While inflation is a concern in the UK and is making the Bank of England think twice about keeping interest rates at their all time low of 0.5%, inflation in Japan is being celebrated. The Japanese economy has been plagued by deflation for over a decade and for the past 2 years inflation has never been above 0%. However, in April the consumer price index (CPI) rose to 0.6% from the previous year, fuelled by petrol prices. Strangely it might be the Japanese earthquake and tsunami that helped this situation, as Japan was unable to generate sufficient electricity and hence had to import fuel from abroad.
A typical question from non-economists is always about why deflation and hence falling prices is such a bad thing. Surely, it’s great for consumers? For those shopping for bargains, perhaps it is helpful – after all, if prices fall, a consumer’s real income will be higher. However, the problem with falling prices is that people start to hold off buying. If you want to buy a car, but expect prices to be lower next month, then it’s a rational decision to delay your purchase until next month when prices are lower. However, next month, you still expect prices to be lower in the following month and so delay purchasing again. And so the process continues. When people expect prices to fall they put off their purchases, this reduces demand and so prices do indeed fall. There are also costs for businesses: as consumers delay buying, sales begin to fall. And businesses are also consumers, and so they start delaying their purchases of inputs.
While many central banks across the world have begun to tighten monetary policy, the Japanese central bank seems inclined to keep monetary policy loose and has even considered expanding the emergency lending programme. As Azusa Kato, an economist at BNP Paribas, said:
“The bank will probably add stimulus if it sees more signs of weakening demand”. “If you strip out energy and food costs, consumer prices are basically flat now.”
Despite this inflationary pressure, many believe that it is unlikely to continue and deflationary pressures may appear once again in the near future. The following articles consider the Japanese deflationary situation.
Articles
Japan ends 25 months of deflation Bloomberg, Mayumi Otsuma (27/5/11)
Japan consumer prices log first rise in 28 months Associated Press (27/5/11)
Japan beats deflation for the first time in two years BBC News (275/11)
Japan overcomes deflation for first time in two years Guardian, Julia Kollewe (27/5/11)
Japanese consumer price rise (including video) BBC News (27/5/11)
Japan April core CPI rises 0.6 pct yr/yr Reuters (26/5/11)
Japan experiences inflation for first time in over two years Telegraph (27/5/11)
Data
Japan Inflation Rate Trading Economics
Consumer Price Index (Japan) Japanese Statistics Bureau
Inflation Rate and Consumer Price Index (CPI) (for USA, Canada, Australia, UK and Japan) Rate Inflation
Statistical Annex, Preliminary Version OECD
Questions
- What are the main costs of deflation? Think about the wider effects on consumers, businesses and the government.
- What has caused the increase in inflation to 0.6% in Japan and why was there an expectation that inflation would re-appear?
- What explanation can be given for the belief that deflation will soon re-emerge?
- Using a demand and supply diagram, explain the process by which consumers delaying their consumption will lead to prices falling continuously.
- What is the best policy for the Japanese central bank to pursue in light of the new data?
The banking sector was at the heart of the credit crunch and it may also be at the heart of the recovery. Too much lending to those who could not repay has now translated into government encouragement and targets to stimulate further lending. Banks made a deal with the government (Project Merlin) to lend £76bn to small and medium sized companies (SMEs) in 2011, however, the data for the first quarter of 2011 shows that the top five UK banks lent only £16.8bn, some £2.2bn short of their quarterly target (about 12%). Despite this sum still being a significant figure, small companies have said that they are still finding it difficult to obtain credit from banks. A poll found 44% of companies that asked for a loan were turned down and many were discouraged from even applying as they had almost no chance.
Encouraging banks to lend and hence stimulating investment by businesses may prove crucial to the UK’s recovery. Vince Cable’s words with regard to lending emphasise its importance:
“We will monitor the banks’ performance extremely closely and if they fail to meet the commitments they have agreed we will examine options for further action.”
If small businesses can obtain credit, it will help them to develop and expand and this should have knock on effects on the rest of the economy. Jobs could be created, giving more people an income, which in turn should stimulate consumption, further investment and finally aggregate demand. It may not be the case that the UK’s recovery is entirely dependent on bank lending, but it could certainly play an important role, hence the government’s insistence for further lending. It may also act to create confidence in the economy. The following articles consider the bank’s role in providing credit to SMEs.
