The OECD published its latest interim assessment of the world economy on April 7. This showed a world gradually bouncing back from recession, with growing GDP (albeit at variable speeds in different countries), rising industrial production, increasing business confidence, a stabilising of financial markets, an easing of credit conditions and yet continuing low inflation.
The UK is forecast to have an annualised rate of growth of GDP in quarter 2 of 3.1%. This is the second highest of the G7 countries, behind only Canada. This would seem like good news – an economic spring for the UK.
Despite continuing growth in the OECD countries, in most of them recovery is fragile. The OECD thus recommends caution in removing the stimulus measures adopted in most countries and hence caution in embarking on measures to cut public-sector deficits. As the report states:
Despite some encouraging signs on activity, the fragility of the recovery, a frail labour market and possible headwinds coming from financial markets underscore the need for caution in the removal of policy support. Central banks have already begun to rein in the exceptional liquidity stimulus injected during the recession. Further action in this area will need to be guided by financial conditions. The normalisation of policy interest rates should be carried out at a pace that will be contingent on the strength of the recovery in individual countries and the outlook for inflation beyond the near-term projection horizon. As for fiscal policy, the sharp increase in government indebtedness in the OECD area during the downturn calls for ambitious, clearly communicated medium-term consolidation programmes in many countries. Consolidation should start in 2011, or earlier where needed, and progress gradually so as not to undermine the incipient recovery.
The following webcast from the OECD presents the report.
Webcast
Interim Assessment OECD, Pier Carlo Padoan, OECD Chief Economist (7/4/10)
Report
Portal to report and webcast OECD
What is the economic outlook for OECD countries? An interim assessment OECD, Pier Carlo Padoan (7/4/10)
Articles
Economy set to speed up and beat UK’s rivals, says OECD Independent, Sean O’Grady (8/4/10)
Economy poised for rapid expansion Financial Times, Norma Cohen and Daniel Pimlot (8/4/10)
OECD sees slower growth in US, Europe, Japan Sydney Morning Herald (8/4/10)
UK business confidence ‘hits four-year high’ BBC News (12/4/10)
British companies confident of recovery but need investment, BDO warns Telegraph, Angela Monaghan (12/4/10)
Questions
- What are the main findings in the report?
- What are the policy implications of the findings?
- What are the implications of developments in financial markets? What are the possible ‘headwinds’?
- What factors could threaten the recovery of the UK economy?
With an election approaching, there is much debate about recovery and cuts and about the relationships between the two. Will rapid cuts stimulate confidence in the UK by business and bankers and thereby stimulate investment and recovery, or will they drive the economy back into recession? The debate is not just between politicians vying for your vote; economists too are debating the issue. Many are taking to letter writing.
In the February 2010 news blog, A clash of ideas – what to do about the deficit, we considered three letters written by economists (linked to again below). There has now been a fourth – and doubtless not the last. This latest letter, in the wake of the Budget and the debates about the speed of the cuts, takes a Keynesian line and looks at the sustainability of the recovery – including social and environmental sustainability. It is signed by 34 people, mainly economists.
Letter: Better routes to economic recovery Guardian (27/3/10)
Letter: UK economy cries out for credible rescue plan Sunday Times, 20 economists (14/2/10)
Letter: First priority must be to restore robust growth Financial Times, Lord Skidelsky and others (18/2/10)
Letter: Sharp shock now would be dangerous Financial Times, Lord Layard and others (18/2/10)
Questions
- Summarise the arguments for making rapid cuts in the deficit.
- Summarise the arguments for making gradual cuts in the deficit in line with the recovery in private-sector demand.
- Under what conditions would the current high deficit crowd out private expenditure?
- What do you understand by a ‘Green New Deal’? How realistic is such a New Deal and would there be any downsides?
- Is the disagreement between the economists the result of (a) different analysis, (b) different objectives or (c) different interpretation of forecasts of the robustness of the recovery and how markets are likely to respond to alternative policies? Or is it a combination of two of them or all three? Explain your answer.
- Why is the effect of the recession on the supply-side of the economy crucial in determining the sustainability of a demand-led recovery?
The pound is regarded as an international currency, but its value has been declining throughout the financial crisis. Indeed, this downward trend is one of the factors that has prevented the recession in the UK from getting worse. As the exchange rate changes, the relative competitiveness of a country’s products changes and this therefore affects exports and imports.
