Interest rates have, for some years, been the main tool of monetary policy and of steering the macroeconomy. Across the world interest rates were lowered, in many cases to record lows, as a means of stimulating economic growth. Interest rates in the UK have been at 0.5% since March 2009 and on 2nd May 2013, the ECB matched this low rate, having cut its main interest rate from 0.75%. (Click here for a PowerPoint of the chart.)
Low interest rates reduce the cost of borrowing for both firms and consumers and this in turn encourages investment and can boost consumer expenditure. After all, when you borrow money, you do it to spend! Lower interest rates will also reduce the return on savings, again encouraging spending and for those on variable rate mortgages, mortgage payments will fall, increasing disposable income. However, these above effects are dependent on the banks passing the ECB’s main interest rate on its customers and this is by no means guaranteed.
Following the cut in interest rates, the euro exchange rate fell almost 2 cents against the dollar.
Interest rates in the eurozone have been at 0.75%, but a 0.25 point cut was widely expected, with the ongoing debt crisis in the Eurozone continuing to adversely affect growth and confidence. A lack of trust between banks has also contributed to a lack of lending, especially to small and medium sized enterprises. The ECB has injected money into financial institutions with the aim of stimulating lending, but in many cases, banks have simply placed this extra money back with the ECB, rather than lending it to other banks or customers. The fear is that those they lend to will be unable to repay the money. In response to this, there have been suggestions of interest rates becoming negative – that is, if banks want to hold their money with the ECB they will be charged to do it. Again, the idea is to encourage banks to lend their money instead.
Small and medium sized businesses have been described as the engine of growth, but it is these businesses who have been the least able to obtain finance. Without it, they have been unable to grow and this has held back the economic recovery. Indeed, GDP in the Eurozone has now fallen for five consecutive quarters, thus prompting the latest interest rate cut. A key question, however, will be how effective this quarter of a percent cut will be. If banks were unwilling to lend and firms unwilling to invest at 0.75%, will they be more inclined at 0.5%? The change is small and many suggest that it is not enough to make much of a difference. David Brown of New View Economics said:
The ECB rate cut is no surprise as it was well flagged by Draghi at last month’s meeting. Is it enough? No. The marginal effect of the cut is very limited, but at least it should have some symbolic rallying effect on economic confidence.
This was supported by Howard Archer at HIS Global Insight, who added:
Admittedly, it is unlikely that the trimming of interest rates from 0.75% to 0.5% will have a major growth impact, especially given fragmented credit markets, but any potential help to the eurozone economy in its current state is worthwhile.
Inflation in the eurozone is only at 1.2%, which is significantly below the ceiling of 2%, so this did give the ECB scope for the rate to be cut. (Click here for a PowerPoint of the chart.) After all, when interest rates fall, the idea is to boost aggregate demand, but with this, inflation can emerge. Mr Draghi said ‘we will monitor very closely all incoming information, and assess any impact on the outlook for price stability’. The primary objective of the ECB is the control of inflation and so had inflation been somewhat higher, we may have seen a different decision by the ECB. However, even then, 5 consecutive quarters of negative growth is hard to ignore.
So, if these lower interest rates have little effect on stimulating an economic recovery, what about a movement away from austerity? Many have been calling for stimulus in the economy, arguing that the continuing austerity measures are stifling growth. The European Council President urged governments to promote growth and job creation. Referring to this, he said:
Taking these measures is more urgent than anything … After three years of firefights, patience with austerity is wearing understandably thin.
However, Mr. Draghi urged for policymakers to stick with austerity and continue to focus on bringing debt levels down, while finding other ways to stimulate growth, including structural reform. The impact of this latest rate cut will certainly take time to filter through the economy and will very much depend on whether the 0.5% interest rate is passed on to customers, especially small businesses. Confidence and trust within the financial sector is therefore key and it might be that until this emerges, the eurozone itself is unlikely to emerge from its recession.
