially first-time buyers, in obtaining mortgage credit, has contributed to a weakening of demand. The impact on the number of potential first-time buyers has been particularly acute because, by being increasingly credit-constrained, they have in effect become increasingly deposit-constrained too. The point is that buyers, especially first-time buyers, are being asked to find relatively large deposits to compensate for limited mortgage credit and both their limited ability and willingness to find these deposits is impacting on housing demand. So with a weakening demand we have been left with what Rightmove describes as a ‘supply hangover’. The effect has been for prices to fall.
It is a feature of housing markets that demand–supply imbalances induce considerable volatility in house prices. Going forward, it will continue to be the relative magnitudes of instructions to buy (housing demand) and of instructions to sell (housing supply) that will determine the path of house prices. Just how imbalanced will those estate agents books remain? How long will the supply hangover persist? Could supply increase further as people rush to sell and thereby further destabilising the market? Or will sellers begin taking property off the market, deciding that now is not the time to sell? Questions like these help to show just how real and how exciting the concepts of demand and supply are. Demand and supply are not concepts confined to the pages of textbooks they are alive and at work. The UK housing market demonstrates just how alive they are!
Articles
House prices record worst monthly fall ever Independent, Alistair Dawber (8/10/10)
Regions slip behind in bleak housing market Financial Times, Norma Cohen (8/10/10)
What next for house prices? Telegraph, Kara Gammell (8/10/10)
Fears grow for new market crash as house prices plummet Daily Record, Holly Williams (8/10/10)
Property price plunge blamed on need to sell The Herald, Helen McArdle (8/10/10)
Housing market crash feared after average house prices take record plunge Guardian, Jill Treanor (7/10/10)
UK house prices fell 3.6% in September, Halifax says BBC News (7/10/10)
Data
Halifax House Price Index Halifax (part of the Lloyds Banking Group)
Nationwide House Price Index Nationwide Building Society
Rightmove House Price Index Rightmove
Live Tables on Housing Market and House Prices Department of Communities and Local Government
Questions
- 2010 has been a year of contrasting fortunes for house prices. See if by using a demand and supply diagram you can illustrate the impact of demand and supply shifts on house prices in the first half of the year and then do the same again for more recent months.
- What do Rightmove mean by a ‘supply hangover’? What factors do you think will determine whether this effect persists?
- You become an estate agent. You buy 2 big books. One is to be used to record instructions to buy and the other instructions to sell. You have a meeting with your staff where you discuss those factors that you think will determine how full these two books will be from period to period. What factors do you think you are likely to identify? What impact would one book being fuller than the other have on house prices?
- Explain what we mean by a potential house buyer being credit-constrained. What is meant by a potential buyer being deposit-constrained? Why might first-time buyers be more deposit-constrained than other types of buyers?
- You often hear people talk about the housing market. But, what do we mean by a market? And what do we mean by a housing market? Do prices in all housing markets behave in the same way?
- We’ve seen that there are several institutions that publish an average house price figure. How do you think the likes of Halifax and Nationwide do this? What of Rightmove? Are there any other ways of estimating the average house price? Can you think of any problems that might arise with these estimates?
- It’s now your time for you to dust-off your crystal ball. Imagine that you are employed to write a monthly commentary on UK house prices. What would you expect to be reporting in the coming months?