Tag: fiscal policy

Posted on

The UK government’ fiscal stance

In this blog we show how we can apply fiscal metrics to assess the UK government’s fiscal stance. This captures the extent to which fiscal policy contributes to the level of economic activity in the economy.

Changes in the fiscal stance can then be used to estimate the extent to which discretionary fiscal policy measures represent a tightening or loosening of policy. We can measure the size and direction of fiscal impulses arising from changes in the government’s budgetary position.

Such an analysis is timely given the Autumn Budget presented by Rachel Reeves on 30 October 2024. This was the first Labour budget in 14 years and the first ever to be presented by a female Chancellor of the Exchequer.

We conclude by considering the forecast profile of expenditures and revenues for the next few years and the new fiscal rules announced by the Chancellor.

The fiscal stance

At its most simple, the fiscal stance measures the extent to which fiscal policy increases or decreases demand, thereby influencing growth and inflation (see Box 1.F, page 28, Autumn Budget 2024: see link below).

The fiscal stance is commonly estimated by measures of pubic-sector borrowing. To understand this, we can refer to the circular flow of income model. In this model, excesses of government spending (an injection) over taxation receipts (a withdrawal or leakage) represent a net injection into the circular flow and hence positively affect the level of aggregate demand for national output, all other things being equal.

A commonly used measure of borrowing in assessing the fiscal stance of the is the primary deficit. Unlike public-sector net borrowing, which is simply the excess of the sector’s spending over its receipts (largely taxation), the primary deficit subtracts net interest costs. It therefore excludes the interest payments on outstanding public-sector debts (and interest income earned on financial assets). The primary deficit can therefore be written as public-sector borrowing less net interest payments.

As discussed in our blog Fiscal impulses in November 2023, the primary deficit captures whether the public sector is able to afford its present fiscal choices by abstracting from debt-serving costs that reflect past fiscal choices. In this way, the primary deficit is a preferable measure to net borrowing both in assessing the impact on economic activity, i.e. the fiscal stance, and in assessing whether today’s fiscal choices will require government to issue additional debt.

Chart 1 shows public-sector net borrowing and the primary balance as shares of GDP for the UK since financial year 1975/76 (click here for a PowerPoint). The data are from the latest Public Finances Databank published by the Office for Budget Responsibility, published on the day of the Autumn Budget in October (see Data links below).

Over the period 1975/6 to 2023/24, public-sector net borrowing and the primary deficit had averaged 3.8% and 1.3% of GDP respectively. In the financial year 2023/24, they were 4.5% and 1.5% (they had been as high as 15.1% and 14.1% in 2020/21 as a result of COVID support measures). In 2024/25 net borrowing and the primary deficit are forecast to be 4.5% and 1.6% respectively. By 2027/28, while net borrowing is forecast to be 2.3% of GDP, there is forecast to be a primary surplus of 0.7% of GDP.

The Autumn Budget lays out plans for higher tax revenues to contribute two-thirds of the overall reduction in the primary deficit over the forecast period (up to 2029/30), while spending decisions contribute the remaining third.

The largest tax-raising measure is an increase in the employer rate of National Insurance Contributions (NICs) by 1.2 percentage points to 15% from April 2025. This will be levied on employee wages above a Secondary Threshold of £5000, reduced from £9100, which will increase in line with CPI inflation each year from April 2028. (See John’s blog, Raising the minimum wage: its effects on poverty and employment, for an analysis on the effects of this change.) This measure, allowing for other changes to the operation of employer NICs, is expected to raise £122 billion over the forecast period. This amounts to over two-thirds of the additional tax take from the taxation measures taken in the Budget.

Chart 2 shows both net borrowing and the primary deficit after being cyclically-adjusted (click here for a PowerPoint). This process adjusts these fiscal indicators to account for those parts of spending and taxation that are affected by the position of the economy in the business cycle. These are those parts that act as automatic stabilisers helping, as the name suggests, to stabilise the economy.

The process of cyclical adjustment leads to estimates of receipts and expenditures as if the economy were operating at its potential output level and hence with no output gap. The act of cyclically adjusting the primary deficit, which is our preferred measure of the fiscal stance, allows us to assess better the public sector’s fiscal stance.

Over the period from 1975/6 up to and including 2023/24, the cyclically-adjusted primary deficit (CAPD) averaged 1.1% of potential GDP. In 2024/25 the CAPD is forecast to be 1.5% of potential GDP. It then moves to a surplus of 0.5% by 2027/28. It therefore mirrors the path of the unadjusted primary deficit.

Measuring the fiscal impulse

To assess even more clearly the extent to which the fiscal stance is changing, we can use the cyclically-adjusted primary deficit to measure a fiscal impulse. This captures the magnitude of change in discretionary fiscal policy.

The term should not be confused with fiscal multipliers which measure the impact of fiscal changes on outcomes, such as real GDP and employment. Instead, we are interested in the size of the impulse that the economy is being subject to. Specifically, we are measuring discretionary fiscal policy changes that result in structural changes in the government budget and which, therefore, allow an assessment of how much, if at all, a country’s fiscal stance has tightened or loosened.

The size of the fiscal impulse is measured by the year-on-year percentage point change in the cyclically-adjusted public-sector primary deficit (CAPD) as a percentage of potential GDP. A larger deficit or a smaller surplus indicates a fiscal loosening. This is consistent with a positive fiscal impulse. On the other hand, a smaller deficit or a larger surplus indicates a fiscal tightening. This is consistent with a negative fiscal impulse.