However, despite a declining pound, exports from the UK have fallen and this has contributed to an unexpected global goods trade deficit in January of nearly £8 billion – the largest level since August 2008 and well above the forecast of £7 billion. This is putting further pressure on the pound. A key to the UK’s economic recovery was argued to be growth in exports, but this now appears to be a somewhat forlorn hope. The figures released show that exports slumped 6.9% to £19.5 billion in January, whilst imports only fell by 1.6%. A contributing factor might be the bad weather that hit the UK in January, but the long-term decline of manufacturing in Britain has also been put forward as a reason.
The following articles consider the UK’s trade deficit and the possibility of an export-led recovery.
Articles
January trade deficit widens as exports fall Guardian, Kathryn Hopkins (9/3/10)
UK trade gap widens to worst in 17 months BBC News (9/3/10)
Exports plunge heaps pressure on pound Independent (9/3/10)
Pound slides back against dollar and euro Guardian, Ashley Seager (21/9/09)
Trade gap widens despite weak pound Financial Times (9/3/10)
UK exports plunge by £1.4 billionThe Press Association (9/3/10)
Pound falls again on deficit fears Guardian (9/3/10)
UK trade gap widens as exports sink Wall Street Journal, Nicholas Winning (9/3/10)
Rebalancing, deferred BBC News blogs, Stephanomics Stephanie Flanders (9/3/10)
Global recovery is helping UK, says Bank of England’s Sentance Guardian, Larry Elliott (18/3/10)
Pound Declines as Investors Bet Bank of England Will Hold Rates BusinessWeek, Lukanyo Mnyanda (20/3/10)
Data
For UK balance of trade data, see UK Trade (Office for National Statstics)
For exchange rate data, see Statistical Interactive Database (Bank of England)
Questions
- How is the value of the pound determined?
- Illustrate a depreciation of the pound on a diagram. What are the factors that could cause this?
- When the value of the pound falls, why should UK goods become more competitive?
- Explain why an export-led recovery was a possibility for the UK economy. How can we use the transmission mechanisms to help explain this?
- Despite a weak pound, exports have fallen. What are the explanations for this?
- What are the consequences of a widening trade deficit and how can it be tackled?
On February 14, the Sunday Times published a letter by 20 eminent economists calling on the next government to cut the public-sector deficit more rapidly than that planned in last December’s pre-Budget report.
In order to minimise this risk and support a sustainable recovery, the next government should set out a detailed plan to reduce the structural budget deficit more quickly than set out in the 2009 pre-Budget report.
The exact timing of measures should be sensitive to developments in the economy, particularly the fragility of the recovery. However, in order to be credible, the government’s goal should be to eliminate the structural current budget deficit over the course of a parliament, and there is a compelling case, all else being equal, for the first measures beginning to take effect in the 2010-11 fiscal year.
Then on 18 February the Financial Times published two letters, between them from more than 60 economists, backing Alistair Darling’s policy of delaying cuts until the recovery is firmly established. They openly disagreed with the 20 economists who wrote to the Sunday Times.
… while unemployment is still high, it would be dangerous to reduce the government’s contribution to aggregate demand beyond the cuts already planned for 2010-11 (which amount to 1 per cent of gross domestic product). Further immediate cuts – even supposing they are practicable – would not produce an offsetting increase in private sector aggregate demand, and could easily reduce it. History is littered with examples of premature withdrawal of the government stimulus, from the US in 1937 to Japan in 1997. With people’s livelihoods at stake, a responsible government should avoid reckless actions.
… A sharp shock now would not remove the need for a sustained medium-term programme of deficit reduction. But it would be positively dangerous. If next year the government spent less and saved more than it currently plans, this would not “make a sustainable recovery more likely”. The weight of evidence points in the opposite direction.
So why do such eminent economists have apparently such divergent views on tackling the public-sector deficit? Is there any common ground between them? What does the disagreement imply about the state of macroeconomics? Read the letters and articles and then try answering the questions.