Articles
Bank lending falling short of promises by £25m a day Mail Online, Becky Barrow (24/5/11)
Cable tells banks to increase lending to small firms BBC News (23/5/11)
Bank lending targets: What the experts say Guardian, Alex Hawkes (23/5/11)
Major banks fail to meet their lending targets Independent, Sean Farrell (24/5/11)
Banks on course to miss small business lending target Guardian, Philip Inman (23/5/11)
Project Merlin needs to be less woolly and more wizard Guardian, Nils Pratley (23/5/11)
Bankers caused the crash and now they strangle recovery Guardian, Polly Toynbee (27/5/11)
Data
Trends in Lending Bank of England (see in particular, Lending to UK Businesses)
Questions
- Why have banks not met their lending targets for the first quarter of 2011?
- Why is project Merlin so potentially important to the recovery of the economy?
- Using an AD/AS diagram, illustrate the possible effects of further lending.
- Are there any possible adverse consequences of too much lending?
- Why might banks have little incentive to increase their lending to SMEs?
The debate about how much and how fast to cut the deficit has often been presented as a replaying of the debates of the 1920s and 30s between Keynes and the Treasury.
The justification for fiscal expansion to tackle the recession in 2008/9 was portrayed as classic Keynesianism. The problem was seen as a short-term one of a lack of spending. The solution was seen as one of expansionary fiscal and monetary policies. There was relatively little resistance to such stimulus packages at the time, although some warned against the inevitable growth in public-sector debt.
But now that the world economy is in recovery mode – albeit a highly faltering one in many countries – and given the huge overhang of government deficits and debts, what would Keynes advocate now? Here there is considerable disagreement.
Vince Cable, the UK Business Secretary, argues that Keynes would have supported the deficit reduction plans of the Coalition government. He would still have stressed the importance of aggregate demand, but would have argued that investor and consumer confidence, which are vital preconditions for maintaining private-sector demand, are best maintained by a credible plan to reduce the deficit. What is more, inflows of capital are again best encouraged by fiscal rectitude. As he argued in the New Statesman article below
One plausible explanation, from Olivier Blanchard of the IMF, is that the Keynesian model of fiscal policy works well enough in most conditions, but not when there is a fiscal crisis. In those circumstances, households and businesses react to increased deficits by saving more, because they expect spending cuts and tax increases in the future. At a time like this, fiscal multipliers decline and turn negative. Conversely, firm action to reduce deficits provides reassurance to spend and invest. Such arguments are sometimes described as “Ricardian equivalence” – that deficits cannot stimulate demand because of expected future tax increases.
Those on the other side are not arguing against a long-term reduction in government deficits, but rather that the speed and magnitude of cuts should depend on the state of the economy. Too much cutting and too fast would cause a reduction in aggregate demand and a consequent reduction in output. This would undermine confidence, not strengthen it. Critics of the Coalition government’s policy point to the fragile nature of the recovery and the historically low levels of consumer confidence
The following articles provide some of the more recent contributions to the debate.
Keynes would be on our side New Statesman, Vince Cable (12/1/11)
Cable’s attempt to claim Keynes is well argued — but unconvincing New Statesman, David Blanchflower and Robert Skidelsky (27/1/11)
Growth or cuts? Keynes would not back the coalition – especially over jobs Guardian, Larry Elliott (17/1/11)
People do not understand how bad the economy is Guardian, Vince Cable (20/5/11)
The Budget Battle: WWHD? (What Would Hayek Do?) AK? (And Keynes?) PBS Newshour, Paul Solman (29/4/11)
Keynes vs. Hayek, the Rematch: Keynes Responds PBS Newshour, Paul Solman (2/5/11)
On Not Reading Keynes New York Times, Paul Krugman (1/5/11)
Would a More Expansionary Fiscal Policy Be Effective Right Now? Yes: On the Invisible Bond Market and Inflation Vigilantes Once Again Blog: Grasping Reality with a Prehensile Tail, Brad DeLong (12/5/11)
Keynes, Crisis and Monopoly Capitalism The Real News, Robert Skidelsky and Paul Jay (29/4/11)
Questions
- What factors in the current economic environment affect the level of consumer confidence?
- What are the most important factors that will determine whether or not a policy of fiscal consolidation will drive the economy back into recession?
- How expansionary is monetary policy at the moment? Is it enough simply to answer this question by reference to central bank repo rates?
- What degree of crowding out would be likely to result from an expansionary fiscal policy in the current economic environment? If confidence is adversely affected by expansionary fiscal policy, would this represent a form of crowding out?
- Why may fiscal multipliers have ‘turned negative’?
- For what reasons might a tight fiscal policy lead to an increase in aggregate demand?
- Your turn: what would Keynes have done in the current macroeconomic environment?
