How A Restaurant Can Increase Its Profit?

This posting is dedicated to my friend, Mr. Tong a restaurant manager. Well, I’m no great consultant. Neither am I, someone experienced in food business, but I can always give sound argument & opinion on how to increase business efficiency

The restaurant is operating in a monopolistic environment, since it fulfills all the condition:

(a) There are many customers & restaurants in the same area

(b) It produces goods (in this case chicken rice & hor fun) which are identical to many other restaurants BUT is differentiated with branding (the restaurant is well known for recipes from Ipoh)

(c) It has some price making ability

(d) It operates in an environment of low entry barriers & exit barriers. New restaurants can therefore come in easily & leave as they wish due to low set up costs. RM 150,000 to RM 400, 000 is considered low enough compared to setting up a multinational firm. He even told me that several restaurants have went bankrupt

(e) In long run it (may) achieves normal-profit (AC = AR), since any short run supernormal profit (AR > AC) will be competed away by new restaurants operating in the same area. Probably true, since the growth rate of restaurants greater than growth rate of customers in that area. In other word, profits being ‘shared’ out



Since all firms exist to make profit, thereby the restaurant operates where MC = MR. This intersection is called profit-maximisation. In other word, profit of the restaurant is maximised when MR (marginal revenue) is equal to MC (marginal cost). Producing there means profit is at its peak & can no longer go any higher

Equally, one can also look at the TR (total revenue) & TC (total cost) diagram above. We can see that profit is maximised when the gap between TR & TC is the BIGGEST

One should never think that profit is the same as total revenue. This is because

Profit = TR – TC
Profit = (price x quantity) – TC
Profit = (PxQ) – TC

From our conversation, he mentioned that since the restaurant (2nd branch) is relatively new in the area of about 5 months & the margin is thin due to stiff competition & high operating costs, he needs to think how to reduce costs & increase volume of food sold

Here’s what I think:

To increase the profit, there are generally 3 broad ways, either increase TR or minimise TC or if both can be done simultaneously, that would be great

(1) To increase total revenue (TR = P x Q):

(a) Manipulate P. Flirting with P could be a little difficult. Increasing the price may lead to fall in quantity of food sold in near term. In other word, losing the customers. The more sensible, but indirect way of price increase would be to reduce the amount of chicken, rice, hor fun, putting more ice in the drinks etc while maintaining the same price. However, he outlawed that option since the restaurant’s policy is ‘generosity’.

(b) Manipulating Q. He repeatedly used the word VOLUME & this is tied with quantity of food & drinks sold. From economic point of view, this refers a necessarily increase in demand. To increase demand the following can be done:

(b)(i) Advertising. Earlier, Kar Heong has launched an advertisement in the form of booklet. According to him, it was effective in pulling a larger crowd to the restaurant. It costs them about RM4, 000. Since that’s the case, I would recommend the restaurant owner to advertise more often, e.g. every few months. Never belittle the power of advertisement. The short term advertising expenditure should not be seen as a great barrier towards greater sales in future

(b)(ii) Credit card facilities. At the meantime the restaurant is accepting cash payment. Later it will have credit facilities as well. This is important since modern urban consumers are increasingly not carrying cash with them when they go out

(b)(iii) Good customer relationship. Always ‘attack’ parents that bring kids along with them e.g. giving them candies or sweets. I saw you did it that day, congratulations! I remembered a businessman told me that if you can make the kids like you, for some reason you have already won the heart of their parents. This will ensure them to come more often. Also I recommend, greeting the names of those regular customers. People like when their names being called. It is actually a kind of respect. I got this from Dale Carnegie in his book “How To Win Friends & Influence People”. To me, I always look at customers as the ambassador of the product we sold

(b)(iv) Loyalty cards. Although there is, I feel that the 10% discount given for the tenth visit is not strong enough to create an incentive for customers to ‘hit that target’. Perhaps a 30%-40% would do. Anyway, I do understand that at the meantime the profit margin is thin. Perhaps, putting 2-3 marks for every visit is good a beginning. At least people will think, to reach the hilltop, I just have to climb 4 stairs rather than 10 stairs. This may create those incentives

