In its report A Distorted Debate: the need for clarity on Debt, Deficit and Coalition Aims, the Centre for Policy Studies claims that the public is confused by economic terminology surrounding the government’s finances. We try and understand this confusion and offer a bath-time solution!
In a survey conducted for the Centre for Policy Studies only 10 per cent of Britons knew that despite cuts to parts of the government’s spending plans, the stock of public sector debt (also known as the national debt) is expected to rise by a further £60 billion by 2015. Rather, 47 per cent of respondents thought that debt would have fallen by this amount.
The confusion is not terribly surprising because there are two important core economic concepts that can confuse: stocks and flows. To try to help we will show how reference to a bath tub can hopefully eliminate the confusion. However, first, let us considerthe Coalition government’s principal fiscal objective. Its so-called fiscal mandate is for the cyclically-adjusted current budget to be in balance by 2015/16. In simple terms, the government wants to be able afford its day-to-day expenditures by this date, after taking into account where the economy is in the business cycle. In other words, if the economy’s output was at its sustainable or potential level in 2015-16 the government should be able to raise sufficient taxes to meet what it refers to as current expenditures. This would still allow the government to borrow to fund investment expenditure, e.g. infrastructural projects, which are enjoyed or consumed over a period of time.
An important thing to note about the fiscal mandate is that the government can expect to need to borrow money in order to afford its current expenditures up to 2015/16. Even beyond this date, assuming that the mandate can be met, it is likely to need money to afford capital expenditures. This is where we introduce the bath tub. Think of government spending as water coming through the bath taps while the taxes that government collect are water leaving through the plug hole. Therefore, spending and tax receipts are flows. If the water pouring into the bath (spending) is greater than the water leaving the bath (tax receipts), the level of water in the bath will rise. You can think of the water level in the bath as the stock of national debt. Therefore, if government is spending more than it receives it needs to borrow money. Borrowing is therefore a flow concept too. As it borrows, the stock of debt (the amount of water in our bath tub) rises.
So we know that government will continue to borrow in the near future. What it is hoping to be able to do, year by year, is begin to borrow less. It wants the deficit to fall. Then, if it can meet its target, it will at least be able to afford current expenditure (after adjustment for where the economy is in the cycle) by 2015/16. As the deficit begins to decline then the stock of debt will rise less quickly. But, the bath tub will continue to fill because more is flowing through the taps than is leaving through the plug hole. However, it will fill less quickly.
What our use of the bath tub analogy demonstrates is the confusion that can be caused when economic terminology is misused. It is important that the terms debt and deficit be used carefully and correctly. Therefore, the next time you are sitting in bath see if you can be the next Chancellor by understanding these key economic concepts.
Don’t know your debts from your deficit? You’re not alone Independent, Andrew Johnson (27/8/12)
Government unlikely to meet deficit targets, warns CPS Telegraph (27/8/12)
Coalition ‘most unlikely’ to meet key economic goals by next election Guardian, Andrew Sparrow (27/8/12)
Public ‘don’t know their debt from their deficit’ Public Finance, Vivienne Russell (28/8/12)
George Osborne ‘still failing to stop rising deficit’ Daily Express (28/8/12)
Questions
- Explain the difference between the concepts of government deficits and government debt?
- Explain what will happen to both the size of the government’s deficit and to its stock of debt if borrowing begins to decline.
- Can the stock of government debt fall if the government continues to borrow? Can the ratio of the stock of government debt fall relative to GDP (i.e. Debt/GDP), if government continues to borrow?
- With examples, explain the differences between the government’s current and investment (capital) expenditures.
- What are the economic arguments for trying to cut the deficit quickly or more slowly?
With droughts and poor harvests in both North America and in Russia and the Ukraine, there are worries that food prices are likely to see sharp rises in the coming months. This is clearly bad news for consumers, especially the poor for whom food accounts for a large proportion of expenditure.
But it’s also bad news more generally, as higher food prices are likely to have a dampening effect on the global economy, struggling to recover from five years of low or negative growth. And it’s not just food prices. Oil prices are rising again. Since mid June, they have risen by nearly 25%. This too is likely to have a dampening effect.
Another contributing factor to rising food prices is a response, in part, to rising oil prices. This is the diversion of land from growing food to growing crops for biofuels.
G20 countries held a conference call on 28 August to discuss food prices. Although representatives decided against an emergency meeting, they agreed to reassess the situation in a few weeks when the size of the US harvest would be clearer. If the situation proved as bad as feared, then the G20 would call an emergency meeting of the Rapid Response Forum, to consider what could be done.
