Australia was one of the few economies that seemed to be somewhat insulated from the 2008/09 recession and credit crunch. However, with the UK now back in recession and global economic conditions worsening in much of Europe, Australia has now joined the list of countries that are experiencing economic conditions that are ‘weaker than forecast’.
Today’s world involves economies that are increasingly interdependent, hence the spread of the world economic slowdown. As such, with weak global demand, Australia has started to feel the effects, with demand for its goods and raw materials falling. This has led Australia’s central bank – the Reserve Bank of Australia – to cut its key interest rate (the ‘cash rate’) by more than expected. The rate had been at 4.25% and it was widely believed that a 0.25 percentage point cut would occur. However, the central bank cut the cash rate rate to 3.75% to counter the weakening conditions. The Reserve Bank said:
“This decision is based on information received over the past few months that suggests that economic conditions have been somewhat weaker than expected, while inflation has moderated …Growth in the world economy slowed in the second half of 2011, and is likely to continue at a below-trend pace this year.”
Banks’ interest rates have been falling in Australia for the past few months and this latest cut will do much to help financially squeezed households. Data show that Australian house sales have fallen, as have house prices, and retail sales have fared little better.
Lower interest rates are often a tool used to steer inflation and the Australian central bank may not have been as willing to cut rates had the inflation rate not come down in recent months. Keeping consumer prices under control remains a top priority for the central bank and so it will be interesting to see the impact that these rate cuts will have on the Australian economy.
Articles
Australia cenbank surprises with aggressive half point rate cut Reuters, Wayne Cole (1/5/12)
Australia cuts rates by than forecast to 3.75% BBC News (1/5/12)
Banks unlikely to pass on full rate cut The Australian, Wall Street Journal, Peter Trute (1/5/12)
Australia cuts rate to support economy Financial Times, Neil Hume (1/5/12)
Australia slashes interest rates by 0.5pc to boost economy The Telegraph (1/5/12)
Australia cuts interest rates as economy slows Guardian, Phillip Inman (1/5/12)
Banks must pass on rate cut: businesses Sydney Morning Herald, Ehssan Veiszadeh (1/5/12)
Bond prices rally after rate cut Sydney Morning Herald (1/5/12)
Surplus remains appropriate: Swan Sydney Morning Herald, Colin Brinsden (1/5/12)
Webcasts
Reserve Bank of Australia Cuts Rates by 50 Basis Points to 3.75% CNBC video, Lauren Rosborough (1/5/12)
Further `Modest’ RBA Easing Possible, ANZ Says Bloomberg, Tony Morriss (1/5/12)
Australia’s central bank shifts focus to growth BBC News, Duncan Kennedy (1/5/12)
Questions
- Which factors will a central bank consider when setting interest rates?
- Explain the components of aggregate demand that will be affected by a lower rate of interest.
- Using diagrams to illustrate the process, explain both the interest-rate and the exchange-rate transmission mechanisms of the fall in interest rates.
- How are interest rates used to target inflation?
- How will lower rates of interest help the Australian economy recover from weakening global economic conditions?
- Why are Australia’s banks unlikely to pass on the full rate cut to consumers?
- Why did bond prices rise and the Australian dollar depreciate after the rate cut? Why does this suggest that a 0.5% cut was greater than anticpated by markets?
With the financial crisis came accusations towards the banking sector that they had taken on too many bad risks. Banks were lending money on more and more risky ventures and this in part led to the credit crunch. Since then, bank lending has fallen and banks have been less and less willing to take on risky investments.
Small businesses tend to fall (rightly or wrongly) into the category of high risk and it is this sector in particular that is finding itself struggling to make much needed investments. All businesses require loans for investments and improvements and if the banking sector is unable or unwilling to lend then these improvements cannot take place.
Quantitative easing has been a key response across the world to the credit crisis to encourage banks to begin lending to each other and to customers. A new government backed scheme worth £20bn aims to increase bank lending to small and medium sized enterprises (SMEs). By guaranteeing £20bn of the participating banks’ own borrowing, lenders will be able to borrow more cheaply than normal. As the banks (so far including Barclays, Santander, RBS and Lloyds Banking Group) can borrow at a cheaper rate, they will therefore be able to pass this on to the businesses they lend to. Under this National Loan Guarantee Scheme (NLGS), businesses will be able to borrow at interests rates that are 1 percentage point lower than those outside the scheme. £5bn will initially be made available with subsequent installments each of £5bn to come later.
