One of the structural problems facing the UK economy is that people have been borrowing too much and saving too little. As a result, vast numbers of people have been living on credit and accumulating large debts, and many people have little in the way of savings when they retire.
So should the government or Bank of England be encouraging people to save? Not according to Charles Bean, Deputy Governor of the Bank of England – at least not in the short term. While acknowledging that people should be saving more over the long term, he argues that the main purpose of the historically low Bank Rate since the beginning of 2009 has been to encourage people to spend, thereby boosting the economy. In other words, if the purpose of a loose monetary policy is to increase aggregate demand and stimulate the economy, then what is needed is increased consumption and reduced saving, not increased saving.
In the following webcast, Charles Bean gives his views about interest rates and counters the criticism that savers are being pid too little interest. He argues that for many the solution is to start drawing on some of their capital – not a solution that most savers find very appealing!
Webcast
Bank of England: savers should eat into cash Channel 4 News, Faisal Islam (27/9/10)
Articles
Savers told to stop moaning and start spending Telegraph, Robert Winnett and Myra Butterworth (28/9/10)
Bean Says Bank of England Trying to Get Reasonable Economic Activity Level Bloomberg, Scott Hamilton and Gonzalo Vina (27/9/10)
Spend, spend, spend, demands Bank of England deputy governor Investment & Business News , Tom Harris (28/9/10)
Data
International saving data (see Table 23) Economic Outlook, OECD
AMECO on line (see tables in section 15.3) AMECO, Economic and Financial Affairs (European Commission)
Economic and Labour Market Review (see Table 1.07) National Statistics
Questions
- What is meant by the ‘paradox of thrift’?
- Reconcile the argument that it is in the long-term interests of the UK economy for people to save more with the Bank of England’s current intention that people should save less?
- Is there a parallel argument about fiscal policy and government spending (see the news item The ‘paradox of cuts’?)
- What are the determinants of saving?
- Look at the data links above and compare the UK’s saving rate with that of other countries.
- What has happened to the UK saving rate over the past four years? Attempt an explanation of this.
Economists are famous for disagreeing – as, of course, are politicians. And there is a lot of disagreement around at the moment. George Osborne is determined to cut Britain’s large public-sector deficit, and cut it quickly. This, argues the Coalition government and many economists, is necessary to maintain the UK’s AAA sovereign credit rating. This, in turn, will allow interest rates to be kept down and the international confidence will encourage investment. In short, the cut in aggregate demand by government would be more than compensated by a rise in aggregate demand elsewhere in the economy, and especially from investment and exports. By contrast, not cutting the deficit rapidly would undermine confidence. This would make it more expensive to borrow and would discourage inward investment.
Not so, say the opposition and many other economists. A contractionary fiscal policy will achieve just that – an economic contraction. In other words, there is a real danger of a double-dip recession. Far from encouraging investment, it will do just the opposite. Consumers, fearing falling incomes and rising unemployment, will cut back on spending. Businesses, fearing a fall in sales, will cut back on investment. Economic pessimism, and hence caution, will feed on themselves.
So who are right? The first two blogs by Stephanie Flanders, the BBC’s Economics Editor, look at the arguments on both sides. The third attempts to sum up. The other articles continue the debate. For example, the link to The Economist contains several contributions from commentators on either side of the debate. See also the earlier posting on this site, The ‘paradox of cuts’.
Articles
The case for Mr Osborne’s austerity BBC News Blogs, Stephanomics, Stephanie Flanders (7/9/10)
The case against Mr Osborne’s austerity BBC News Blogs, Stephanomics, Stephanie Flanders (8/9/10)
Austerity plans: Where do you stand? BBC News Blogs, Stephanomics, Stephanie Flanders (10/9/10)
Are current deficit reduction plans likely to boost growth? The Economist debates, various invited guests
Debt and growth revisited Vox, Carmen M. Reinhart and Kenneth Rogoff (11/8/10)
Leading article: Mr Osborne should prepare a Plan B Independent (13/9/10)
Shock fall in UK retail sales adds to fears of double-dip recession Guardian, Larry Elliott (16/9/10)
Chancellor accused of £100bn economic growth gamble by Compass Guardian, Larry Elliott (18/9/10)
Double-dip recession: bulls and bears diverge over future economic prospects Guardian, Phillip Inman (16/9/10)
Speech by Mervyn King to TUC Congress TUC (15/9/10)
Barber, Blanchflower and the fake debate on double dip The Spectator, Ed Howker (14/9/10)
Confidence data
Consumer confidence Nationwide
ICAEW / Grant Thornton UK Business Confidence Monitor (BCM) ICAEW
Business and Consumer Surveys Economic and Financial Affairs, European Commission
Questions
- Summarise the arguments for the Coalition government’s programme of rapidly reducing the public-sector deficit.
