Tight monetary policy in the EU

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Tight monetary policy implies the Central Bank is trying to reduce the demand for money and limit the pace of economic expansion.

A tightening of monetary policy, could involve an increase in interest rates. – Higher interest rates increase the cost of borrowing and discourage investment and consumer spending. A tightening of monetary policy would be appropriate in a period of positive economic growth and rising inflation, above the inflation target.

Europe has neither. The Eurozone is facing an inflation rate of 0.4% and weak economic growth. However, monetary policy has been relatively tight.

Two graphs from Antonio Fatas help to illustrate this.

Real interest rates in US and EU

Latest-real-interest-rates
Source: Helicopter money A.Fatas

Real interest rates are the nominal interest rate – inflation rate.

Therefore, with base rates of 0.5% and inflation of 4%, the US would have a real interest rate of -3.5% – This negative interest rates, in theory, should be more encouraging for people to spend rather than save.

By contrast, the ECB have had higher real interest rates. This is partly because they increased nominal interest rates in 2013, but mainly because European inflation has been lower. The decline in Eurozone inflation to 0.4% has had the effect of increasing real interest rates.

UK real interest rates have been similar to the US. UK inflation has been higher than Eurozone inflation.

The increase in real interest rates in Europe are a serious cause for concern and a good illustration of one of the problems of deflation / low inflation.

With deflation, monetary policy can become unsuitable. Because you can’t cut base rates below zero, monetary policy can become tighter than market conditions allow.

Unfortunately the higher real interest rates and the tightening of monetary policy makes deflation more likely. It is a vicious circle.

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Unemployment during economic boom

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Q2: Why are there millions of people unemployed even when the economy is booming? During periods of strong economic growth, we can often experience high rates of unemployment. Firstly, there may be structural unemployment. This occurs when the unemployed are unsuited or unable to fill job vacancies. For example, a booming economy may have a …

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The truth about debt

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Readers Question: You have partially explained the answer to my question in your reply to my other question, “What will we do when we can’t pay back the money owing to the government bond holders when they reach the end if their term”. While I appreciate the convenient use of the debt to GDP ratio I feel that it tends to sidestep the truth about the remaining debt. This is almost like the government using the reduction in the deficit rather than the reality of remaining, possibly increasing debt.

For some reason, the first thing that comes into my mind is the famous quote from Dr Strangelove – “how I learned to stop worrying and love the bomb (debt)”

I guess we can blame Charles Dickens and Wilkins Micawber from David Copperfield.

“Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery.”

No matter how much you talk about government debt, people won’t feel comfortable until we have a zero budget deficit and zero government debt. –  (even though, I don’t think any modern economy has ever had such a situation – nor would one be particularly desirable.) Many issues are addressed here: The political appeal of austerity.

What does debt cost?

Another way of thinking about government debt is the annual cost of servicing the debt. What percentage of GDP is spent on debt interest payments? What percentage of tax revenues is spent on servicing the debt? You could have an increase in the real value of debt, but a smaller percentage spent on paying interest on the debt. Would you worry about a mortgage – if every year the monthly mortgage payments were becoming a smaller percentage of your disposable income?

uk-debt-interest-payments

The cost of servicing UK debt has risen in the past few years, due to rise in debt. But, by historical standards, it is still quite low and certainly quite manageable. More on Cost of borrowing

Of course, the cost of debt interest payments also depend on interest rates. A rise in interest rates will cause higher borrowing costs. But, with low interest rates predicted, we are unlikely to see a jump in borrowing costs – at least in the medium term.

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The false goal of a balanced budget

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The German economy has been one of the world’s strongest economies in the post-war period. There are many aspects of the German economy which deserve praise and emulation – not least strong productivity growth, a booming export sector and prolonged low inflationary growth. In the post-war period Germany has played an important role in promoting economic stability and prosperity within Europe.

But, in recent years, the German economy has seen several cracks appear and German economic thinking is now causing a major drag on Eurozone economic growth and prosperity.

The false goal of a balanced budget

An very important issue in German politics is the desirability of seeing a balanced budget (government spending = government tax revenue). Many German finance ministers have made balancing the budget their primary economic objective. In the UK and US, we see that austerity has a strong political appeal – but in Germany the appeal of ‘responsibility’ and avoiding debt is perhaps even greater. A German friend told me that there is a certain guilt attached to the idea of holding on to debt. (though this guilt is especially felt with government debt – mortgages and business loans are somehow different)

changes-budget-deficit-08-15

On the objective of reducing budget deficits Germany has been successful. It is also keen to enforce EU rules and the idea of encouraging a balanced budget for its struggling European neighbours.