Chart 3 shows the magnitude of UK fiscal impulses since the mid-1970s (Click here for a PowerPoint file). The scale of the fiscal interventions in response to the COVID-19 pandemic, which included the COVID-19 Business Interruption Loan Scheme (CBILS) and Job Retention Scheme (‘furlough’), stand out sharply. In 2020 the CAPD to potential output ratio rose from 1.7 to 14.4%. This represents a positive fiscal impulse of 12.4% of GDP.

This was followed in 2021 by a tightening of the fiscal stance, with a negative fiscal impulse of 10.1% of GDP as the CAPD to potential output fell back to 4.0%. Subsequent tightening was tempered by policy measures to limit the impact on the private sector of the cost-of-living crisis, including the Energy Price Guarantee and Energy Bills Support Scheme.

For comparison, the fiscal response to the global financial crisis from 2007 to 2009 saw a cumulative positive fiscal impulse of 5.6% of GDP. While smaller in comparison to the discretionary fiscal responses to the COVID-19 pandemic, it nonetheless represented a sizeable loosening of the fiscal stance.

Chart 4 focuses on the implied fiscal impulse for the forecast period up to 2029/30 (click here for a PowerPoint). The period is notable for a negative fiscal impulse each year. Across the period as a whole, this there is a cumulative negative fiscal impulse of 2.6% of GDP. Most of the ‘heavy-lifting’ of the fiscal consolidation occurs in the three financial years from 2025/26 during which there is a cumulative negative impulse of 2.0% of GDP.

Looking forward

To conclude, we consider the implications for the projected profiles of public-sector spending, receipts and liabilities over the forecast period up to 2029/30.

Chart 5 plots data since the mid-1950s (click here for a PowerPoint). It shows the size of total public-sector spending (also known as ‘total managed expenditures’), taxation receipts (sometimes referred as the ‘tax burden’) and total public-sector receipts as shares of GDP. This last one includes additional receipts, such as interest payments on financial assets and income generated by public corporations, as well as taxation receipts.

The OBR forecasts that in real terms (i.e. after adjustment for inflation), public-sector spending will increase on average over the period from 2025/26 to 2029/30 by 1.4% per year, but with total receipts due to rise more quickly at 2.5% per year and taxation receipts by 2.8% per year. The implications of this, as discussed in the OBR’s October 1014 Economic and Fiscal Outlook (see link below), are that:

the size of the state is forecast to settle at 44% of GDP by the end of the decade, almost 5 percentage points higher than before the pandemic” while additional tax revenues will “push the tax take to a historic high of 38% of GDP by 2029-30

Finally, the government has committed to two key rules: a stability rule and an investment rule.

The stability rule. This states that the current budget must be in surplus by 2029/30 or, once 2029/30 becomes the third year of the forecast period, it will be in balance or surplus every third year of the rolling forecast period thereafter. The current budget refers to the difference between receipts and expenditures other than capital expenditures. In effect, it captures the ability of government to meet day-to-day spending and is intended to ensure that over the medium term any borrowing is solely for investment. It is important to note that ‘balance’ is defined in a range of between a deficit and surplus of no more than 0.5% of GDP.

The stability rule replaces the borrowing rule of the previous government that public net borrowing, therefore inclusive of investment expenditures, was not to exceed 3% of GDP by the fifth year of the rolling forecast period.

The investment rule. The government is planning to increase investment. In order to do this in a financially sustainable way, the investment rule states that public-sector net financial liabilities (PSNFL) or net financial debt for short, is falling as a share GDP by 2029/30, until 2029/30 becomes the third year of the forecast period. PSNFL should then fall by the third year of the rolling forecast period. PSNFL is a broader measure of the sector’s balance sheet than public-sector net debt (PSND), which was targeted under the previous government and which was required to fall by the fifth year of the rolling forecast period.

The new target, as well as now extending to the Bank of England, ‘nets off’ not just liquid liabilities (i.e. cash in the bank and foreign exchange reserves) but also financial assets such as shares and money owed to it, including expected student loan repayments. While liabilities are broader too, including for example, the local government pension scheme, the impact is expected to reduce the new liabilities target by £236 billion or 8.2 percentage points of GDP in 2024/25. The hope is that both rules can support what the Budget Report labels a ‘step change in investment’.

As Chart 6 shows, public investment as a share of GDP has not exceeded 6% this century and during the 2010s averaged only 4.4% (click here for a PowerPoint). The forecast has it rising above 5% for a time, but easing to 4.8% by end of the period.

This suggests more progress will be needed if the UK is to experience a significant and enduring increase in public investment. Of course, this needs to be set in the context of the wider public finances and is illustrative of the choices facing fiscal policymakers across the globe after the often violent shocks that have rocked economies and impacted on the state of the public finances in recent years.