- Summarise the arguments against the Coalition government’s programme of rapidly reducing the public-sector deficit.
- What factors are likely to determine whether there will be a double-dip recession as a result of the austerity programme?
- Why is it very hard to predict the effects of the austerity programme?
- How effective is an expansionary monetary policy likely to be in the context of a tightening fiscal policy?
- How important are other countries’ macroeconomic policies in determining the success of George Osborne’s policies?
- How similar to or different from other recessions has the recent one been? What are the policy implications of these similarities/differences?
Recent data on the US economy suggest that it may be heading back towards recession. Confidence is waning as growth slows. US GDP growth figures for the second quarter of 2010 have just been revised downwards: from 2.4% to 1.6%. And although growth is still quite strongly positive, unemployment is not coming down.
Most economists still think that the US economy will avoid a double dip, but many think that it is nevertheless a distinct possibility. For example, economists at Goldman Sachs put the likelihood of a double-dip recession at 25% to 30%, which although less than 50% is still a substantial risk.
Ben Bernanke, Chairman of the Federal Reserve, told a gathering of bankers and economists in Wyoming on August 27 that the Fed “will do all that it can” to avoid a double dip. According to Bernanke:
In many countries, including the United States and most other advanced industrial nations, growth during the past year has been too slow and joblessness remains too high… Central bankers alone cannot solve the world’s economic problems. That said, monetary policy continues to play a prominent role in promoting the economic recovery and will be the focus of my remarks today.
Bernanke outlined four monetary policy options that could be pursued, the first three of which were real possibilities for the Fed if economic growth did stall.
• The first would be to sell long-term government securities on the open market – a form of open-market operation. This quantitative easing would expand the money supply and should push long-term interest rates down (short-term interest rates are already virtually zero).
• The second would be to reduce interest rates paid to banks on reserves held in the Fed. These are currently around 0.25% and hence the scope for reductions here are very limited
• The third would be to promise to keep short-term interest rates low for a longer period than markets currently expect, thereby assuring markets that borrowing would remain cheap for some considerable time.
• The fourth option, and one not currently contemplated by the Fed, would be to raise the inflation rate target above its current level of 1.5% to 2%.
The first of the following two podcasts, which includes an interview with US Managing Editor of the Financial Times, Gillian Tett, looks at what the Fed might do. Is the solution to expand aggregate demand through monetary policy or are the problems more structural in nature? The other podcasts and the articles look at Bernanke’s proposals and their scope for avoiding a double dip.
