Economics help blog – Page 165

Napoleon, eggs and capturing consumer surplus

18 November 20179 June 2014 by Tejvan Pettinger

On campaign in the early 1800s, Napoleon approached a hostelry on the slopes of Col du Pin Bouchain near Roanne. (BTW: the Col du Pin Bouchain at 759m was the first mountain ever used in the Tour de France in the 1903 edition.) Napoleon was shocked at the price of eggs, and so he asked …

Should we worry about a trade deficit?

1 February 20206 June 2014 by Tejvan Pettinger

A trade deficit implies the value of imports of goods is greater than exports. (M>X) The trade deficit is an important component of the current account on the balance of payments. Sometimes people use a trade deficit and a current account interchangeably, but in the UK this is not correct. The current account also includes …

Bond Spreads

10 February 20202 June 2014 by Tejvan Pettinger

Readers Question: How do bond spreads affect the value of the Dollar or Euro?

A bond yield refers to the interest payment that you receive from holding the bond yield. If the yield is 4%, you can expect £4 a year from a £100 bond.

A bond spread refers to the differences in bond yields. For example, it could mean the spread between different government 10 year bond yields. In the US bond yields may be 2%, whereas in the Eurozone, bond yields may be 4%.

There could be many different reasons for this bond spread (difference) But, if markets are concerned that one country is at risk of debt default or liquidity shortages, investors may be unwilling to hold those bonds and therefore bond yields go up to try and attract investors. (See inverse relationship between bond price and bond yield)

EU bond Yields — A time when Italian and Spanish bonds had a large bond spread over UK and German.

If investors are nervous about holding Eurozone bonds, due to fears of illiquidity, then international investors will be demanding less Euros – they would prefer to hold dollars and buy US bonds. Therefore, in this case, we would expect to see an appreciation in the US dollar and a fall in the Euro.

If you look at government bond yields (FT) – Greece has a high bond yield 6%. If Greece had its own currency, you would expect the Greek Drachma to fall.

Argentina has had periods of high bond yields because investors are nervous about holding Argentinian debt due to fears of a debt default. This corresponded with a fall in the Argentinian currency.

However, high bond yields are not necessarily a reflection that markets are nervous about the state of government finances. Bond yields can rise when markets are optimistic about future economic growth. See: Factors affecting bond yields

However, it is worth bearing in mind, many other factors determine exchange rates, apart from bond spreads, such as:

Higher interest rates can attract hot money flows. If people are confident of a country and they see high interest rates, they may move their currency to benefit from better interest rates.
Relative inflation rates. If inflation is relatively low in a country, then demand for the currency will be higher in the long-term as their goods will become more competitive.
See: Factors influencing exchange rate

Narrowing of bond yields on Eurozone

The ECB decision to purchase bonds and intervene in the market (since 2012) to provide liquidity has calmed investors and lead to lower bond yields amongst members of the Eurozone

The great Europe debate

18 November 201728 May 2014 by Tejvan Pettinger

The rise of UKIP and Euro-scepticism in the UK inspired me to have another look at an old blog post – Benefits of the European Union.

I’ve spent the past four years criticising the economic policy of the EU, and more specifically the ECB. There are may good reasons to be dissappointed at the EU in recent years. But there is always a danger that people can lose any sense of perspective and see the EU only as an unmitigated bureaucratic disaster more reminiscent of the Soviet Union than a modern progressive block of countries, who have made substantial progress in the past couple of decades.

Researching the benefits of the European Union was a reminder to myself that despite all the problems of the EU, it is not quite as bad as some politicians would like to make out. If nothing else – there is nowhere else in the world I would rather live than within the EU, where there is the rule of law, respect for human rights and decent living standards.

The European Union can count many significant achievements of the past few decades.

Reduction of tariff and non-tariff barriers have led to increased trade and, despite problems of recent years, real prosperity for most of the population.
Promoting human rights and helping Europe to become continent of peace, rather than the near perpetual conflict which marred the first half of the Twentieth Century.
Harmonisation of rules and regulations has helped simplify trade and commerce, and enabled the free movement of people.

