According to political business cycle theory, incoming governments tend to take harsh measures at first, when they can blame the cuts on the ‘mess they’ve inherited’ from their predecessors. And then two or three years later, as an election looms, they can start spending more and/or cutting taxes, hoping that the good will this creates will help them win the election.
So are we seeing the start of a new political business cycle with the start of the new Coalition government? The following two articles look at the issue.
Coalition will inflict cuts now and spend later to win a second term Guardian, Larry Elliott (17/5/10)
If you get all the bad news out at once, the only way left to go will be up. Or will it? Independent, Sean O’Grady (18/5/10)
Questions
- Explain what is meant by the ‘political business cycle’.
- Would the existence of a political dimension to the business cycle amplify or dampen the cycle, or could it do either depending on the circumstances? Explain.
- Does the existence of an independent central bank eliminate the political business cycle?
- Will the new Office for Budget Responsibility (see Nipping it in the Budd: Enhancing fiscal credibility?) help to eliminate the political business cycle? Explain your answer.
The incoming coalition government in the UK has been spelling out its fiscal policy. It is sticking to the Conservative pledge of cutting £6bn from government spending this fiscal year (6 April 2010 to 5 April 2011). It hopes to make most of these by ‘efficiency savings’ – in other words, providing the same level of service for less money. It has, however, said that it will take advice from the Treasury and the Bank of England as to whether the cuts need to be delayed if the economy weakens substantially.
But the Bank of England is forecasting a continuation of the recovery (see its latest Inflation Report below), even assuming no further quantitative easing beyond the £200bn of assets purchased by the Bank. The Governor, Mervyn King, feels that the economy can indeed bear the proposed £6bn cut in government spending and that this will also send an important signal to the market that the government is committed to reducing the deficit.
The new government has also said that it will honour the Liberal Democrat pledge to raise the personal tax free allowance on income tax to £10,000. It has also backtracked somewhat on the Conservative pledge not to raise national insurance. Only employers will be spared the rise; employees will have to pay it.
So has there been a major change in fiscal policy? Has the focus moved from one of maintaining aggregate demand in order to avoid falling back into recession to one of making a start on tackling the deficit straight away? Or is the change in emphasis more one of presentation than substance? The following webcasts looks at the new fiscal policy emerging from number 11 and at the latest forecasts for growth and inflation.
Webcasts
What kind of medicine is the economy going to be fed? BBC Newsnight, Paul Mason (13/5/10)
Policy breakdown for Lib Dem-Conservative coalition BBC News, James Landale (12/5/10)
Savings cuts to ‘hit middle class families’ BBC News, Keith Doyle (15/5/10)
Inflation Report, May 2010 Bank of England (click on Watch Webcast) (12/5/10)
Documents and data
Coalition Agreement published (see here for text of agreement) Conservative Party (11/5/10)
Conservative – Liberal Democrat coalition negotiations agreements Liberal Democrats (11/5/10)
Inflation Report, May 2010 (portal) Bank of England, see in particular:
Articles
Department by department, what the new Government plans to do Independent (13/5/10)
VAT rise looms as coalition deal adds estimated £10bn to debt Guardian, Katie Allen and Julia Kollewe (13/5/10)
Some initial reaction to the Tory / Lib Dem coalition agreement Institute for Fiscal Studies Press Release, Robert Chote and Mike Brewery (12/5/10)
Tax rises likely under coalition government, says Institute for Fiscal Studies Telegraph, Edmund Conway (13/5/10)
Give and take BBC News blogs, Stephanomics, Stephanie Flanders (12/5/10)
Questions
- What ground has been given by (a) the Conservatives; (b) the Liberal Democrats in terms of their proposed economic policies (see Looking at the manifestos for details of their proposed policies).
- What will be the implications of a £6bn cut in government spending on aggregate demand? What other determinants of aggregate demand need to be taken into account in order to assess the likely growth in GDP over the coming months?
- What are the distributional consequences of (a) a rise in the personal income tax allowance to £10,000; (b) a rise in VAT?
- Has there been a major change in fiscal policy?
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?
It’s not just the roads in the UK that were frozen, as the Bank of England unsurprisingly decided to keep interest rates frozen at 0.5%. Furthermore, many economists do not expect to see interest rates increase for some time. Roger Bootle has predicted that rates could stay low for up to 5 years and this will contribute to a continuing weak pound and spell further trouble for importers and their customers.
The Bank of England also left its money-creation programme of ‘quantitative easing’ unchanged, but next month it will have to decide whether to extend quantitative easing beyond the limits of £200 billion that it set back in November.