Podcasts
‘No magic wand’ for US economy BBC Today Programme, Mark Mardell and Gillian Tett (27/8/10)
Fed Offers Higher Ground In Economic Mudslide NPR, Scott Horsley (28/8/10)
Roubini Interview Excerpt Bloomberg, Nouriel Roubini (27/8/10)
Articles
Bernanke Says Fed Will Do `All It Can’ to Ensure U.S. Recovery Bloomberg, Craig Torres and Scott Lanman (27/8/10)
What ammunition does the Fed have left? Reuters (27/8/10)
Fed is prepared to keep U.S. out of recession, Bernanke vows Los Angeles Times, Jim Puzzanghera (28/8/10)
Bernanke soothes rattled markets Telegraph (28/8/10)
Ben Bernanke promises to step in as US economy veers back towards recession Guardian, Katie Allen (27/8/10)
Shoot out at Jackson Hole – the world’s central bankers take aim at deflation Independent, Sean O’Grady (27/8/10)
Treasury Two-Year Yields Increase Most Since April After Bernanke Speech Bloomberg, Cordell Eddings (28/8/10)
Bernanke speech shows effort to find Fed consensus One News Now, Jeannine Aversa (28/8/10)
Analysis: The uncomfortable mathematics of monetary policy Reuters, Pedro Nicolaci da Costa (28/8/10)
Ben Bernanke calls for help to revive the stuttering US economy Guardian, Richard Adams (28/8/10)
Fed stands by to boost US growth Financial Times, Robin Harding, Michael Mackenzie and Alan Rappeport (27/8/10)
Bernanke outlines options for Fed Financial Times, Robin Harding (27/8/10)
Speech
The Economic Outlook and Monetary Policy Ben Bernanke (27/8/10)
Data
US Bond Rates Yahoo Finance
US interest rates Federal Reserve Statistical Release
Questions
- Why is growth in the US economy slowing?
- Why has the recovery from recession in the USA so far not resulted in a reduction in unemployment?
- What structural problems are there in the US economy?
- What further scope is there for monetary policy in stimulating the US economy?
- What are the arguments for the Fed introducing a new programme of quantitative easing?
- How important are expectations in determining whether the US recovery will be maintained or whether there will be a double-dip recession?
- What impact did Bernanke’s speech have on bond markets and why?
What will happen to interest rates over the next two or three years? There is considerable disagreement between economists on this question at the moment.
There are those who argue that recovery in the UK, the USA and Europe is faltering. With much tighter fiscal policy being adopted as countries attempt to claw down their deficits, there is a growing fear of a double-dip recession. In these circumstances central banks are likely to keep interest rates at their historically low levels for the foreseeable future and could well embark on a further round of quantitative easing (see Easy money from the Fed?). But what about inflation? With demand still expanding in developing countries and commodity prices rising, won’t cost pressures on inflation continue? Those who forecast that interest rates will stay low, argue that the pressure on commodity prices will ease as global demand slows. Also, in the UK, now that sterling is no longer depreciating, this will remove a key ingredient of higher inflation.
These views are not shared by other economists. They argue that interest rates could soar over the next two years. In fact, one economist, Andrew Lilico, the Chief Economist at Policy Exchange argues that interest rates in the UK will reach 8% by 2012. Central to their argument is the role of the money supply. The monetary base has been expanded enormously through programmes of quantitative easing. And yet, consumer credit has fallen. When the economy does eventually start to recover strongly, Lilico and others argue that there is a danger that consumer credit and broad money will expand rapidly, thereby fuelling inflation. But won’t the spare capacity that has built up during the recession allow the increase in aggregate demand to be met by a corresponding increase in output, thereby keeping inflation low. No, say these economists. A lot of capacity has been lost and output cannot easily expand to meet a rise in demand.
It’s not uncommon for economists to disagree! See, by reading the articles below, if you can unpick the arguments and establish where the disagreements lie and whose case is the strongest.
Articles
America’s century is over, but it will fight on Guardian, Larry Elliott (23/8/10)
Rates to remain low for foreseeable future Interactive Investor, Rhian Nicholson (18/8/10)
BoE gets benefit of doubt on inflation – for now Reuters, Christina Fincher (19/8/10)
BGilts reflect continued uncertainty AXA Elevate, Tomas Hirst (23/8/10)
A bull market in pessimism The Economist (19/8/10)
Interest rates ‘may hit 8%’ by 2012 says think tank BBC News (22/8/10)
Interest rates ‘may hit 8pc’ in two years Telegraph, Philip Aldrick (21/8/10)
Bernanke Must Raise Benchmark Rate 2 Points, Rajan Says Bloomberg, Scott Lanman and Simon Kennedy (23/8/10)
Inflation, not deflation, Mr. Bernanke Market Watch, Andy Xie (22/8/10)
Inflation comes through the door and wisdom flies out of the window Telegraph, Liam Halligan (21/8/10)
Data
British Government Securities, Yields Bank of England
Bankstats: Data on UK money and lending Bank of England
Questions
- Summarise the arguments of those who believe that interest rates will stay low for the foreseeable future.