Articles

Official documents

Data

Questions

  1. Explain what is meant by the following fiscal terms:
    (a) Structural deficit,
    (b) Automatic stabilisers,
    (c) Discretionary fiscal policy,
    (d) Public-sector net borrowing,
    (e) Primary deficit,
    (f) Current budget balance,
    (g) Public-sector net financial liabilities (PSNFL).
  2. Explain the difference between a fiscal impulse and a fiscal multiplier.
  3. In designing fiscal rules what issues might policymakers need to consider?
  4. What are key differences between the fiscal rules of the previous Conservative government and the new Labour government in the UK? What economic arguments would you make for and against the ‘old’ and ‘new’ fiscal rules?
  5. What is meant by the ‘sustainability’ of the public finances? What factors might impact on their sustainability?
Posted on

Crude oil – a volatile market

The market for crude oil is usually a volatile one. Indeed, in the last few months, the market has seen prices rise and fall due to various supply and demand influences. Crude oil is coined the ‘King of Commodities’ due to the impact it has on consumers, producers and both the micro and macro economy. The price of crude oil affects everything from the cost of producing plastics, transportation, and food at the supermarket.

This makes the market for crude oil an economic powerhouse which is closely watched by businesses, traders, and governments. To gain a full understanding of the movements in this market, it is important to identify how demand and supply affect the price of crude oil.

What influences the demand and supply of crude oil?

The law of demand and supply states that if demand increases, prices will rise, and if supply increases, prices will fall. This is exactly what happens in the market for crude oil. The consumer side of the market consists of various companies and hundreds of millions of people. The producer side of the market is made up of oil-producing countries. Collectively, both consumers and producers influence the market price.

However, the demand and supply of crude oil, and therefore the price, is also affected by global economic conditions and geopolitical tensions. What happens in the world impacts the price of oil, especially since a large proportion of the world’s biggest oil producers are in politically unstable areas.

Over the past five years, global events have had a major impact on the price of oil. The economic conditions created by the impact of the COVID pandemic saw prices plummet from around $55 per barrel just before the pandemic in February 2020 to around $15 per barrel in April 2020. By mid-2021 they had recovered to around $75 per barrel. Then, in the aftermath of Russia’s invasion of Ukraine in February 2022, the price surged to reach $133 in June 2022. More recently, geopolitical tensions in the Middle East and concerns about China’s economic outlook have intensified concerns about the future direction of the market. (Click here for a PowerPoint of the chart.)

Geopolitical tensions

In the first week of October 2024, the price of crude oil rose by almost 10% to around $78 per barrel as the conflict in the Middle East intensified. It unfortunately comes at a time when many countries are starting to recover from the rise in oil prices caused by the pandemic and the war in Ukraine. Any increase in prices will affect the price that consumers pay to fill up their vehicles with fuel, just when prices of diesel and petrol had reached their lowest level for three years.

The Governor of the Bank of England, Andrew Bailey, has said that the Bank is monitoring developments in the Middle East ‘extremely closely’, as the conflict has the potential to have serious impacts in the UK. The Bank of England will therefore be watching for any movement in oil prices that could fuel inflation.

The main concerns stem from further escalation in the conflict between Israel and the Iran-backed armed group, Hezbollah, in Lebanon. If Israel decides to attack Iran’s oil sector, this is likely to cause a sharp rise in the price of oil. Iran is the world’s seventh largest oil exporter and exports over half of its production to China. If the oilfields of a medium-sized supplier, like Iran, were attacked, this could threaten general inflation in the UK, which could in turn influence any decision by the Bank of England to lower interest rates next month.

Supply deficits

This week (2nd week of October 2024) saw the price of crude oil surge above $81 per barrel to hit its highest level since August. This rise means that prices increased by 12% in a week. However, this surge in price also means that prices rose by almost 21% between the start September and the start of October alone. Yet it was only in early September when crude oil hit a year-to-date low, highlighting the volatility in the market.

As the Middle-East war enters a new and more energy-related phase, the loss of Iranian oil would leave the market in a supply deficit. The law of supply implies that such a deficit would lead to an increase in prices. This also comes at a time when the US Strategic Petroleum Reserve has also been depleted, causing further concerns about global oil supply.

However, the biggest and most significant impact would be a disruption to flows through the Strait of Hormuz. This is a relatively narrow channel at the east end of the Persian Gulf through which a huge amount of oil tanker traffic passes – about a third of total seaborne-traded oil. It is therefore known as the world’s most important oil transit chokepoint. The risk that escalation could block the Strait of Hormuz could technically see a halt in about a fifth of the world’s oil supply. This would include exports from big Gulf producers, including Saudi Arabia, UAE, Kuwait and Iraq. In a worst-case scenario of a full closure of the Strait, a barrel of oil could very quickly rise to well above $100.

Disruption to shipments would also lead to higher gas prices and therefore lead to a rise in household gas and electricity bills. As with oil, gas prices filter down supply chains, affecting the cost of virtually all goods, resulting in a further rise in the cost of living. With energy bills in the UK having already risen by 10% for this winter, an escalation to the conflict could see prices rise further still.

China’s economic outlook


Despite the concern for the future supply of oil, there is also a need to consider how the demand for oil could impact price changes in the market. The price of oil declined on 14 October 2024 in light of concerns over China’s struggling economy. As China is the world’s largest importer of crude oil, there are emerging fears about the potential limits on fuel demand. This fall in price reversed increases made the previous week as investors become concerned about worsening deflationary pressures in China.

Any reduced demand from China could indicate an oversupply of crude oil and therefore potential price declines. Official data from China reveal a sharp year-on-year drop in the producer price index of 2.8% – the fastest decline in six months. These disappointing results have stirred uncertainty about the Chinese government’s economic stimulus plans. Prices could fall further if there are continuing doubts about the government’s ability to implement effective fiscal measures to promote consumer spending and, in turn, economic growth.