ECB ready to enter unchartered waters as bank cuts interest rate to fresh low of 0.5pc The Telegraph, Szu Ping Chan (2/5/13)
Draghi urges Eurozone governments to stay the course on austerity Financial Times, Michael Steen (2/5/13)
Eurozone interest rates cut to a record low of 0.5% The Guardian, Heather Stewart (2/5/13)
ECB’s Draghi ‘ready to act if needed’ BBC News (2/5/13)
Eurozone interest rates cut again as ECB matches Bank of England Independent, Russell Lynch (3/5/13)
Margio Draghi urges no let-up in austerity reforms after Eurozone rate cut – as it happened The Guardian, Graeme Wearden (2/5/13)
ECB cuts interest rate to record-low 0.5% in desperate measure to drag Eurozone out of recession Mail Online, Simon Tomlinson and Hugo Duncan (2/5/13)
ECB cuts interest rates, open to further action Reuters, Michael Shields (2/5/13)
Eurozone loosens up austerity, slowly Wall Street Journal (2/5/13)
ECB cuts interest rate, not enough to pull the region out of recession The Economic Times of India (2/5/13)
Euro steady ahead of ECB interest rate announcement Wall Street Journal, Clare Connaghan (2/5/13)
European Central Bank (ECB) cuts interest rates BBC News (2/5/13)
All eyes on ECB as markets expect rate cut Financial Times, Michael Steen (2/5/13)
Questions
- How is a recession defined?
- Using an aggregate demand/aggregate supply diagram, illustrate and explain the impact that this cut in interest rates should have.
- On which factors will the effectiveness of the cut in interest rates depend?
- Using the interest rate and exchange rate transmission mechanisms to help you, show the impact of interest rates on the various components of aggregate demand and thus on national output.
- What would be the potential impact of a negative interest rate?
- Why did the low inflation rate give the ECB scope to cut interest rates?
- What are the arguments for and against austerity measures in the Eurozone, given the 5 consecutive quarters of negative growth?
The UK economy faces a growing problem of energy supplies as energy demand continues to rise and as old power stations come to the end of their lives. In fact some 10% of the UK’s electricity generation capacity will be shut down this month.
Energy prices have risen substantially over the past few years and are set to rise further. Partly this is the result of rising global gas prices.
In 2012, the response to soaring gas prices was to cut gas’s share of generation from 39.9% per cent to 27.5%. Coal’s share of generation increased from 29.5% to 39.3%, its highest share since 1996 (see The Department of Energy and Climate Change’s Energy trends section 5: electricity). But with old coal-fired power stations closing down and with the need to produce a greater proportion of energy from renewables, this trend cannot continue.
But new renewable sources, such as wind and solar, take a time to construct. New nuclear takes much longer (see the News Item, Going nuclear). And electricity from these low-carbon sources, after taking construction costs into account, is much more expensive to produce than electricity from coal-fired power stations.
So how will the change in balance between demand and supply affect prices and the security of supply in the coming years. Will we all have to get used to paying much more for electricity? Do we increasingly run the risk of the lights going out? The following video explores these issues.
Webcast
UK may face power shortages as 10% of energy supply is shut down BBC News, Joe Lynam (4/4/13)
Data
Electricity Statistics Department of Energy & Climate Change
Quarterly energy prices Department of Energy & Climate Change
Questions
- What factors have led to a rise in electricity prices over the past few years? Distinguish between demand-side and supply-side factors and illustrate your arguments with a diagram.
- Are there likely to be power cuts in the coming years as a result of demand exceeding supply?
- What determines the price elasticity of demand for electricity?
- What measures can governments adopt to influence the demand for electricity? Will these affect the position and/or slope of the demand curve?
- Why have electricity prices fallen in the USA? Could the UK experience falling electricity prices for similar reasons in a few years’ time?
- In what ways could the government take into account the externalities from power generation and consumption in its policies towards the energy sector?
The UK economy is suffering from a lack of aggregate demand. Low spending in real terms is preventing the economy from growing. A simple solution would seem to be to stimulate aggregate demand through fiscal policy, backed up by even looser monetary policy. But this is easier said than done and could result in undesirable consequences in the medium term.
If increased borrowing were to be used to fund increased government expenditure and/or cuts in taxes, would any resulting growth be sufficient in the medium term to reduce the public-sector deficit below the initial level through automatic fiscal stabilisers? And would the growth be sustainable? The answer to this second question depends on what happens to the supply side of the economy. Would there be an increase in aggregate supply to match the increase in aggregate demand?
This second question has led many economists to argue that we need to see a rebalancing of the economy. What is needed is an increase in investment and exports, rather than an increase in just consumer expenditure funded by private borrowing and government current expenditure funded by public borrowing.