(b)(v) Promotion at the entrance. There are many passer-bys & of course many will take notice of this. If it’s appealing enough, people may want to step in. The previous ice-cream promotion wasn’t a bad one, just that it’s not sufficient, although I understand that it’s not cost-effective due to last minute of getting a provider for that. I would recommend the restaurant owner, to reconsider the ice-cream option. Perhaps over the time, something else could be dished out as dessert, e.g. pudding. Higher initial expenditure is common in any business, but this is necessarily to create those demand

(b)(vi) Introducing new menus. I would recommend the types of drinks to be diversified e.g. cappuccino, mocha, cokes with ice-cream top, ice-blended drinks etc. First, it is not that difficult to learn how to produce these drinks. Secondly, they give very high MR (marginal revenue). People don’t mind paying. I have seen simple drink like those being sold at RM 5.50-RM 6.00 & how much is the cost? Or perhaps could introduce dessert to be added in the menu

(b)(vii) Customers’ suggestion form. As mentioned earlier, businesses must strive to understand consumers’ need. Those who are successful at doing so will win their heart & loyalty. Customers don’t pay for the sake of paying it. They are willing to pay because they like it. Having a suggestion form on the table, shows how much the business owner is concern towards customers’ need. This is also part of the effort to achieve greater allocative efficiency (P = MC). I understand that it is difficult to fulfill everyone’s need, but having that form on the table at least will also create an impression that you care for their need

(2) Reducing cost

(a) Energy efficiency. A small space shouldn’t be occupied with so many air conditioners. It’s time to shift one & move it to the right, so that the cool air circulation is more balanced. Closed, perhaps one air conditioner after peak period such as lunch. I don’t see the need of fans too

(b) Reduce water shortage. Make more frequent trips to the back to ensure that the kitchen helper do not waste water by turning on the tap all the time

(c) Reduce wages cost in future. Since the commitment has been made, it is sort of difficult to turn & reverse the decision. However, for future maybe the owner can consider reducing the payroll. In fact I feel that the current pay is extremely high for a Myanmar worker. Furthermore, they have been provided with food & accommodation or even transportation. Busy during the peak period is not a good excuse to ‘overhire’ workers. Many restaurants operate the same way too

(d) Not necessarily for specialisation. Normally, division of labour each specialising in a specific task applies more to big large organisations. This is because the volume of production is very high & also it enables them to actually achieve economies of scale (EOS) from doing so. For small scale business, such action is not feasible as it only increase the production costs. Say, 3 workers preparing the meals are paid RM 1200 each (RM 3600). I would rather reduce them to 2 & the task of the third worker is shared between those 2. Now I will just have to pay them say, RM 1400 each (RM 800 cost saving). The restaurant at the meantime is said as being productive inefficiency (MC ≠ AC, not producing at the minimum of LRAC)

I didn't mention about reducing the cost of raw materials due to difficulty to get a supplier for good meatballs, vegetables, chicken etc at reasonable price

Economics Of Specialisation

Specialisation of labor: Happens when workers are assigned specific tasks within a production process


Ford's Model T

“Ford’s Model T initially took 12 hours 28 minutes to assemble, then later became 5 hours 28 minutes before arriving at 1 hour 33 minutes after a refinement at the assembly line by Mr. Ford”

Benefits of specialisation

(1) Increase in output. By constant repetition & specifically targeting one task, a worker can easily increase his or her efficiency & skills. The production process of that particular segment will also be speedier. As a result more output is produced

(2) Time saving. We can look at this from 2 angles. First, by focusing on one task the worker is not obliged to move around & switching one task to another. Imagine what will happen if a cook becomes a waiter at the same time. Also time can be saved when it comes to training people. It would take years just to train a worker to fully assemble a car. But a single worker can be trained immediately to fulfill one operation from the whole production process. As such companies will be able to deliver goods on time

