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?
Reforms and budget cuts seem to be the norm across the world. In the UK, we’ve seen announcements about substantial cuts in government spending and reforms to our welfare state, including child benefit and pension reforms. But how will people react? Perhaps, we should look to France to see what could be to come. People across the country are protesting against the plan to raise the pension age from 60 to 62.
Workers at French oil refineries have ceased work and, as as a result, shortages of petrol across France look set to continue. There has been mass disruption to various transport markets, including cancelled flights and lorry drivers using ‘go-slow tactics’.
Furthermore, it’s not just workers at oil refineries who are on strike. Rubbish remains uncollected; oil tankers are floating off the coast; rail strikes and postal strikes have disrupted daily life; and even the school system has been affected. But, what are the costs of these strikes? Will the French economy suffer? Will economic growth be affected? It’s certainly an inefficient use of resources and will undoubtedly cost money.
Yet, despite these strikes, the President has said that the reforms will still go ahead, as he looks forward to a Senate vote on the pension bill. But what are the problems necessitating pension reform, not just in France, but across the world? And will it be France’s turn to experience a ‘winter of discontent’?
French strikes force petrol stations to shut BBC News (18/10/10)
Defiant Marseille, heart of France’s social unrest Reuters (18/10/10)
French Fuel Crisis: Protests turn violent Sky News, Huw Borland (18/10/10)
JPMorgan says French strike will cut demand for oil next year Bloomberg, Grant Smith (18/10/10)
French strikes hit airlines, trucking, gas pipes Philippine Star (19/10/10)
French riot police clash with students as petrol stations run dry Telegraph, Henry Samuel (18/10/10)
French based for another day of strike action Guardian, Angelique Chrisafis (18/10/10)
France strike: flights cancelled, airlines told to carry enough fuel for return journey Telegraph (18/10/10)
Questions
- What action other than striking is open to workers? What are the costs and benefits of each?
- Why are strikes by groups of workers likely to be more effective than protests by individual workers?
- Illustrate on a diagram the effect of a trade union entering an industry. How does it affect equilibrium wages and equilibrium employment? Is there any difference if the trade union faces a monopsonist employer of labour?
- What are the efficiency arguments against strike action?
- How are oil prices determined? What will be the impact on oil prices of these strikes in France? Will there be an impact on the rest of the world?
- What are the key issues necessitating pension reform? Are these issues worth the price of the strikes?
National debt has increased rapidly over the past few years. In 2006/7 general government debt was £577.8bn or 42.9% of GDP. In 2009/10 it was £1000.4bn or 71.3% of GDP. It is set to go higher, with government debt forecast to be around 87% of GDP in 2011. This compares with forecasts of 82% for Germany, 87% for France, 103% for the USA, 134% for Greece and 195% for Japan.
Getting the deficit and debt down has, not surprisingly, become an issue in many countries. In the UK it has become the major current pre-occupation of the Coalition government and on 20 October it is set to announce major public spending cuts as a means of achieving this.
To get a flavour of the government’s thinking and the message that ministers are putting out to the electorate, the following are quotes from the Prime Minister’s and then the Chancellor’s speeches to the Conservative Party Conference:
This year, we’re going to spend £43 billion pounds on debt interest payments alone. £43 billion – not to pay off the debt – just to stand still. Do you know what we could do with that sort of money? We could take eleven million people out of paying income tax altogether. We could take every business in the country out of corporation tax. That’s why we have acted decisively – to stop pouring so much of your hard-earned money down the drain. We are already paying £120m of interest every single day thanks to the last Labour government. (David Cameron)
It’s the borrowing that doesn’t go away as the economy grows, and we have £109bn of it. It’s like with a credit card. The longer you leave it, the worse it gets. You pay more interest. You pay interest on the interest. You pay interest on the interest on the interest. We are already paying £120m of interest every single day thanks to the last Labour government. Millions of pounds every day that goes to the foreign governments we owe so they can build the schools and hospitals for their own citizens that we aren’t able to afford for ours. How dare Labour call that protecting the poor? (George Osborne)
Let’s unpick this a bit. Who earns the interest? The answer is that it is paid to holders of government debt in the form of government bonds (gilts), national savings certificates, premium bonds, etc. In other words it is paid to savers, whether individuals or pension funds or companies.
Does it all go abroad? In fact 29% of gilts are held abroad. The rest are held by British residents. Thus some 70% of the interest rate paid on government debt goes to British residents and supports pensions and savers. It can thus be seen as a transfer from taxpayers to savers.
Because of the record low interest rates many pensioners who rely on savings interest have seen their incomes fall dramatically. Others draw income from a ‘self-invested personal pension’. The amount that can be drawn each year is based on tables according to a person’s age and the current 15-year Treasury gilt yield (currently 3.45%). Thus the lower the rate of interest, and the less the yield, the less that can be drawn.
So who are the gainers and losers from high general government debt and attempts to get it down? Read the following articles and look at the data and then try answering the questions.