Tories right on cuts, say economists Sunday Times, David Smith (14/2/10)
Letter: UK economy cries out for credible rescue plan Sunday Times, 20 economists (14/2/10)
Economists reject calls for budget cuts Financial Times, Jean Eaglesham and Daniel Pimlott (18/2/10)
Letter: First priority must be to restore robust growth Financial Times, Lord Skidelsky and others (18/2/10)
Letter: Sharp shock now would be dangerous Financial Times, Lord Layard and others (18/2/10)
Economists urge swift action to reduce budget deficit BBC News (14/2/10)
Economists back delay on government spending cuts BBC News (19/2/10)
Economists back delay on government spending cuts BBC News (19/2/10)
Men of letters III BBC News blogs: Stephanomics, Stephanie Flanders (19/2/10)
Daily View: When to cut spending? (including podcast) BBC News blogs, Clare Spencer (19/2/10)
Cautious economists and cutters battle it out in print Guardian (20/2/10)
The great economics rift reopens Guardian, Gavyn Davies (19/2/10)
Focus on growth. Don’t argue about cuts Times Online, Eamonn Butler (20/2/10)
Recession’s ruins hide plenty of spare capacity Sunday Times, David Smith (14/2/10)
Questions
- To what extent is the disagreement between the two sets of economists largely one of the timing of the cuts?
- Is the disagreement the result of (a) different analysis, (b) different objectives or (c) different interpretation of forecasts of the robustness of the recovery and how markets are likely to respond to alternative policies? Or is it a combination of two of them or all three? Explain your answer.
- How would new classical economists respond to the Keynesian argument that it is necessary to focus on aggregate demand if the economy is to experience a sustained recovery?
- How would Keynesian economists respond to the argument that rapid cuts will reassure markets and allow private-sector recovery to more than compensate for reduced public-sector activity?
- Why is the effect of the recession on the supply-side of the economy crucial in determining the sustainability of a demand-led recovery?
- Distinguish between the cyclical and structural deficits. How would the policies advocated by the two groups of economists impact on the structural deficit?
Since March 2009, the Bank of England has engaged in a process of quantitative easing (QE). Over the period to January 2010 the Bank of England injected £200 billion of new money into the economy by purchasing assets from the private sector, mainly government bonds. The assets were purchased with new money, which enters the economy as credits to the accounts of those selling the assets to the Bank of England. This increase in narrow money (the monetary base) is then able to form the basis of credit creation, allowing broad money (M4) to increase by a multiple of the increased monetary base. In other words, injecting £200 billion allows M4 to increase by considerably more.
But just how much more will M4 rise? How big is the money multiplier? This depends on the demand for loans from banks, which in turn depends on the confidence of business and households. With the recovery only just beginning, demand is still very dampened. Credit creation also depends on the willingess of banks to lend. But this too has been dampened by banks’ desire to increase liquidity and expand their capital base in the wake of the credit crunch.
Not surprisingly, the growth in M4 has been sluggish. Between March and Decmber 2009, narrow money (notes, coin and banks’ reserve balances in the Bank of England) grew from £91bn to £203bn (an increase of 123%). M4, however, grew from £2011bn to £2048bn: an increase of only 1.8%. In fact, in December it fell back from £2069bn in November.
Despite the continued sluggishness of the economy, at its February meeting the Bank of England announced an end to further quantitiative easing – at least for the time being. Although Bank Rate would be kept on hold at 0.5%, there would be no further injections of money. Part of the reason for this is that there is still considerable scope for a growth in broad money on the basis of the narrow money already created. If QE were to continue, there could be excessive broad money in a few months’ time and that could push inflation well above target. As it is, rising costs have already pushed inflation above the 2% target (see Too much of a push from costs but no pull from demand).
So will this be an end to quantitative easing? The following articles explore the question.
Bank of England halts quantitative easing Guardian, Ashley Seager (4/2/10)
Bank calls time on quantitative easing (including video) Telegraph, Edmund Conway (5/2/10)
Bank of England’s time-out for quantitative easing plan BBC News (4/2/10)
Shifting goalposts keep final score in question Financial Times, Chris Giles and Jessica Winch (5/2/10)
Bank halts QE at £200bn despite ‘sluggish’ recovery Independent, Sean O’Grady (5/2/10)
Easy does it: No further QE BBC News blogs, Stephanomics, Stephanie Flanders (4/2/10)
Leading article: Easing off – but only for now Independent (5/2/10)
Not easy Times Online (5/2/10)
Quantitative easing: What the economists say Guardian (4/2/10)
Questions
- Explain how quantitative easing works?
- What determines the rate of growth of M4?
- Why has the Bank of England decided to call a halt to quantiative easing – at least for the time being?
- What is the transmission mechanism whereby an increase in the monetary base affects real GDP?
- What role does the exchange rate play in the transmission mechanism?
- Why is it difficult to predict the effect of an increase in the monetary base on real GDP?
- What will determine whether or not the Bank of England will raise interest rates in a few months’ time?