As a result of the 2% price fall in oil prices on 14 October, OPEC (the Organization of the Petroleum Exporting Countries) has lowered its 2024 and 2025 global oil demand growth. This negative news outweighed market concerns over the possibility that an Israeli response to Iran’s missile attack could disrupt oil production.

What is the future for oil prices?

It is expected that the market for oil will remain a volatile one. Indeed, the current uncertainties around the globe only highlight this. It is never a simple task to predict what will happen in a market that is influenced by so many global factors, and the current global landscape only adds to the complexity.

There’s a wide spectrum of predictions about what could come next in the market for crude oil. Given the changes in the first two weeks of October alone, supply and demand factors from separate parts of the globe have made the future of oil prices particularly uncertain. Callum Macpherson, head of commodities at Investec, stated in early October that ‘there is really no way of telling where we will be this time next week’ (see the first BBC News article linked below).

Despite the predominately negative outlook, this is all based on potential scenarios. Caroline Bain, chief commodities economist at Capital Economics suggests that if the ‘worst-case scenario’ of further escalation in the Middle East conflict does not materialise, oil prices are likely to ‘ease back quite quickly’. Even if Iran’s supplies were disrupted, China could turn to Russia for its oil. Bain says that there is ‘more than enough capacity’ globally to cover the gap if Iranian production is lost. However, this does then raise the question of where the loyalty of Saudi Arabia, the world’s second largest oil producer, lies and whether it will increase or restrict further production.

What is certain is that the market for crude oil will continue to be a market that is closely observed. It doesn’t take much change in global activity for prices to move. Therefore, in the current political and macroeconomic environment, the coming weeks and months will be critical in determining oil prices and, in turn, their economic effects.

Articles

Questions

  1. Use a demand and supply diagram to illustrate what has happened to oil prices in the main two scenarios:
    (a) Conflict in the Middle East;
    (b) Concerns about China’s economic performance.
  2. How are the price elasticities of demand and supply relevant to the size of any oil price change?
  3. What policy options do the governments have to deal with the potential of increasing energy prices?
  4. What are oil futures? What determines oil future prices?
  5. How does speculation affect oil prices?
Posted on

The approach to monetary and fiscal policy

The following blog is inspired by my teaching of macroeconomic issues to my final year students at Aston University. In the classes we’ve been discussing important aspects of monetary and fiscal policy design. What has become clear to me and my students is that the trade-offs which characterise the discipline of economics are certainly alive and well in the current environment in which monetary and fiscal policy choices are being made.

To demonstrate this we consider here some of the discussions we’ve had in class around central bank independence and monetary policy mandates. We’ve also looked at fiscal policy. Here we’ve examined the state of the public finances and the importance that seems to be attached to debt stabilisation and the imposition of debt rules.

Delegation and central bank mandates

My teaching this term began by introducing my students to one of the most important and influential monetary policy models. This is the model of Kydland and Prescott. Their model, published in the Journal of Political Economy in 1977 has become the theoretical bedrock for the modern-day operational independence of central banks.1

The model explores how systemically high inflation can become established in economies when policymakers have the political incentive to lower unemployment or increase output above its long-run equilibrium value. This may be the case if governments operate monetary policy rather than the central bank (of if the central bank operates monetary policy but follows government objectives). By adopting expansionary monetary policy, governments can increase their popularity.

But this is likely to be short-lived, as any increased economic activity will only be temporary (assuming that the natural-rate hypothesis holds). Soon, inflation will rise.

But, if an election is on the horizon, there may be enough time to boost output and employment before inflation rises. In other words, an expectations-augmented Phillips curve may present governments with an incentive to loosen monetary policy and worry about the inflation consequences after the election.

However, the resulting ‘inflation surprise’ through the loosening of monetary policy means a fall in real pay and therefore in purchasing power. If people suspect that governments will be tempted to loosen policy, they will keep their expectations of inflation higher than the socially optimal inflation rate. Consequently, low-inflation targets lack credibility when governments have the temptation to loosen monetary policy. Such targets are time-inconsistent because governments have an incentive to renege and deliver higher inflation through a looser monetary policy. The result is an inflation bias.

Central bank independence
To prevent this inflationary bias arising, many central banks around the world have been given some form of operational independence with a mandate centred around an inflation-rate target. By delegating monetary policy to a more conservative central bank, the problem of inflationary bias can be addressed.

Yet central bank independence is not without its own issues and this has been an important part of the discussions with my students. Today, many economies are continuing to experience the effects of the inflationary shocks that began in 2021 (see Chart 1 for the UK CPI inflation rate: click here for a PowerPoint). The question is whether the appointment of a conservative or hard-nosed hawkish central banker trades off the stabilisation of inflation for greater volatility in output or unemployment.

The inflation–output stabilisation trade-off is closely associated with the works of Kenneth Rogoff2 and John Taylor3. The latter is known for his monetary policy rule, which has become known as the ‘Taylor rule’. This advocates that a rules-based central bank ought to place weight on both inflation and output stabilisation.

This is not without its own issues, however, since, by also placing weight on output stabilisation, we are again introducing the possibility of greater inflationary bias in policy making. Hence, while the act of delegation and a rules- or target-based approach may mitigate the extent of the bias relative to that in the Kydland and Prescott model, there nonetheless still remain issues around the design of the optimal framework for the conduct of monetary policy.