Whilst we are supposedly beginning our economic recovery – with 2009 quarter 4 figures showing the first rise in output since the first quarter of 2008 – its strength remains questionable. Indeed, the rise in output in the last three months of 2009 was a mere 0.1%. So how important are interest rates in helping to sustain the recovery? Can they really pull us out of the recession by remaining at just 0.5%? Read the articles below which look at freezing interest rates and quantitative easing.
FTSE unaffected by interest rate decision In the News (7/1/10)
Freeze on UK interest rates BBC News (7/1/10)
Bank of England may raise interest rates as soon as March, leading economist predicts Telegraph (7/1/10)
Interest rates and quantitative easing on hold Guardian, Larry Elliott (7/1/10)
Bank of England extends quantitative easing by £25bn – but is it enough? Guardian, Larry Elliott (5/11/10)
Questions for QE BBC News blogs, Stephanomics, Stephanie Flanders (7/1/10)
Interest rates could stay low for 5 years, says Bootle BBC News (7/1/10)
Questions
- How do low interest rates contribute to a weak pound? How does this affect exporters and importers?
- What is quantitative easing? Should the QE programme be extended? What are the arguments for and against this in terms of economic recovery and public debt?
- How much of an impact do you think the recession will have on government policy over the next few months?
- Explain the transmission mechanisms by which changes in interest rates affect the goods market.
- If the Bank of England were not independent, what do you think would be happening to interest rates?
Inflation’s rising again! After a year of falling inflation, with CPI inflation being below the Bank of England’s target of 2% since June 2009, inflation began rising again in October 2009 and then shot up in December. In the year to November 2009, CPI inflation was 1.9%. In the year to December it had risen to 2.9% – well above the 2% target. As the National Statistics article states, however:
This record increase is due to a number of exceptional events that took place in December 2008:
the reduction in the standard rate of Value Added Tax (VAT) to 15 per cent from 17.5 per cent
sharp falls in the price of oil
pre-Christmas sales as a result of the economic downturn
These exceptional events led to the CPI falling by 0.4 per cent between November and December 2008 (a record fall between these two months). The CPI increase between November and December 2009 of 0.6 per cent is far more typical (the CPI increased by 0.6 per cent between November and December in both 2006 and 2007). These exceptional events also affected the change in the RPI annual rate.
So what should the Bank of England do? 2.9% is well above the target of 2%. So should the Monetary Policy Committee raise interest rates at its next meeting? The answer is no. Although inflation is above target, the Bank of England is concerned with predicted inflation in 24 months’ time. Almost certainly, the rate of inflation will fall back as the special factors, such as the increase in VAT back to 17.5% and earlier falls in VAT and oil prices, fall out of the annual data.
What is more, the sudden rise in CPI inflation is almost entirely due to cost-push factors, not demand-pull ones. Rises in costs have a dampening effect on demand. Raising interest rates in these circumstances would further dampen demand – the last thing you want to do as the economy is beginning a fragile recovery from recession.
The Bank of England’s policy recognises that the prime determinant of inflation over the medium term is aggregate demand relative to potential output. For this reason it doesn’t respond to temporary supply-side (cost) shocks.
Avoid false alarm over UK inflation Financial Times (20/1/10)
Oh dear. Inflation is back again Telegraph, Jeremy Warner (19/1/10)
Mervyn King confident on inflation target Times Online, Grainne Gilmore (19/1/10)
How should we remember 2009? As the year the Bank of England’s inflation target died Telegraph, Jeremy Warner (20/1/10)
An embarrassing bungee-jump The Economist (21/1/10)
Priced in BBC News, Stephanomics, Stephanie Flanders’ blog (19/1/10)
This MPC is not fit for purpose New Statesman, David Blanchflower (21/1/10)
Jobs joy takes sting out of inflation misery Sunday Times, David Smith (24/1/10)
For CPI inflation data, see Consumer Prices Index (CPI) National Statistics
Questions
- For what reasons might inflation be expected to fall back to 2% later in the year?
- Does the rise in inflation to 2.9% put pressure on the Bank of England’s Monetary Policy Committee (MPC) to raise interest rates? Explain why or why not.
- What factors is the MPC likely to consider at its February meeting when deciding whether or not to embark on a further round of quantitative easing?
- What effects has the depreciation of sterling had on inflation? Explain whether this effect is likely to continue and what account of it should be taken by the MPC when setting interest rates.
- What is meant by ‘core inflation’? Why did this rise to 2.8% in December 2009?
- What is the role of expectations in determining (a) inflation and (b) real GDP in 24 months’ time?
- Why, according to David Blanchflower, is the MPC not ‘fit for purpose’?