Yes, despite many impressive achievements, the EU do seem in danger of throwing away, or at least diminishing many of these hard won gains. I don’t see the problem as regulation on bendy bananas (which are usually false or exaggerated for effect by Daily Trash newspapers – who seem to latch onto anti-EU headline with a glee previously reserved for stories about Princess Diana). The real problem the EU faces is economic stagnation, mass unemployment and the alienation of a whole young generation.

What makes it doubly sad is that it didn’t have to be like this.

The biggest problem facing the EU is one of economic policy. The Single Currency was a bridge too far. The EU is simply not an optimal currency area. The limitations of the Single Currency have been magnified by an attempt to deal with deflationary pressure through a combination of misplaced austerity and the dogma of suffering. What makes it worse is that countries who have suffered the most economically, have the feeling that their economic suffering has been imposed from the outside. And this just isn’t political rhetoric, that’s how a single monetary policy works. It’s the worst combination – economic stagnation caused by policies outside your country. With the toxic mix of unemployment and outside influence, it is hardly surprising that political extremism is on the rise.

Source: ECB

The ECB may claim that in the coming months they may do more to combat the threat of deflation and low growth. Now the ECB is willing to effectively act as lender of resort, bond yields have fallen. The Euro may hold together. But, that doesn’t change the fact Europe has been failing for the past five years. The crisis was never about bond yields or EU debt. When bond yields on government debt rise to 12%, this doesn’t cause social alienation and a surge in political extremism. The social and political alienation is caused by mass unemployment and a sense of powerlessness.

UK’s Target for Economic Growth

13 March 201826 May 2014 by Tejvan Pettinger

Readers Question: What is the UK’s target for economic growth? Economic growth is the annual % increase in national output (Real GDP) The UK doesn’t have an explicit target for economic growth (for example, we have an inflation target of CPI 2%+/-1.) However, the government will aim to achieve economic growth close to the …

Policies to ease pressure on the housing market

18 November 201720 May 2014 by Tejvan Pettinger

Readers Question: What policies could be used to ease pressure on housing market?

Firstly, the main pressure in the UK housing market is the persistent and continued above inflation price increases. Back in 2004, Kate Barker’s report into housing market trends found that the UK would need to build 250,000 houses to reduce the house price inflation rate to 1.1%. But, since 2004, the UK housing market has fallen short of this target. In the middle of the recession, the number of home starts fell to just over 100,000. (Housing supply)

The Home Builders Federation claim to catch up, we would need to increase home building to 320,000 a year – something not seen in the UK since the 1950s.

Policies to ease pressure on housing market

1. New Garden cities The building of new cities, in the mode of Milton Keynes, can enable a significant increase in homes. Currently there are plans for a new city in Ebbsfleet, Kent on the high speed railway line to London.

However, from planning to completion this will take a long time. It also means building on greenbelt land, which is likely to raise objections.

2. Government subsidy / council homes. Additional government spending to subsidise the building of ‘social’ housing could help increase supply. In the past decades, council housing has fallen out of vogue as the government have sought to sell off council housing and cut back on the building of council housing. But, it was council houses which provided a significant boost to the UK’s housing stock in the post war period.

Clement Attlee’s post-war Labour government built more than a million homes, 80% of which were council houses. In recent years, local authority building of new houses has virtually ceased. It is notable that since local authorities ceased to build homes, the UK housing shortage has become more acute. Housing associations have never been able to replace the large numbers built by local authorities.

It would require a change in political commitment and the willingness to spend extra money. Also, since the Thatcher era, the notion of council housing has gained a form of social stigma. However, it could make a big difference to the number of homes built.

3. Greater flexibility in planning. Planning restrictions are quite strict in the UK. Loosening the number of restrictions and making it easier for builders will make supply more elastic. This could involve reducing the amount of protected greenbelt land. It could also involve streamlining the regulations home-builders have to meet.

However, this could lead to significant local objections as people protest about the increased building, congestion and loss of green fields. One other solution would be to provide grants for turning derelict brown field sites into new homes.

4. Incentives for local authorities

Home building is a local issue. Local authorities have to deal with opposition to home building, so there is often local political pressure to stop house building. However greater financial incentives, such as allowing the council to keep council tax receipts from new housing developments, could give them a greater motivation to allow home building.