Angela Merkel recently stated to the EU Parliament, that EU rules must be met:

“All, and I stress again all, member states must respect in full the rules of the strengthened stability and growth pact,” she said. “These rules must be applied credibly to all member states — only then can the pact fulfill as a central anchor for stability and above all for confidence in the eurozone.” (US Today)

Although, Merkel did not name France, the implication was that France must do more to meet the EU Stability and growth pact.

Why is a balanced budget a false goal?

1. Lack of investment

A successful business does not have its objective to borrow nothing. A successful business knows that it needs to invest to make progress and retain its prosperity. Years of cutting government spending has meant that Germany has cut back substantially on public sector investment. There are widespread reports that Germany has a lack of investment in roads, bridges and other forms of transport. There is a fear that important infrastructure, such as roads and bridges are reaching the end of their 70 year cycle, but there is no money to successfully replace them. The economic problem is growing congestion, time wasted and damage to the long term productive capacity of the economy. The Guardian notes

Its (German) investment rate in 2013 was the fourth lowest in the EU; only Austria, Spain and Portugal spent less. Fratzscher, who is head of the German Institute for Economic Research, calculates there is an “investment gap” of €80bn (£63bn).

The Economist reports that German public sector investment is —a paltry 1.6% of GDP— one of lowest in Europe and has fallen since 2009.

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The need for a higher inflation target in the EU

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The ECB inflation target is 2% – ‘it aims to maintain inflation rates below, but close to, 2% over the medium term. ‘

However, some economists argue that in the current situation, the ECB should have a higher inflation target of 3-4%.

The main reason for having a higher inflation rate would be to prioritise economic growth and help to reduce unemployment. Higher inflation would also help to contain and reduce government debt to GDP ratios – without excessive austerity.

Having a higher inflation rate will be resisted by many other economists and Central Bankers who believe that allowing higher inflation will lead to costs of uncertainty, lower investment and greater instability in the long-term. (see: costs of inflation) Also, some doubt whether higher inflation will actually help real economic growth.

EU inflation

EU inflation
EU inflation – St Louis Fed

 

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Inflation target during deflation

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Readers Question: How does inflation targeting operate when there is a deflation? and what are the problems associated with this?

It’s a good question to ask at the moment, especially with regard to the ECB and Eurozone.

Firstly, the EU inflation target is – below but close to 2%. If inflation falls below 2%, the Central Bank should pursue a loosening of monetary policy – lower interest rates (if possible), quantitative easing and allowing the exchange rate to fall.

The ECB state

By referring to “an increase in the HICP of below 2%” the definition makes clear that not only inflation above 2% but also deflation (i.e. price level declines) is inconsistent with price stability.

Basically, the ECB target is 2%

The UK has an inflation target of CPI 2% +/-1 (i.e an inflation rate of 1-3%)

If inflation falls below the target then this is a problem and Central Banks should be committed to solving it.

How to increase the inflation rate?

If inflation is falling below 1% – or even forecast to be falling below 1% a Central Bank should intervene. There are several things it can try and do.

1. Reduce interest rates. Lower interest rates make borrowing cheaper and should help to stimulate demand. However, for the UK and the EU, interest rates are already at zero. Therefore, interest rates are not an effective tool for fighting deflation.

The ECB themselves mention a problem of deflation

“Having such a safety margin against deflation is important because nominal interest rates cannot fall below zero. In a deflationary environment monetary policy may thus not be able to sufficiently stimulate aggregate demand by using its interest rate instrument. This makes it more difficult for monetary policy to fight deflation than to fight inflation.” (ECB Price stability)

2. Quantitative easing. – Money creation. In the UK and US, the Central Banks have electronically created money to purchase bonds and gilts. This has increased the monetary base and in theory increased the money supply in the economy. The effect of Q.E. is hard to quantify but it does seem that the economic recovery in UK and US has been stronger – with a higher inflation rate than Europe – Europe is reluctant to pursue Quantitative easing and as a result is seeing its inflation rate fall close to 0%.