Indeed, the announcement that the UK had moved into recession in the last two quarters of 2023 can be seen as evidence that an otherwise abstract theoretical trade-off between inflation and output stabilisation is actually very real.

My classroom discussions have also shown how economic theory struggles to identify an optimal inflation-rate target. Beyond accepting that a low and stable inflation rate is desirable, it is difficult to address fully the student who asks what is so special about a 2% inflation target. Would not a 3% target, for example, be preferable, they might ask?

Whilst this may sound somewhat trivial, it has real-world consequences. In a world that now seems to be characterised by greater supply-side volatility and by more frequent inflation shocks than we were used to in recent history, might a higher inflation rate target be preferable? Certainly, one could argue that, with an inflation–output stabilisation trade-off, there is the possibility that monetary policy could be unduly restrictive in our potential new macroeconomic reality. Hence, we might come to see governments and central banks in the near future revisiting the mandates that frame the operation of their monetary policy. Time will tell.

Fiscal policy and debt stabilisation

The second topic area that I have been discussing in my final-year macroeconomics classes has centred around fiscal policy and the state of the public finances. The context for this is that we have seen a significant increase in public debt-to-GDP ratios over the past couple of decades as the public sector has attempted to absorb significant economic shocks. These include the global financial crisis of 2007–8, the COVID-19 pandemic and the cost-of-living crisis. These interventions in the case of the UK have seen its public debt-to-GDP ratio more than triple since the early 2000s to close to 100% (see Chart 2: click here for a PowerPoint).

Understandably, given the stresses placed on the public finances, economists have increasingly debated issues around debt sustainability. These debates have been mirrored by politicians and policymakers. A key question is whether to have a public debt rule. The UK has in recent years adopted such a rule. The arguments for a rule centre on ensuring sound public finances and maintaining the confidence of investors to purchases public debt. A debt rule therefore places a discipline on fiscal policy, with implications for taxation and spending.

How easy it is to stick to a debt rule depends on three key factors. It will be harder to stick to the rule:

  • The higher the current debt-to-GDP ratio and hence the more it needs to be reduced to meet the rule.
  • The higher the rate of interest and hence the greater the cost of servicing the public debt.
  • The lower the rate of economic growth and hence the less quickly will tax revenues rise.

With a given debt-to-GDP ratio, a given average interest rate payable on its debt, and a given rate of economic growth, we can determine the primary fiscal balance relative to GDP a government would need to meet for the debt-to-GDP ratio to remain stable. This is known as the ‘debt-stabilising primary balance’. The primary balance is the difference between a government’s receipts and its expenditures less the interest payments on its debt.

This fiscal arithmetic is important in determining a government’s fiscal choices. It shows the implications for spending and taxation. These implications become ever more important and impactful on people, businesses, and society when the fiscal arithmetic becomes less favourable. This is a situation that appears to be increasingly the case for many countries, including the UK, as the rate of interest on public debt rises relative to a country’s rate of economic growth. As this happens, governments are increasingly required to run healthier primary balances. This of course implies a tightening of their fiscal stance.

Hence, the fiscal conversations with my students have focused on both the benefits and the costs of debt-stabilisation. In respect of the costs, a few issues have arisen.

First, as with the inflation-rate target, it is hard to identify an optimal public debt-to-GDP ratio number. While the fiscal arithmetic may offer some clue, it is not straightforward to address the question as to whether a debt-to-GDP ratio of say 100% or 120% would be excessive for the UK.

Second, it is possible that the debt stabilisation itself can make the fiscal arithmetic of debt stabilisation more difficult. This occurs if fiscal consolidation itself hinders long-term economic growth, which then makes the fiscal arithmetic more difficult. This again points to the difficulties in designing policy frameworks, whether they be for monetary or fiscal policy.

Third, a focus on debt stabilisation alone ignores the fact that there are two sides to any sector’s balance sheet. It would be very unusual when assessing the well-being of businesses or households if we were to ignore the asset side of their balance sheet. Yet, this is precisely the danger of focusing on public debt at the exclusion of what fiscal choices can mean for public-sector assets, from which we all can potentially benefit. Hence, some would suggest a more balanced approach to assessing the soundness of the public finances might involve a net worth (assets less liabilities) measure. This has parallels with the debates around whether mandates of central banks should be broader.

Applications in macroeconomics

What my teaching of a topics-based macroeconomics module this term has vividly demonstrated is that concepts, theories, and models come alive, and are capable of being understood better, when they are used to shine a light on real-world issues. The light being shone on monetary and fiscal policy in today’s turbulent macroeconomic environment is perhaps understandably very bright.

Indeed, the light being shone on fiscal policy in the UK and some other countries facing an upcoming election, is intensified further with the state of the public finances shaping much of the public discourse on fiscal choices. Hopefully, my students will continue to debate these important issues beyond their graduation, stressing their importance for people’s lives and, in doing so, going beyond the abstract.