5. Introduction of a Planning-gain Supplement scheme

At the moment, building new houses tends to give the greatest benefit to landowners. Local residents feel they just lose out – depressed house prices, loss of unique village e.t.c. One solution is to make sure local residents near new housing schemes gain some compensation in return for accepting more houses. For example, a new housing development could be accompanied with a bypass or better public transport links. This is interesting from an economic perspective as it is seeking to provide a pareto improvement (one where everyone benefits).

The difficulty is that in the real world, it can be difficult to ensure people are compensated. Some local residents may feel there is nothing to compensate for the loss of a beautiful view. People may also exaggerate how much they lose from a new housing scheme.

6. Government’s Help to to buy

The government’s help to buy scheme is controversial because it is seeking to ease the problem through helping homeowners borrow more money. Critics argue this merely fuels demand and keeps prices artificially high.

However, to some extent, the Help to Buy scheme has provided some incentive for private builders to increase supply. In particular the first part of the scheme which offers buyers an interest-free loan worth up to 20% of the value of a new-build home. This increased demand for new build homes, encourages house builders because they are more confident there will be demand for the new homes.

Are UK house price rises sustainable or are we heading for a crash?

18 November 201715 May 2014 by Tejvan Pettinger

Readers comment on – House prices stats Excuse me for pointing out the obvious, but why are those ratios (House price to incomes) unsustainable if interest rates stay low? It’s the ratio of house-price-multiplied-by-interest-rate to earnings that determines affordability, not ratio of house price to earnings.

If rates fall as prices rise, then the first ratio remains affordable. If earnings rise, the ratio remains affordable.

Interest rates have been on a downward trend for 25 years and inflation has been tamed, there’s no reason for that trend to change..

UK base interest rates

UK base rates have stayed at 0.5% since early 2009. But, how long will they stay at 0.5%

It is true that housing affordability is determined b:

Disposable income
The cost of mortgage payments; (this depends on both the cost of buying a house and interest rates).

The ratio of house price to earnings is not a reliable guide to the actual cost of housing because there are other factors we need to consider.

We can see this by comparing two graphs which show house price to earnings.

ftb-house-price-earnings

These two graphs show that we can have an improvement in affordability (fall in the cost of mortgage payments) even as house prices rise.

I agree that in the long term the sustainable ratio of house price to earnings can increase. There is no law that the ratio of house price to earnings has to stay at (say 3). For example if we see a decade of lower interest rates and / or rising real incomes. Then house price to income ratios could increase.

However, that doesn’t mean we should ignore a rapid increase in house price to earning ratios.

Affordability has been increased by the significant fall in interest rates to 0.5% – Interest rates certainly can’t fall any further and are likely to increase.
House prices are rising much faster than average earnings.
Many first time buyers, struggle to raise the increased deposits required to buy a house.

ONS house price index Nov, 2013 – Deposits are rising as % of income
There is evidence that house prices are being pushed higher by investors rather than young buyers. The ratio of people renting is increasing.

An increasingly small % of the population is able to get a mortgage. The median income of mortgage borrowers has nearly tripled since 1990.

income mortgage borrowers

Long Interest rate prediction

base-rates

House price affordability has increased because interest rates are at record lows. In the long term I cannot see a return to double digit interest rates that we saw in the 1980s and early 1990s. However, I do expect interest rates to increase above 0.5%. When the economy recovery becomes stronger, I would expect interest rates of 4%. Historically, we see real interest rates of 2%. If inflation stays on target of 2%, then the most likely long-term interest rate is around 4%.

It is possible that the UK and Eurozone economies could replicate Japan ‘lost decade’ of deflationary pressures. In this case interest rates could stay at 0.5% for a decade. But, I would hope, this is still a reasonable chance we can escape this threat of prolonged deflation. Recent growth edging towards 2% a year is promising. The balance of probability suggests interest rates will rise by the end of 2014, or definitely in 2015.

What happens when you destroy money?

12 February 202012 May 2014 by Tejvan Pettinger

Readers question: What happens to the underlying money (supply) if someone destroys currency rather than saving it or spending it? The money supply is the total stock of notes, coins and bank deposits in the economy. If money is destroyed (taken out of circulation) and not put back in by the Central Bank, then the …