The problem Europe has is that many (especially in Germany) have an almost irrational fear of creating money. Any policy of Q.E. could see itself challenged in European courts. It is also more difficult when you have a common currency area of many countries, whose bonds do you buy?

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What happens when the government runs out of money?

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Readers Question: Since the debt is mainly in the form of government bonds or gilts then it can only be paid back when the term of the bond terminates. What happens if there is not enough money to pay this back?

bond-government-us

Government bonds are a method for the government to borrow money. They sell bonds (e.g. for £1,000) and promise to pay back the bond holder in say 30 years. In the meantime, they will pay an interest rate of e.g. 5% a year as compensation.

Default on debt. If the government has no money to pay bond holders, then it will be defaulting on its debt. Bond holders lose their investment.

The government will be reluctant to do this because once it has started to default on its debt – no-one will want to buy or hold government bonds – so you will see the price of government bonds fall, and the market interest rate rise. The government will have to pay much higher interest rates to compensate for the risk of default and it will be difficult to attract buyers of bonds in the future.

Haircut / partial default. If the government is in great financial difficulty it may offer a deal to bond holders that it will pay back a certain percentage, e.g. 50%. In response for writing off 50% of the bond, bondholders may feel it is better to get 50% than nothing. Alternatively, the government may extend the maturity of the bond, e.g. change a 30 year bond into a 45 year bond, to give itself more time to pay it back.

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The price of petrol and tax levels in UK

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The UK has one of the highest tax rates on petrol / diesel in Europe – roughly 60% of the final price of petrol goes to the government in excise duty or VAT.

  • UK fuel duty is currently 58p per litre for petrol and diesel
  • VAT accounts for 20-25p per litre
  • The product cost is around 50p per litre
  • firms profit margins is often as low as 5p per litre – even lower for supermarkets, who use petrol as a type of ‘loss leader’ to entice shoppers into the supermarket to spend on groceries.

Between 1993 and 1999, fuel duty rose at 3% above inflation, causing an increase in the price of petrol. However, in 2011, the chancellor introduced a fuel duty stabiliser with a pledge to pledge to keep rates down.

fuel-duty

Source: Fuel duty UK

However, there are economic arguments to suggest that breaking the fuel duty escalator is a mistake. With falling inflation, falling oil prices and rising congestion levels – higher petrol tax could help improve struggling government tax revenues and also contribute to a better environment and lower congestion levels.

Arguments for higher tax on petrol

Environmental costs of petrol. Using petrol causes carbon dioxide (CO2 emissions which contribute to global warming. But, also burning petrol / diesel creates other compounds  toxic to life. For example carbon monoxide and methanol. Also, fine particulates of soot cause from car exhausts cause lung problems and are carcinogenic. Air quality standards in cities would be improved by reducing petrol and diesel consumption. Higher tax would act as an incentive to reduce the pollution caused by driving petrol/ diesel cars (See: tax on negative externality for more on the economics of taxing these negative externalities)

Costs of congestion. Cheaper petrol will cause increased congestion levels. Time wasted in traffic jams is a major individual cost and also cost for business. Without increasing the price of petrol, there will be a rise in the social cost of traffic congestion. The CBI estimate that congestion costs the UK economy £8bn a year. Given the limited scope for increasing the road network in many areas, pricing will have to pay a role – otherwise, we will pay for cheap petrol in other ways.

Improved fuel efficiency and falling tax revenue. One of the benefits of increasing petrol duty in the past has been to increase the incentive for manufacturers and consumers to choose more fuel efficient cars. The consequence is that although petrol tax has risen, the total amount of fuel duty we actually pay is falling – because we are using less fuel. This means government tax revenue from petrol tax is falling. In 2012, the government could expect £38bn from fuel duty and VED. (Link) But, by 2029, this tax revenue could be £13bn lower.

A study by the Institute for Fiscal Studies (IFS) has stated the government face a significant fall in tax revenue from fuel duty and vehicle excise duty (VED). They state that revenue will fall from the current levels of 1.7pc and 0.4pc of GDP respectively, to 1.1pc and 0.1pc by 2029 – in its report Fuel for Thought, commissioned by the RAC Foundation.

Given the poor performance of UK tax revenues in recent years, increasing petrol tax would help meet this deficit. Also, higher petrol tax would further increase the incentive for greater fuel efficiency.

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