References

  1. Rules rather than discretion: The inconsistency of optimal plans
    The Journal of Political Economy, Finn E Kydland and Edward C. Prescott (1977, 85(3), pp 473–92)

  2. The optimal degree of commitment to an intermediate monetary target
    Quarterly Journal of Economics, Kenneth Rogoff (November 1985, 100(4), pp 1169–89)

  3. Discretion versus policy rules in practice
    Carnegie-Rochester Conference Series on Public Policy, John B Taylor (December 1993, 39, pp 195–214)

Articles

Questions

  1. What is meant by time-inconsistent monetary policy announcements? How has this concept been important for the way in which many central banks now conduct monetary policy?
  2. What is meant by a ‘conservative’ central banker? Why is the appointment of this type of central banker thought to be important in affecting inflation?
  3. What is the contemporary macroeconomic relevance of the inflation–output (or inflation–unemployment) stabilisation trade-off?
  4. How is the primary balance different from the actual budget balance?
  5. What do you understand by the concept of ‘the fiscal arithmetic’. Explain how each element of the fiscal arithmetic affects the debt-stabilising primary balance?
  6. Analyse the costs of benefits of a debt-based fiscal rule.
Posted on

The Russian economy after two years of war

It’s two years since Russia invaded Ukraine. Western countries responded by imposing large-scale sanctions. These targeted a range of businesses, banks and other financial institutions, payments systems and Russian exports and imports. Some $1 trillion of Russian assets were frozen. Many Western businesses withdrew from Russia or cut off commercial ties. In addition, oil and gas imports from Russia have been banned by most developed countries and some developing countries, and a price cap of $60 per barrel has been imposed on Russian oil. What is more, sanctions have been progressively tightened over the past two years. For example, on the second anniversary of the invasion, President Biden announced more than 500 new sanctions against individuals and companies involved in military production and supply chains and in financing Russia’s war effort.

The economy in Russia has also been affected by large-scale emigration of skilled workers, the diversion of workers to the armed forces and the diversion of capital and workers to the armaments industry.

So has the economy of Russia been badly affected by sanctions and these other factors? The IMF in its World Economic Forecast of April 2022 predicted that the Russian economy would experience a steep, two-year recession. But, the Russian economy has fared much better than first predicted and the steep recession never materialised.

In this blog we look at Russia’s economic performance. First, we examine why the Russian economy seems stronger today than forecast two years ago. Then we look at its economic weaknesses directly attributable to the war.

Apparent resilience of the Russian economy

GDP forecasts have proved wrong. In April 2022, just after the start of the war, the IMF was forecasting that the Russian economy would decline by 8.5% in 2022 and by 2.3% in 2023 and grow by just 1.5% in 2024. In practice, the economy declined by only 1.2% in 2022 and grew by 3.0% in 2023. It is forecast by the IMF to grow by 2.6% in 2024. This is illustrated in the chart (click here for a PowerPoint).

Similarly, inflation forecasts have proved wrong. In April 2022, Russian consumer price inflation was forecast to be 21.3% in 2022 and 14.3% in 2023. In practice, inflation was 13.8% in 2022 and 7.4% in 2023. What is more, consumer spending in Russia has remained buoyant. In 2023, retail sales rose by 10.2% in nominal terms – a real rise of 2.8%. Wage growth has been strong and unemployment has remained low, falling from just over 4% in February 2022 to just under 3% today.

So why has the Russian economy seemingly weathered the war so successfully?

The first reason is that, unlike Ukraine, very little of its infrastructure has been destroyed. Even though it has lost a lot of its military capital, including 1120 main battle tanks and some 2000 other armoured vehicles, virtually all of its production capacity remains intact. What is more, military production is replacing much of the destroyed vehicles and equipment.

The second is that its economy started the war in a strong position economically. In 2021, it had a surplus on the current account of its balance of payments of 6.7% of GDP, reflecting large revenues from oil, gas and mineral exports. This compares with a G7 average deficit of 0.7%. It had fiscal surplus (net general government lending) of 0.8% of GDP. The G7 countries had an average deficit of 9.1% of GDP. Its gross general government debt was 16% of GDP. The G7’s was an average of 134%. This put Russia in a position to finance the war and gave it a considerable buffer against economic sanctions.

The third reason is that Russia has been effective in switching the destinations of exports and sources of imports. Trade with the West, Japan and South Korea has declined, but trade with China and various neutral countries, such as India have rapidly increased. Take the case of oil: in 2021, Russia exported 4.4 billion barrels of oil per day to the USA, the EU, the UK, Japan and South Korea. By 2023, this had fallen to just 0.6 billion barrels. By contrast, in 2021, it exported 1.9 billion barrels per day to China, India and Turkey. By 2023, this had risen to 4.9 billion. Although exports of natural gas have fallen by around 42% since 2021, Russian oil exports have remained much the same at around 7.4 million barrels per day (until a voluntary cut of 0.5 billion barrels per day in 2024 Q1 as part of an OPEC+ agreement to prop up the price of oil).

China is now a major supplier to Russia of components (some with military uses), commercial vehicles and consumer products (such as cars and electrical goods). Total trade with China (both imports and exports) was worth $147 billion in 2021. By 2023, this had risen to $240 billion.

The use of both the Chinese yuan and the Russian rouble (or ruble) has risen dramatically as a means of payment for Russian imports. Their share has risen from around 5% in 2021 (mainly roubles) to nearly 75% in 2023 (just over 37% in each currency). Switching trade and payment methods has helped Russia to circumvent many of the sanctions.

The fourth reason is that Russia has a strong and effective central bank. It has successfully used interest rates to control inflation, which is expected to fall from 7.4% in 2023 to under 5% this year and then to its target of 4% in subsequent years. The central bank policy rate was raised from 8.5% to 20% in February 2022. It then fell in steps to 7.5% in September 2022, where it remained until August 2023. It was then raised in steps to peak at 16% in December 2023, where it remains. There is a high level of confidence that the Russian central bank will succeed in bringing inflation back to target.