But is the sole cause of rising food prices a lack of production? Are there other problems on the supply side, such as poor distribution systems and waste? And what about the role of demand? How is this contributing to long-term increases in food prices? The articles consider these various factors and what can be done to dampen food prices.
Articles
G20 points to ‘worrying’ food prices Financial Times, Javier Blas (28/8/12)
US food prices to surge on drought Gulf News(30/8/12)
Best to get used to high food and energy prices – they’re here to stay The Telegraph, Jeremy Warner (29/8/12)
Feeling a drought The Economist (14/8/12)
Q&A: World food and fuel prices BBC News (14/8/12)
G20 considers global meeting as food prices rise BBC News (28/8/12)
Biofuels and Food Prices (direct link) BBC ‘In the Balance’ programme (25/8/12)
U.N. body urges G20 action on food prices, waste Reuters, Patrick Lannin (27/8/12)
Ethanol industry hits back over food price claims EurActiv (28/8/12)
The era of cheap food may be over Guardian, Larry Elliott (2/9/12)
Data
Food Price Index Index Mundi
Questions
- Why have food prices been rising in recent weeks?
- Use a demand and supply diagram to demonstrate what has been happening to food prices.
- What determines the price elasticity of demand for wheat? What might this elasticity vary over time?
- What is the role of speculation in determining food prices?
- Illustrate on an aggregate demand and supply diagram the effect of a commodity price shock. What is likely to be the policy response from central banks?
- What determines the price elasticity of supply of food in (a) the short term and (b) the long term?
- What determines the cross price elasticity of supply of food to the price of oil? Is the cross price elasticity of supply positive or negative?
- What can governments do to reduce food prices, or at least reduce food price inflation?
- What benefits may come from higher food and fuel prices over the longer term?
New data released on 25/7/12 by the Office for National Statistics showed that the UK economy shrank by a further 0.7% in the second quarter of 2012. This makes it the third quarter in a row in which GDP has fallen – and it is the steepest fall of the three. Faced with this, should the government simply maintain the status quo, or does it need to take new action?
The construction sector declined the most steeply, with construction output 5.2% down on the previous quarter, which in turn was 4.9% down on the quarter previous to that. The output of the production industries as a whole fell by 1.3% and the service sector fell by 0.1%. (For a PowerPoint of the following chart, click here.)
The immediate cause of the decline in GDP has been a decline in real aggregate demand, but the reasons for this are several. Consumer demand has fallen because of the squeeze on real wages, partly the result of low nominal pre-tax wage increases and partly the result of inflation and tax rises; the government’s austerity programme is holding back a growth in government expenditure; export growth has been constrained by a slowing down in the global economy and especially in the eurozone, the UK’s major trading partner; and investment is being held back by the pessimism of investors about recovery in the economy and difficulties in raising finance.
So what can be done about it?
Monetary policy is already being used to stimulate demand, but to little effect (see Pushing on a string. Despite record low interest rates and a large increase in narrow money through quantitative easing, broad money is falling as bank lending remains low. This is caused partly by a reluctance of banks to lend as they seek to increase their capital and liquidity ratios, and partly by a reluctance of people to borrow as individuals seek to reduce their debts and as firms are pessimistic about investing. But perhaps even more quantitative easing might go some way to stimulating lending.
Fiscal policy might seem the obvious alternative. The problem here is that the government is committed to reducing the public-sector deficit and is worried that if it eases up on this commitment, this would play badly with credit rating agencies. Indeed, on 27/7/12, Standard & Poor’s, one of the three global credit rating agencies, confirmed the UK’s triple A rating, but stated that “We could lower the ratings in particular if the pace and extent of fiscal consolidation slows beyond what we currently expect.” Nevertheless, critics of the government maintain that this is a risk worth taking.
The following articles look at the causes of the current double-dip recession, the deepest and most prolonged for over 100 years. They also look at what options are open to the government to get the economy growing again.