But how will exports and investment be stimulated? As far as exports are concerned, it was hoped that the depreciation of the pound since 2008 would give UK exporters a competitive advantage. Also domestic producers would gain a competitive advantage in the UK from imports becoming more expensive. But the current account deficit has actually deteriorated. According to the EU’s AMECO database, in 2008 the current account deficit was 1% of GDP; in 2012 it was 3.7%. It would seem that UK producers are not taking sufficient advantage of the pound’s depreciation, whether for exports or import substitutes.
As far as investment is concerned, there are two major problems. The first is the ability to invest. This depends on financing and things such as available land and planning regulations. The second is the confidence to invest. With not little or no growth in consumer demand, there is little opportunity for the accelerator to work. And with forecasts of sluggish growth and austerity measures continuing for some years, there is little confidence in a resurgence in consumer demand in the future. (Click here for a PowerPoint of the above chart. Note that the 2013 plots are based on AMECO forecasts.)
So hope of a rebalancing is faint at the current time. Hence the arguments for an increase in government capital expenditure that we looked at in the last blog post (The political dynamite of calm economic reflection). The problem and the options for government are considered in the following articles.
Articles
Budget 2013: Chancellor’s rebalancing act BBC News, Stephanie Flanders (11/3/13)
Why George Osborne is failing to rebalance the economy The Guardian, Larry Elliott (17/3/13)
Economy fails to ‘rebalance’ Financial Times, Sarah O’Connor (27/2/13)
Analysis – Long haul ahead for Britain’s struggling economy Reuters, William Schomberg (3/3/13)
Can banks be forced to lend more? BBC News, Robert Peston (12/3/13)
Budget 2013: What the commentators are saying BBC News (13/3/13)
Data
UK Trade, January 2013 (ONS) (12/3/13)
Business investment, Q4 2012 ONS (27/2/13)
Questions
- Draw a diagram to illustrate the effects of a successful policy to increase both aggregate demand and aggregate supply. What will determine the effect on the output gap?
- For what reasons has the UK’s current account deteriorated over the past few years while those of the USA and the eurozone have not?
- Using ONS data, find out what has happened to the UK’s balance of trade in (a) goods and (b) services over the past few years and explain your findings.
- Why are firms reluctant to invest at the moment? What policy measures could the government adopt to increase investment?
- With interest rates so low, why don’t consumers borrow and spend more, thereby aiding the recovery?
Recent figures from the ONS suggest that the UK lags well behind its competitors in terms of labour productivity. In terms of output per hour worked, Germany produces 22% more than the UK, France produces 26% more, the USA produces 27% more, the Netherlands 31% more and Ireland 43% more. The first chart illustrates some of these figures.
(Click here for a PowerPoint of this chart.)
And in the past few years the problem has been getting worse. This is shown in the second chart. This, however, is a relatively recent phenomenon. Until 2006, the gap was narrowing, but since then it has widened. (Click here for a PowerPoint of the second chart.)
What has caused this widening of the gap? Part of the problem is a historical lack of investment in the UK. Between 2005 and 2012, the UK invested on average 15.7% of GDP. The USA invested 16.5%, Germany 17.9% and France 20.1%. And part of the problem has been the cut back in private-sector investment in response to the recession (which has been deeper in the UK) and in public-sector investment as part of the government’s austerity measures.
Part of the problem has been lower levels of inward investment. Inward direct investment to the UK in 2011 was only 24 per cent of that in 2007. In France, Germany, Italy and the USA, the figures were 43, 50, 66 and 105 per cent respectively.
Part of the problem has been the size of the financial sector in the UK. This is considerably larger as a proportion of the economy than in most the UK’s major competitors. And it was this sector most hard hit by the crisis of 2007/8.
With this poor productivity performance, you might expect unemployment to have soared. In fact, the UK has one of the lowest unemployment rates of the developed countries and in recent months it has been falling while other countries have seen their unemployment rates rise.
In fact, low productivity and high employment are compatible. If people produce less than their counterparts abroad, then more people will be needed to produce the same level of output. The problem, of course, is that this only works if wages are kept down. Indeed, wages have fallen in real terms and now stand at the level of 10 years ago.
The problem of falling real wages is that this translates into a lack of demand – especially when people are trying to reduce their debts. Not only does this result in a lack of economic growth, it discourages firms from investing – and investment is one of the prime drivers of future productivity growth!
The following articles explore the problem of low productivity and its relationship with employment and with both short-term and long-term economic growth.