With the Budget looming, the Chancellor is keen to show that the government is delivering on its promise to give smaller businesses access to finance at lower interest rates. If this initiative does indeed stimulate higher lending, it may be a much needed boost for the economy’s faltering economic growth. Criticisms have been leveled at the scheme, saying that although it is a step in the right direction, it can by no means be assumed that it will be sufficient to solve all the problems. In particular, the NLGS is unlikely to provide much help for those small businesses that can’t get finance in the first place, irrespective of the cost of the borrowing. Furthermore some banks, notably HSBC, have chosen not to participate in the scheme, due to it not being commercially viable. The overall effect of this scheme will take some time be seen, but if it is effective, it could give the economy and the small business sector a much needed boost.
Banks to join credit-easing scheme Associated Press (20/3/12)
Credit easing: small businesses to get £20bn of guaranteed cheap loans Telegraph, Harry Wilson (20/3/12)
Bank lending scheme targets small businesses BBC News (20/3/12)
Move over Merlin, credit easing has arrived Independent, Ben Chu (20/3/12)
Credit easing injects £20bn into small firms Sky News (20/3/12)
UK launches small firm loan scheme, critics want more Reuters, Fiona Shaikh (20/3/12)
Osborne’s big plan: £20bn for small businesses Independent, Andrew Grice and Ben Chu (20/3/12)
George Osborne launches new scheme to boost lending to businesses Guardian, Larry Elliott (20/3/12)
Questions
- What is credit easing? Has the government’s previous credit easing had the intended effect?
- Why are small and medium sized enterprises normally seen as risky investments?
- Briefly explain the thinking behind this National Loan Guarantee Scheme.
- What are the criticisms currently levelled at this scheme? To what extent are they justified?
- Why has HSBC said that the scheme is not commercially viable for the bank?
- Explain why this scheme could provide a stimulus to the UK economy.
Here’s an excellent article (the first link below) for giving an overview of macroeconomic thinking and policy since the start of the financial crisis in 2007. It looks at how a Keynesian consensus emerged in 2008–9, culminating in policies of fiscal and monetary stimulus being adopted in most major economies.
It also looks at how this consensus broke down from 2010 with the subsequent problem of rising public-sector deficits and debt, and was replaced by a new, although less widespread, consensus of fiscal restraint.
The article is not just about economic theory and policy, but also about the process and politics of how consensus and ‘dissensus’ emerge. It looks at the spread of ideas as a process of ‘contagion’ and how dissent may reflect the view of different defined groups, such as political parties or schools of economic thought.
Consensus, Dissensus and Economic Ideas: The Rise and Fall of Keynesianism During the Economic Crisis, Henry Farrell (George Washington University) and John Quiggin (University of Queensland) (9/3/12)
Keynesianism in the Great Recession Out of the Crooked Timber, Henry Farrell (9/3/12)
Economics in the Crisis (see also) The Conscience of a Liberal, Paul Krugman (5/3/12)
Questions
- What were the features of the Keynesian consensus in 2008–9?
- To what extent can the consensus of that period be described as the result of ‘contagion’?
- Why did consensus break down in 2010?
- How do economic experts play a political role in economic crises?
- To what extent does a lack of consensus benefit politicians?
- Why may the appearance of a consensus be more important in driving policy than actual consensus?
In December 2011, the ECB provided some €489bn to banks in the form of three-year loans at low interest rates (1%) through open-market operations (see Will new ECB repo operations support the eurozone bond market?).
These ‘Longer-term refinancing operations’ or ‘LTROs’ are designed to ease the burden on European banks which have been struggling to persuade markets that they are dealing with their large amounts of toxic debt, some of which is sovereign debt. Indeed, some of the ECB loans have been used to purchase Italian and Spanish bonds, thereby reducing the likelihood that these countries will default on their debts – at least for the timebeing.
On 29 February 2012, the ECB offered another round of LTROs. Some 800 banks borrowed €530bn under the scheme, bringing the total to a little over €1tr. Initially, much of the money has been put back on overnight deposit with the ECB. The hope, however, is that the loans will be used to support increased credit throughout the eurozone and to fund further purchases of sovereign debt.
But will the increased narrow money supply in the eurozone through these open-market operations result in increased broad money and increased spending and growth? The answer to that depends a great deal on confidence: confidence of banks to lend to firms and consumers; confidence of firms and consumers to borrow. The hope is that the extra money supply will not simply see a corresponding reduction in the velocity of circulation.
The following articles consider the likely effects of these longer-term repos on the real economy.
Articles
ECB hands €529bn in emergency loans to European banks Guardian, Heather Stewart (29/2/12)
Q&A: The ECB’s bank funding programme The Telegraph, Angela Monaghan (29/2/12)
Fighting Debt with Debt Forbes, Bob McTeer (5/3/12)
Is ECB’s €1trn cash boost just the tip of the iceberg? Investment Week, Kyle Caldwell, Dan Jones (5/3/12)
Banks deposit record €821bn at ECB Financial Times, Mary Watkins (5/3/12)
Europe economy may see slim gain from supersize funding: poll Reuters, Sumanta Dey (5/3/12)
Who is the ECB helping? BBC News, Stephanie Flanders (29/2/12)
ECB information on OMOs
Open Market Operations ECB
Questions
- Explain how longer-term refinancing operations work.