The fifth reason is that the war has provided a Keynesian stimulus to the economy. Military expenditure has doubled as a share of GDP – from 3.7% of GDP in 2021 to 7.5% in 2024. It now accounts for around 40% of government expenditure. The boost that this has given to production and employment has helped achieve the 3% growth rate in 2023, despite the dampening effect of a tight monetary policy.

Longer-term weaknesses

Despite the apparent resilience of the economy, there are serious weaknesses that are likely to have serious long-term effects.

There has been a huge decline in the labour supply as many skilled and professional workers have move abroad to escape the draft and as many people have been killed in battle. The shortage of workers has led to a rise in wages. This has been accompanied by a decline in labour productivity, which is estimated to have been around 3.6% in 2023.

Higher wages and lower productivity is putting a squeeze on firms’ profits. This is being exacerbated by higher taxes on firms to help fund the war. Lower profit reduces investment and is likely to have further detrimental effects on labour productivity.

Although Russia has managed to circumvent many of the sanctions, they have still had a significant effect on the supply of goods and components from the West. As sanctions are tightened further, so this is likely to have a direct effect on production and living standards. Although GDP is growing, non-military production is declining.

The public finances at the start of the war, as we saw above, were strong. But the war effort has turned a budget surplus of 0.8% of GDP in 2021 to a deficit of 3.7% in 2023 – a deficit that will be difficult to fund with limited access to foreign finance and with domestic interest rates at 16%. As public expenditure on the military has increased, civilian expenditure has decreased. Benefits and expenditure on infrastructure are being squeezed. For example, public utilities and apartment blocks are deteriorating badly. This has a direct on living standards.

In terms of exports, although by diverting oil exports to China, India and other neutral countries Russia has manage to maintain the volume of its oil exports, revenue from them is declining. Oil prices have fallen from a peak of $125 per barrel in June 2022 to around $80 today. Production from the Arabian Gulf is likely to increase over the coming months, which will further depress oil prices.

Conclusions

With the war sustaining the Russian economy, it would be a problem for Russia if the war ended. If Russia won by taking more territory in Ukraine and forcing Ukraine to accept Russia’s terms for peace, the cost to Russia of rebuilding the occupied territories would be huge. If Russia lost territory and negotiated a settlement on Ukraine’s terms, the political cost would be huge, with a disillusioned Russian people facing reduced living standards that could lead to the overthrow of Putin. As The Conversation article linked below states:

A protracted stalemate might be the only solution for Russia to avoid total economic collapse. Having transformed the little industry it had to focus on the war effort, and with a labour shortage problem worsened by hundreds of thousands of war casualties and a massive brain drain, the country would struggle to find a new direction.

Articles

Questions

  1. Argue the case for and against including military production in GDP.
  2. How successful has the freezing of Russian assets been?
  3. How could Western sanctions against Russia be made more effective?
  4. What are the dangers to Western economies of further tightening financial sanctions against Russia?
  5. Would it be a desirable policy for a Western economy to divert large amounts of resources to building public infrastructure?
  6. Has the Ukraine war hastened the rise of the Chinese yuan as a reserve currency?
  7. How would you summarise Russia’s current public finances?
  8. How would you set about estimating the cost to Russia of its war with Ukraine?
Posted on

Worries about the Chinese economy

According to the IMF, Chinese GDP grew by 5.2% in 2023 and is predicted to grow by 4.6% this year. Such growth rates would be extremely welcome to most developed countries. UK growth in 2023 was a mere 0.5% and is forecast to be only 0.6% in 2024. Advanced economies as a whole only grew by 1.6% in 2023 and are forecast to grow by only 1.5% this year. Also, with the exception of India, the Philippines and Indonesia, which grew by 6.7%, 5.3% and 5.0% respectively in 2023 and are forecast to grow by 6.5%, 6.0% and 5.0% this year, Chinese growth also compares very favourably with other developing countries, which as a weighted average grew by 4.1% last year and are forecast to grow at the same rate this year.

But in the past, Chinese growth was much higher and was a major driver of global growth. Over the period 1980 to 2018, Chinese economic growth averaged 9.5% – more than twice the average rate of developing countries (4.5%) and nearly four times the average rate of advanced countries (2.4%) (see chart – click here for a PowerPoint of the chart).

Not only is Chinese growth now much lower, but it is set to decline further. The IMF forecasts that in 2025, Chinese growth will have fallen to 4.1% – below the forecast developing-country average of 4.2% and well below that of India (6.5%).

Causes of slowing Chinese growth

There are a number of factors that have come together to contribute to falling economic growth rates – growth rates that otherwise would have been expected to be considerably higher as the Chinese economy reopened after severe Covid lockdowns.

Property market
China has experienced a property boom over the past 20 years years as the government has encouraged construction in residential blocks and in factories and offices. The sector has accounted for some 20% of economic activity. But for many years, demand outstripped supply as consumers chose to invest in property, partly because of a lack of attractive alternatives for their considerable savings and partly because property prices were expected to go on rising. This lead to speculation on the part of both buyers and property developers. Consumers rushed to buy property before prices rose further and property developers borrowed considerably to buy land, which local authorities encouraged, as it provided a valuable source of revenue.