Articles
UK has widest productivity gap since 1993 City A.M., Ben Southwood (14/2/13)
Productivity ‘key to UK’s economic future’ SnowdropKCS (7/2/13)
Low wages and lack of investment – why UK’s productivity has slumped Wales Online, David Williamson (2/3/13)
Recovery in jobs gives a fillip before the news on growth Independent, Russell Lynch (23/1/13)
U.K. Triple-Dipping as Productivity Falls Slate, Matthew Yglesias (25/1/13)
UK productivity puzzle baffles economists BBC News, By Andrew Walker (18/10/12)
Is low productivity a structural problem in the UK? BBC Today Programme, Bridget Rosewell and Andrew Sentance (4/1/13)
We Need to Talk About the Middle Huffington Post, Stewart Wood (14/2/13)
UK Wages Slump to Lowest Level in a Decade – ONS International Business Times, Shane Croucher (13/2/13)
Britain’s low-wage economy serves as a bind on the country The Guardian, Philip Inman (13/2/13)
Real wages fall back to 2003 levels in UK The Guardian, Hilary Osborne (13/2/13)
Data
International Comparisons of Productivity – Final Estimates for 2011 ONS (13/2/13)
International Comparisons of Productivity, datasets ONS (13/2/13)
Changes in real earnings in the UK and London, 2002 to 2012 ONS (13/2/13)
Questions
- Which is a better measure of productivity – output per worker or output per hour worked? Why, do you think, does the USA produce 39% more per worker, but only 27% more per hour worked?
- What policies should the government adopt in order to encourage a growth in productivity?
- If productivity growth increased, what would be the likely effect on employment? Explain.
- Why has unemployment not risen in recent months?
Investment is crucial in all sectors of the economy. With growing demand for travel abroad, airports across the world have begun implementing investment strategies to increase capacity. Airport bosses at Heathrow are currently considering a 5 year investment plan that is expected to cost £3 billion.
Although investment is certainly needed and passengers will benefit in the long run, the cost of this investment will have to be met by someone. If these plans are approved by the airport bosses, it is likely that ticket prices will be pushed upwards to pay for it. Any increase in charges will have to receive approval by the Civil Aviation Authority (CAA). The plan at the moment would see ticket prices, via landing charges, increase by £19.33 per passenger before a further rise to £27.30. The impact on customers has already been raised as a key concern.
If the investment plans proceed, Heathrow expects to see its passenger numbers increase by 2.6m over the next 5 years, despite the proposed price hikes. This would naturally increase revenue and this money would provide at least some of the funds to repay the cost of the investment.
The price rises have been described as ‘incredibly steep’ and there are concerns that they will penalize customers. Airlines, such as Virgin Atlantic have recognized the need for more investment, but are more focused on finding ways to provide it without the price rises.
However, Colin Matthews, the Heathrow Chief said:
Heathrow faces stiff competition from other European hubs and we must continue to improve the service we offer passengers and airlines.
Passengers have already seen prices rise and Heathrow’s cost base has been described by British Airways as ‘inefficient’. Despite the fact that the decision by the CAA is not expected until January 2014, speculation will undoubtedly continue until any decision is reach. The following articles consider this case.
Heathrow hits turbulence over airport charges The Telegraph, Nathalie Thomas (12/2/13)
Heathrow Airport proposes ‘to raise ticket prices’ BBC News (12/2/13)
Heathrow investment to raise ticket prices Sky News (12/2/13)
Cost of Heathrow flights to rise by £27 in five years thanks to investment surcharge plans Mail Online, Helen Lawson (12/2/13)
Airlines fly into a rage as Heathrow warns charges must climb steeply Independent, Simon Calder (12/2/13)
Heathrow investment plan may lead to ticket price rise Reuters (12/2/13)
Heathrow calls for rise in airline tariffs Financial Times, Andrew Parker (12/2/13)
Questions
- If you had to undertake a cost-benefit analysis concerning the above investment proposal, which factors would you consider as the private and external benefits?
- Which factors would have to be taken into account as the private and external costs for any cost-benefit analysis?
- How important is it for the CAA to consider external costs and benefits when making its decision?
- If prices rise as the plans propose, what would you expect to be the effect on passenger numbers? How would this change be shown on a demand and supply diagram?
- According to Heathrow, they are expecting passenger numbers to increase, despite the price rises. What does this suggest about the demand curve? Illustrate your answer.
- Would you expect such an investment to have any macroeconomic impact?