Articles
Britain shrinks again The Economist (25/7/12)
Shock 0.7% fall in UK GDP deepens double-dip recession Guardian, Larry Elliott (25/7/12)
UK GDP figures: expert panel verdict Guardian, Frances O’Grady, Will Hutton, Sheila Lawlor, Vicky Pryce and John Cridland (25/7/12)
GDP shock fall: UK growth in 2012 ‘inconceivable’, warn economists The Telegraph, Angela Monaghan (25/7/12)
UK recession deepens after 0.7% fall in GDP BBC News (25/7/12)
UK economy: Why is it shrinking? BBC News (25/7/12)
UK GDP: A nasty surprise and a puzzle BBC News, Stephanie Flanders (25/7/12)
Tough choices for Mr Osborne BBC News, Stephanie Flanders (26/7/12)
David Cameron in pledge to control UK’s debt Independent, Andrew Woodcock and James Tapsfield (26/7/12)
David Cameron defends economic policies BBC News (26/7/12)
The GDP number is awful – and it’s the product of the Government’s amateur policies, not the euro crisis The Telegraph, Thomas Pascoe (25/7/12)
UK recession: have we heard it all before? Guardian, Duncan Weldon (25/7/12)
US economic growth slows in second quarter BBC News (27/7/12)
GDP data trigger debate on economy Financial Times, Norma Cohen and Sarah O’Connor (25/7/12)
Does weak UK growth warrant more QE? Financial Times (25/7/12)
The recession: Osborne’s mess Guardian editorial (25/7/12)
Data
Gross Domestic Product, Preliminary Estimate, Q2 2012 ONS (25/7/12)
Preliminary Estimate of GDP – Time Series Dataset 2012 Q2 ONS (25/7/12)
Questions
- What are the causes of the deepening of the current recession in the UK?
- Search for data on other G7 countries and compare the UK’s performance with that of the other six countries (see, for example, the OECD’s StatExtracts.
- Compare the approach of George Osborne with that of Neville Chamberlain in 1932, during the Great Depression.
- Does weak UK growth warrant more quantitative easing by the Bank of England?
- To what extent can fiscal policy be used to stimulate the economy without deepening the public-sector deficit in the short term?
- What is meant by ‘crowding out’? If fiscal policy were used to stimulate demand, to what extent would this cause crowding out?
The 2012 London Olympics opened on 27 July. This has been the result of years of planning and investment in infrastructure since London won the bid in 2005.
It is estimated that hosting the Games will have cost over £9bn. It is therefore interesting to consider the long-run impact on a host city years after the last medal has been won. We might expect host cities to achieve increased growth due to the benefits from the improved infrastructure and the impact of increased publicity and exposure on trade, capital and population.
This has recently been investigated in a paper published in the Economic Inquiry by Stephen Billings and James Holladay which looks at the impact hosting the Games has on GDP and trade (working paper available here). One difficulty with trying to identify the impact of hosting the Games, is that only certain cities will have a chance of being chosen as hosts and these may be cities that are more likely to experience future growth. If this is the case, it would appear that the future growth was due to hosting the Games when it would in fact have been likely to occur anyway. In order to control for this, the above paper compares the winners with losing finalists in the selection process for host cities. For example under this approach London would be compared with Singapore, Moscow, New York and Madrid. In addition, subsequent matching processes are also used to select appropriate cities for comparison.
They find that larger cities in wealthier countries are more likely to be chosen to host the Games. However, once comparisons with other appropriate cities are made, overall, they find that hosting the Games has no effect on a cities population, growth or trade. One explanation provided is that the intense competition to host the Games means the potential gains are competed away via escalated promises in order to increase a cities chances of being selected. In addition, they note that there may well still be considerable specific benefits from the investments made to host the Games.
It is also clear that there are both positive and negative externalities from hosting the Games that, whilst difficult to measure, ideally should be taken into account. On the negative side, these include the extra hassle anybody travelling to work in London during the Games will face. On the other hand, on the positive side, it is hoped that part of the long-run legacy of the Games will be increased interest and participation in sport which would result in substantial health benefits.
David Cameron claims London 2012 will bring £13bn ‘gold for Britain’ The Guardian, Hélène Mulholland (05/07/12)
Olympic legacy: how the six Olympic boroughs compare for children The Guardian, Simon Rodgers (19/07/12)
London 2012: Olympics legacy hard to define BBC News, David Bond (13/07/12)
Questions
- Explain how intense competition to host the Games might result in benefits being competed away.
- Can you think of any other externalities resulting from the Olympic Games?
- Why are the impact of externalities difficult to measure?
- What other factors should be taken into account when assessing the costs and benefits of hosting the Games?
- Do you think the decision to bid to host the Games should be purely based on a cost-benefit analysis?
Barclays’ Chief Executive, Bob Diamond, has resigned following revelations that Barclays staff had been involved in rigging the LIBOR in the period 2005–9, including the financial crisis of 2007–9.