- What will determine how much of these ECB loans will be lent to companies?
- Explain what is meant by (a) the velocity of circulation; (b) the money multiplier. Why will the size of these two determine the likely success of the ECB’s LTRO programme?
- Why may the ECB’s actions boost market sentiment? Why might they have the opposite effect?
- Explain what is meant by the “continued de-leveraging by banks”. How does this impact on the money multiplier?
The history of macroeconomic thought has been one of lively debate between different schools.
First there is debate between those who favour active government intervention (Keynesians) to manage aggregate demand and those who favour a rules-based approach of targeting some variable, such as the money supply (as advocated by monetarists) or the rate of inflation (as pursued by many central banks), or a hybrid rule, such as a Taylor rule that takes into account a weighted target of inflation and real output growth.
Second there is debate about the relative effectiveness of monetary and fiscal policy. Monetarists argue that monetary policy is relatively effective in determining aggregate demand, which in turn affects output in the short run but only prices in the long run. Keynesians argue that monetary policy can be weak in the short run if the economy is in recession. Quantitative easing may simply be accompanied by a decline in the velocity of circulation. It’s not enough to make more money available and keep interest rates close to zero; people must have the confidence to borrow and spend. Keynesians argue that in these circumstances fiscal policy is more effective.
Third there is the debate about the size of the state and the extent of government borrowing. Libertarians, following the views of economists such as Hayek, argue that reducing the size of the state and reducing government borrowing will create a more dynamic economy, where the private sector will expand to take up the slack created by a reduction in the size of the public sector. Their approach to policy involves a mixture of cutting deficits and market-orientated supply-side policy. Economists on the left, by contrast, argue that economic growth is best stimulated in the short term by increases in government spending and that supply-side policy needs to be interventionist, with the government investing in infrastructure, research and development, education and health. Such growth policies, they argue can be targeted on the poor and help to arrest the growing inequality in society.
These debates have been given added impetus by the global financial crisis in 2008 and the subsequent recession, slow recovery and possibility of a slide back into recession. The initial response of governments and central banks was to stimulate aggregate demand. Through combinations of expansionary fiscal policy, interest rates cut to virtually zero and programmes of quantitative easing, the world seemed set on a course for recovery. But one result of the policies was a massive expansion in government deficits and debt. This led to increasing criticisms from the right, and a move away from expansionary to austerity fiscal policies in order to contain debts that were increasingly being seen as unsustainable. And all the while the debates have raged.
The following podcast and articles look at the debates and how they have evolved. The picture painted is a more subtle and nuanced one than a stark ‘Keynes versus Hayek’, or ‘Keynesians versus monetarists’.
Podcast
Keynes v Hayek: The debate continues BBC Today Programme, Nicholas Wapshott and Paul Ormerod (23/12/11)
Articles
Von Hayek Revisited – Warts and All CounterPunch, David Warsh (26/12/11)
Fed up with Bernanke Reuters, Nicholas Wapshott (20/12/11)
Paul Krugman Versus Milton Friedman Seeking Alpha, ‘Shareholders Unite’ (6/12/11)
Keynes Was Right New York Times, Paul Krugman (29/12/11)
Keynes, Krugman, and Austerity National Review Online, William Voegeli (3/1/12)
The Madness of Lord Keynes The American Spectator, Samuel Gregg (19/12/11)
Central Bankers vs. Natural Stock Market Cycles in 2012 The Market Oracle, David Knox Barker (28/12/11)
Now is the time to eat, drink and be merry Financial Times, Samuel Brittan (29/12/11)
Questions
- To what extent is quantitative easing consistent with (a) Keynesian and (b) monetarist approaches to macroeconomic policy?
- What is meant by the ‘liquidity trap’ and what are its implications for monetary policy? Have we witnessed a liquidity trap since the beginning of 2009?
- What are the arguments for and against an independent central bank?
- Explain Milton Friedman’s assertion ‘that it was the Fed’s failure in 1930 to pursue “open market operations” on the scale needed that deepened the slump’.
- What are the implications of growing government deficits and debt for policies to avoid a slide back into recession?
Australia was one of the few economies that seemed to be somewhat insulated from the 2008/09 recession and credit crunch. However, with the UK now back in recession and global economic conditions worsening in much of Europe, Australia has now joined the list of countries that are experiencing economic conditions that are ‘weaker than forecast’.