Articles
Britons have donated £7m to help pay off the national debt (but that’s a drop in the ocean) Mail Online, Daniel Martin (9/10/10)
A trillion and rising: Britain’s £1,000,000,000,000 debt means it is now paying as much in interest as it does for defence Mail Online, Hugo Duncan (1/10/10)
Spending cuts “not enough”, say small firms Telegraph, James Hurley (8/10/10)
UK public finances post record August deficit Guardian, Julia Kollewe (21/9/10)
Another paradox of thrift The Economist, Buttonwood (16/9/10)
Data
The gilt market UK Debt Management Office
Gilt market data UK Debt Management Office
Overseas gilt holdings UK Debt Management Office
Public sector: current position ONS (30/9/10)
Public sector finances ONS Statistical Bulletin (21/9/10)
Government deficit and debt under the Maastricht Treaty ONS Statistical Bulletin (30/9/10)
Contributions to the government deficit and debt ONS Statistical Bulletin (31/3/10)
Questions
- Explain the difference between central government, general government and public-sector deficits and debt.
- Who loses from a rising public-sector debt? Who gains?
- Conduct an international comparison of (a) the level of the government deficit and debt and (b) their rate of growth over the past few years.
- What is meant by the ‘yield’ on a particular gilt?
- If gilt yields fall, does this mean that the government pays less on existing gilts? Is it likely to pay less on new gilt issues? Explain.
- How do cuts affect the distribution between savers and borrowers?
Multinational companies bring many advantages to host nations. Whether it is creating jobs, income, investment or sharing technology, governments across the world try to encourage firms to set up in their country. However, once a multinational has been set up, it’s natural for the owners and managers to favour their own countries when decisions have to be made. If there is some new investment planned, where to put it will be a key decision and not just for the firm. New investment may mean new jobs and better working environments. If job cuts are necessary, the decision-maker’s country of origin may determine where they occur.
This so-called ‘Headquarters effect’ is apparent in the case of Siemens, which has guaranteed the safety of all German jobs, both now and in the future. Those employees in the UK are understandably concerned. If job cuts are needed and German workers will not be affected, it takes little intelligence to realise that their jobs may be at risk. The following discussion by Robert Peston considers this issue.
British jobs, for German workers BBC News blogs, Peston’s Picks, Robert Peston (7/10/10)
Questions
- What is the ‘Headquarters effect’?
- The article states: “The HQ effect implies that when a British plant is owned by an overseas company, it may be more vulnerable to being closed down if the going gets tough”. Why is this the case?
- What are the advantages and disadvantages of multinational investment to (a) the multinational company and (b) the host country?
- How is multinational investment affected by the business cycle?
- It Trent UK were to shut down or if a particular office was closed in one part of the country, what type of unemployment would be created?
If you are an Irish resident, you may be feeling very worried! As Irish debt levels reach new heights, the bill will once again fall on the tax payer. Irish government borrowing is almost 12% of GDP, but with two key banks requiring a bail out, government borrowing is expected to treble this figure to some 32% of GDP. The Anglo-Irish bank requires approximately £30 billion and Allied Irish also requires more cash. The Irish Finance Minister said:
‘The state has to downsize these institutions to prevent them becoming a systemic threat to the state itself.’
The Irish have already faced a round of austerity cuts and with the latest banking catastrophe, the next round is about to start. There are concerns that the Irish economy could move into a downward spiral, with more money being removed from the economy causing more people to lose their jobs, which will weaken public finances further and mean that more borrowing will then be required. It is hardly surprising to find a pessimistic mood on the streets of Ireland.
However, with a new interdependent world, this crisis will not only be felt by Ireland. The UK exports a large amount to Ireland – more than to Spain or Italy. With Irish tax-payers facing higher burdens and unemployment still relatively high, UK exporters may feel the squeeze. Other countries on the periphery of Europe, such as Portugal, Greece and even Spain are also feeling the pressure. There are concerns of a ‘two-speed Europe’. Below are some articles about the Irish crisis. Do a search and see if you can find any information on the problems in Greece, Spain or Portugal.
Ireland: a problem soon to be shared BBC News blogs, Stephanomics, Stephanie Flanders (30/9/10)
European recovery hope grows despite Ireland’s swelling deficit Guardian, Richard Wachman (30/9/10)
Ireland bank rescue spurs global debt concerns The World Today (ABC News), Peter Ryan (30/10/10)
Irish debt yields in new record despite better job data BBC News (28/9/10)
Euro Govt-bonds fall after overdone rally on Ireland, Spain Reuters (30/9/10)
Ireland’s love affair with masochism Telegraph, Jeremy Warner (30/9/10)
EU austerity drive country by country BBC News (30/9/10)
Anglo-Irish was ‘systemic threat’ BBC News (30/9/10)
Questions
- What do we mean by government borrowing?
- With such high levels of government debt, what would you expect to happen to interest rates on government debt? Explain your answer.
- When deciding whether or not to bail out the banks, what process could a government use?
- The Irish Finance Minister talks about the institutions becoming a ‘systemic threat’. What does he mean by this?
- Why might the UK economy suffer from the problems in Ireland?
- To what extent do you agree that there is a two-speed Europe, with the core economies, such as France and Germany making good economic progress, but the peripheral economies still suffering from the effects of recession?
- How might the situation in Ireland affect other members of Europe? Will there be an impact on the euro exchange rate?