So what is the LIBOR; how is it set; what were the reasons for Barclays (and other banks, as will soon be revealed) attempting to manipulate the rate; and what were the consequences?
The LIBOR, or London interbank offered rate, is the average of what banks report that they would have to pay to borrow from one another in the inter-bank market. Separate LIBORs are calculated for 15 different lending periods: overnight, one week, one month, two months, three months, six months, etc. The rates are set daily as the average of submissions made to Thomson Reuters by some 15 to 20 banks (a poll overseen by the British Bankers’ Association). Thomson Reuters then publishes the LIBORs, along with all of the submissions from individual banks which are used to calculate it.
Many interest rates around the world are based on LIBORs, or their European counterpart, EURIBORs. They include bond rates, mortgage rates, overdraft rates, etc. Trillions of dollars worth of such assets are benchmarked to the LIBORs. Thus manipulating LIBORs by even 1 basis point (0.01%) can result in millions of dollars worth of gains (or losses) to banks.
The charge, made by the Financial Services Authority, is that Barclays staff deliberately under- or overstated the rate at which the bank would have to borrow. For example, when interbank loans were drying up in the autumn of 2008, Barclays staff were accused of deliberately understating the rate at which they would have to borrow in order to persuade markets that the bank was facing less difficulty than it really was and thereby boost confidence in the bank. In other words they were accused of trying to manipulate LIBORs down by lying.
As it was the LIBORs were rising well above bank rate. The spread for the one-month LIBOR was around 1 to 1.2% above Bank Rate. Today it is around 0.1 to 0.15% above Bank Rate. Without lying by staff in Barclays, RBS and probably other banks too, the spread in 2008 may have been quite a bit higher still.
The following articles look at the issue, its impact at the time and the aftermath today.
Articles
A Libor primer The Globe and Mail, Kevin Carmichael (3/7/12)
60 second guide to Libor Which? (3/7/12)
Explaining the Libor interest rate mess CNN Money (3/7/12)
Fixing Libor Financial Times (27/6/12)
LIBOR in the News: What it is, Why it’s Important Technorati, John Sollars (2/7/12)
Libor rigging ‘was institutionalised at major UK bank’ The Telegraph, Philip Aldrick (1/7/12)
Barclays ‘attempted to manipulate interest rates’ BBC News, Robert Peston (27/6/12)
The Libor Conspiracy: Were the Bank of England and Whitehall in on it? Independent, Oliver Wright, James Moore , Nigel Morris (4/7/12)
Fixing LIBOR The Economist (10/3/12)
Cleaning up LIBOR? The Economist (14/5/12)
Eagle fried The Economist, Schumpeter (27/6/12)
Barclays looks like the victim Financial Post, Terence Corcoran (3/7/12)
Inconvenient truths about Libor BBC News, Stephanie Flanders (4/7/12)
Timeline: Barclays’ widening Libor-fixing scandal BBC News (5/7/12)
The elusive truth about Barclays’ lie BBC News, Robert Peston (4/7/12)
Rate Fixing Scandal Is International: EU’s Almunia CNBC, Shai Ahmed (4/7/12)
Bank-Bonus Culture to Blame for Barclays Scandal The Daily Beast, Alex Klein (3/7/12)
Libor scandal ‘damaging’ for City BBC Today Programme, Andrew Lilico and Mark Boleat (5/7/12)
Data
Libor rate fixing: see each bank’s submissions Guardian Data Blog, Simon Rogers (3/7/12)
Sterling interbank rates Bank of England
Questions
- Using data from the Bank of England (see link above), chart two or three LIBOR rates against Bank rate from 2007 to the present day.
- For what reason would individuals and firms lose from banks manipulating LIBOR rates?
- Why would LIBOR manipulation be more ‘effective’ if banks colluded in their submissions about their interest rates?
- Why might the Bank of England and the government have been quite keen for the LIBOR to have been manipulated downwards in 2008?
- To what extent was the LIBOR rigging scandal an example of the problem of asymmetric information?
- In the light of the LIBOR rigging scandal, should universal banks be split into separate investment and retail banks, rather than erecting some firewall around their retail banking arm?
- What are the arguments for and against making attempts to manipulate LIBOR rates a criminal offences?
In its report A Distorted Debate: the need for clarity on Debt, Deficit and Coalition Aims, the Centre for Policy Studies claims that the public is confused by economic terminology surrounding the government’s finances. We try and understand this confusion and offer a bath-time solution! 