But now there is considerable overcapacity in the sector and new building has declined over the past three years. According to the IMF:

Housing starts have fallen by more than 60 per cent relative to pre-pandemic levels, a historically rapid pace only seen in the largest housing busts in cross-country experience in the last three decades. Sales have fallen amid homebuyer concerns that developers lack sufficient financing to complete projects and that prices will decline in the future.

As a result, many property developers have become unviable. At the end of January, the Chinese property giant, Evergrande, was ordered to liquidate by a Hong Kong court, after the judge ruled that the company did not have a workable plan to restructure around $300bn of debt. Over 50 Chinese property developers have defaulted or missed payments since 2020. The liquidation of Evergrande and worries about the viability of other Chinese property developers is likely to send shockwaves around the Chinese property market and more widely around Chinese investment markets.

Overcapacity
Rapid investment over many years has led to a large rise in industrial capacity. This has outstripped demand. The problem could get worse as investment, including state investment, is diverted from the property sector to manufacturing, especially electric vehicles. But with domestic demand dampened, this could lead to increased dumping on international markets – something that could spark trade wars with the USA and other trading partners (see below). Worries about this in China are increasing as the possibility of a second Trump presidency looks more possible. The Chinese authorities are keen to expand aggregate demand to tackle this overcapacity.

Uncertainty
Consumer and investor confidence are low. This is leading to severe deflationary pressures. If consumers face a decline in the value of their property, this wealth effect could further constrain their spending. This will, in turn, dampen industrial investment.

Uncertainty is beginning to affect foreign companies based in China. Many foreign companies are now making a loss in China or are at best breaking even. This could lead to disinvestment and add to deflationary pressures.

The Chinese stock market and policy responses
Lack of confidence in the Chinese economy is reflected in falling share prices. The Shanghai SSE Composite Index (an index of all stocks traded on the Shanghai Stock Exchange) has fallen dramatically in recent months. From a high of 3703 in September 2021, it had fallen to 2702 on 5 Feb 2024 – a fall of 27%. It is now below the level at the beginning of 2010 (see chart: click here for a PowerPoint). On 5 February alone, some 1800 stocks fell by over 10% in Shanghai and Shenzhen. People were sensing a rout and investors expressed their frustration and anger on social media, including the social media account of the US Embassy. The next day, the authorities intervened and bought large quantities of key stocks. China’s sovereign wealth fund announced that it would increase its purchase of shares to support the country’s stock markets. The SSE Composite rose 4.1% on 6 February and the Shenzhen Component Index rose 6.2%.

However, the rally eased as investors waited to see what more fundamental measures the authorities would take to support the stock markets and the economy more generally. Policies are needed to boost the wider economy and encourage a growth in consumer and business confidence.

Interest rates have been cut four times since the beginning of 2022, when the prime loan rate was cut from 3.85% to 3.7%. The last cut was from 3.55% to 3.45% in August 2023. But this has been insufficient to provide the necessary boost to aggregate demand. Further cuts in interest rates are possible and the government has said that it will use proactive fiscal and effective monetary policy in response to the languishing economy. However, government debt is already high, which limits the room for expansionary fiscal policy, and consumers are highly risk averse and have a high propensity to save.

Graduate unemployment
China has seen investment in education as an important means of increasing human capital and growth. But with a slowing economy, there are are more young people graduating each year than there are graduate jobs available. Official data show that for the group aged 16–24, the unemployment rate was 14.9% in December. This compares with an overall urban unemployment rate of 5.1%. Many graduates are forced to take non-graduate jobs and graduate jobs are being offered at reduced salaries. This will have a further dampening effect on aggregate demand.

Demographics
China’s one-child policy, which it pursued from 1980 to 2016, plus improved health and social care leading to greater longevity, has led to an ageing population and a shrinking workforce. This is despite recent increases in unemployment in the 16–24 age group. The greater the ratio of dependants to workers, the greater the brake on growth as taxes and savings are increasingly used to provide various forms of support.

Effects on the rest of the world

China has been a major driver of world economic growth. With a slowing Chinese economy, this will provide less stimulus to growth in other countries. Many multinational companies, including chip makers, cosmetics companies and chemical companies, earn considerable revenue from China. For example, the USA exports over $190 billion of goods and services to China and these support over 1 million jobs in the USA. A slowdown in China will have repercussions for many companies around the world.

There is also the concern that Chinese manufacturers may dump products on world markets at less than average (total) cost to shift stock and keep production up. This could undermine industry in many countries and could initiate a protectionist response. Already Donald Trump is talking about imposing a 10% tariff on most imported goods if he is elected again in November. Such tariffs could be considerably higher on imports from China. If Joe Biden is re-elected, he too may impose tariffs on Chinese goods if they are thought to be unfairly subsidised. US (and possibly EU) tariffs on Chinese goods could lead to a similar response from China, resulting in a trade war – a negative sum game.

Videos

Articles

Questions

  1. Why is China experiencing slowing growth and is growth likely to pick up over the next five years?
  2. How does the situation in China today compare with that in Japan 30 years ago?
  3. What policies could the Chinese government pursue to stimulate economic growth?
  4. What policies were enacted towards China during the Trump presidency from 2017 to 2020?
  5. Would you advise the Chinese central bank to cut interest rates further? Explain.
  6. Should China introduce generous child support for families, no matter the number of children?