Each month the Bank of England releases figures on the amount of net lending to households. Net lending measures the additional amount of debt acquired by households in the month and so takes into account the amount of debt that households repay over the month. For some time now, the levels of net lending have been remarkably low. Over the first quarter of 2011, monthly net lending to households averaged £1.2 billion. This might sound like a lot of money and in many ways this is true. But, to put the weakness of this figure into perspective, the monthly average over the past ten years is £7 billion.
Household debt can be categorised as either secured debt or unsecured debt. The former is mortgage debt while the latter includes outstanding amounts due on credit and store cards, overdrafts and personal loans. Levels of net secured lending have averaged £1 billion per month over the first 3 months of 2011. This compares with a 10-year average of £5.8 billion per month. Levels of net unsecured lending have averaged £196 million per month over the first 3 months of 2011. This compares with a 10-year average of £1.2 billion per month. In 12 of the months between December 2008 and January 2011 net unsecured lending was actually negative. This means that the value of repayments was greater than new unsecured lending. Once bad debts are taken into account we observe from the autumn of 2008 almost persistent monthly falls in the stock of unsecured debt.
Weak levels of net lending reflect two significant factors. First, on the supply-side, lending levels remain constrained and credit criteria tight. Second, on the demand-side, households remain anxious during these incredibly uncertain times and would appear to have a very limited appetite for taking on additional credit.
Finally, a note on the stock of debt that we households collectively hold. The stock of household debt at the end of March 2011 was £1.45 trillion. This is £7.2 billion or 0.5% lower than in March 2010. The stock of secured debt has risen over this period by only £2.6 billion or 0.2%, while unsecured debt – also known as consumer credit – has fallen £9.9 billion or 4.5%. These figures help to reinforce the message that British households continue to consolidate their financial positions.
Articles
Latest data shows UK economy still sluggish Euronews (4/5/11)
Bank reveals weal lending on mortgages City A.M., Julian Harris (5/5/11)
Mortgage lending plummets by 60% Belfast Telegraph (5/5/11)
Mortgage lending down as borrowers repay debt thisismoney.co.uk (4/5/11)
Average UK household owes more than £50,000 in debts Mirror, Tricia Phillips (6/5/11)
Data
Lending data are available from the Bank of England’s statistics publication, Monetary and Financial Statistics (Bankstats) (See Tables A5.2-A5.7).
Questions
- What is the difference between gross lending and net lending?
- What do you understand by a negative net lending number?
- What is the difference between net secured lending and net unsecured lending?
- What factors do you think help to explain the recent weakness in net lending?
- How would you expect the net lending figures in a year’s time to compare with those now?
- As of 31 March 2011, UK households had accumulated a stock of debt of £1.45 trillion. In what ways could we put this figure into context? Should we as economists be concerned?
- It is said that households are consolidating their financial position. What do you understand by this term and what factors have driven this consolidation?
- What are the implications for the wider economy of households consolidating their financial position?
The snow the UK has seen over the past two winters created massive disruption, but that is only one reason for hoping for a milder winter to come. With the cold weather, the UK economy faced threats of gas shortages, as households turned on their heating. However, despite the freezing temperatures, many households were forced to turn off their heating regularly, due to the excessive bills they would face. This trend is expected to be even more prevalent if the 2011/12 winter is as cold, as fuel tariffs are predicted to rise. The Bank of England has said that gas and electricity prices could rise this year by 15% and 10% respectively. British Gas’s Parent company, Centrica said:
“In the UK the forward wholesale prices of gas and power for delivery in winter 2011/12 are currently around 25% higher than prices last winter, with end-user prices yet to reflect this higher wholesale market price environment.”
These predictions might see the average UK household paying an extra £148 over the next year. Although these are only estimates, we are still very likely to see many households being forced to turn off their heating. One thing which therefore is certain: a warmer winter would be much appreciated!
Articles
Switch energy tariff to help beat bill rises Guardian, Miles Brignall (14/5/11)
Quarter of households predicted to turn off heating BBC News, Brian Milligan (14/5/11)
Power bills set to soar by 50% in four years Scotsman (14/5/11)
Domestic fuel bills poised to rise by up to £200 Financial Times, Elaine Moore (13/5/11)
Data
Energy price statistics Department of Energy & Climate Change
Energy statistics publications Department of Energy & Climate Change
Questions
- Which factors have contributed to rising energy prices? Illustrate these changes on a demand and supply diagram.
- To what extent do these higher prices contribute to rising inflation?
- What impact might these price rises have on (a) poverty and (b) real income distribution in the UK?
- Why are energy prices currently being investigated by Ofgem? What powers does the regulator have and what actions could be taken?