- Summarise the arguments of those who believe that interest rates will be significantly higher by 2010.
- What factors will be the most significant in determining which of the two positions is correct?
- Why are the yields on long-term bonds a good indicator of people’s expectations about future inflation and monetary policy?
- Why has consumer credit fallen? Why might it rise again?
- Why may unemployment not fall rapidly as the economy recovers? Is this an example of hysteresis?
Every three months, the Bank of England produces its Inflation Report. This includes forecasts for inflation and economic growth for the next three years. The forecasts are presented as fan charts. These depict the probability of various outcomes for inflation or growth in the future. “In any particular quarter of the forecast period, GDP is expected to lie somewhere within the fan on 90 out of 100 occasions.” Each coloured band represents a 10% probability of occurrence. “Although not every member will agree with every assumption on which our projections are based, the fan charts represent the MPC’s best collective judgement about the most likely paths for inflation and output, and the uncertainties surrounding those central projections.” The broader the fan the less confident are the forecasts. The fans have tended to get broader in recent Reports, reflecting the greater uncertainties in the UK and global economies since the credit crunch.
Since the last Report, the forecast for economic growth in 2011 has been adjusted downwards from 3.4% to 2.5%. Inflation, while still being forecast to be below the target of 2% in two years’ time, is forecast to rise in the short term, thanks to higher commodity prices and the rise in VAT from 17.5% to 20% in January 2011.
So what impact, according to the Report, will various factors such as the Coalition’s emergency Budget in June, rising commodity prices, falling consumer confidence and improving export performance have on the economy? And how much credence should be put on the forecasts? The following articles address these questions
Articles
Bank chief warns of ‘choppy recovery’ Independent, Russell Lynch (11/8/10)
King warns of ‘choppy recovery’ for economy Channel 4 News, Faisal Islam (11/8/10)
Bank of England warns UK recovery will be weaker than hoped Telegraph (11/8/10)
Bank of England lowers UK growth forecast Telegraph, Angela Monaghan (11/8/10)
Bank of England cuts UK economic growth forecasts Guardian, Katie Allen (11/8/10)
Bank of England forecasts ‘choppy’ economic recovery BBC News, Katie Allen (11/8/10)
Bank of England Cuts Outlook for Economic Growth Bloomberg, Jennifer Ryan (11/8/10)
Why is the UK heading into choppy waters? BBC News Analysis, Hugh Pym (11/8/10)
Bank of England overhauls forecast model after errors Telegraph, Philip Aldrick (11/8/10)
The Bank’s impossible balancing act Independent, David Prosser (11/8/10)
How uncertain exactly is the uncertain BoE? Reuters Blogs, MacroScope (11/8/10)
‘Slowflation’ – the combination the Bank of England fears most Independent, Sean O’Grady (11/8/10)
The Bank is right to paint a mixed picture Independent, Hamish McRae (11/8/10)
Sterling falls, gilts rally after Bank of England cuts growth forecasts Guardian Blogs, Elena Moya (11/8/10)
Report
Inflation Report
Inflation Report Press Conference
Questions
- Do the Bank of England’s forecasts suggest that the UK economy is on track for meeting the inflation target in 24 months’ time?
- How much reliance should be put on Bank of England inflation and growth forecasts? You might want to check out the forecasts made one and two years ago for current (2010) rates of inflation and growth (see Inflation Reports (by date)).
- What are the factors that have persuaded the Bank of England to reduce its forecast for the rate of economic growth in 2011? Are these factors all on the demand side?
- According to the fan chart for economic growth, what is the probability that the UK economy will move back into recession in 2011?
- Will the rise in VAT in January 2011 cause inflation to be higher in 2012 than in 2010 (other things being equal)? Explain.
- Why did the FTSE fall by 2.4% on the day the Report was released?
- If commodity price inflation increases (see Food prices: a question of supply and demand), what impact is this likely to have (a) on the rate of economic growth; (b) on the rate of interest chosen by the MPC?
- What policy should the Bank of England adopt to tackle ‘slowflation’?