(3) Make full use of one’s ability. With division of labour, there is higher chance that people will get to do what they like the most. Greater interest in job will always ensure one perform better e.g. higher productivity than another who is not. For instance, I like lecturing very much but I hate heavy administrative works (some colleges, lecturers have to do everything). As such I’m able to devote all my concentration, energy & interest into teaching

(4) Practical to use machineries. Say, there are 50 workers in a firm. There is no specialisation at all & these workers do exactly the same thing. As such the firm needs to provide 50 machineries for them to work with & this may not be cost-effective. However with division of labour, now it makes more sense to provide a smaller group of workers, say 4 of them with machineries

(5) Greater job opportunities. Specialisation can lead to creation of more jobs, each requiring different set of skills. Say initially the chef is all the waiter & cashier. After specialisation, there will be 2 more vacancies created

Division of labour is not without problems either

(1) Workers may become boring. A worker which performs the same operation each day is likely to become very bored. This may lead to problems like fall in productivity, high turnover of employment etc especially if those jobs are easy tasks e.g. waitresses. To counter this, more employers have given flexibility to workers such as listening to music, taking light snacks e.g. sweets, chocolate bar, other perks & benefits

(2) Alienation of workers. Workers may begin to feel unimportant since they no longer see the final results in their efforts. To make things worse, someone else from another chain of production process may be granted credit for someone’s else labour. This is very common in corporate world. For instance, Mr. A thought of a great marketing strategy, but it is his boss, Mr. B that was given credit by the higher management. This could lead to problems like alienation, dissatisfaction which leads to fall in productivity & strikes as we commonly see in developed economies

(3) Too interdependent. The whole production process relies on the teamwork of each division or department. If there is any breakdown or communication failure within, the smoothness of the production chain will be affected just because of 1 department. This may result in late delivery of goods, complaints, losses, loss of good reputation etc

(4) High risk of unemployment. In the modern labour market, despite specialisation employers do like to hire people that are able to multi-task. This is very true especially smaller but growing firms which often see cost-cutting as their main priority. Being too specialised, one could face difficulty obtaining alternative employment if they are retrenched. This is often related to structural unemployment. For e.g. from 1960s-1980s Scotland, Wales, northern England & northern Ireland faced great unemployment due to declining importance of coal mining & ship building industries

Video Lesson: How AIG Collapse?

All in a sudden I have an interest to explore the in-depth of finance & blog about it. After all being an economist, I feel that I shouldn’t just restrict myself to the boundary of economics. To some extent subjects like finance, economics & even accounting are inter-related. Think about this. What causes the stock market boom towards late 1990s in America which creates mass of wealth & consumption? Which firms that emerged to become 7th largest in America? It’s non-other than Enron with its largest accounting frauds in history. Enron is no more than a loss-making company, but with its revenue being inflated by creating accounting

How about AIG? It stirs curiosity on how a large insurer with such strong branding & long run supernormal profit is on the brink of collapse. This is challenging the principle of monopoly & the wisdom of free market (Unit 4 & Unit 1). AIG is not the only one. We have others like Lehman Brothers, Bear Sterns earlier, the Big 3 etc

AIG’s near-to-collapse has much to do with its interest in flirting around with CDS (credit default swap), something that the Great Sage of Omaha, Warren Buffet called “financial weapon of mass destruction”

What is CDS?

Referring to a contract between 2 counterparties, whereby the buyer will make a periodic payment to the seller & in the event of default, it will receive one-off payment from the seller. Another way to look at this is insuring against risk

Let’s me simplify a real situation (It could be difficult to Econs students than Finance students)
Say, we have the followings (You seriously need a pencil & paper):

1 company called C1
1 pension fund, called P1
1 hedge fund called H1
1 insurer called AIG

Say C1 which was given a bad rating, say BB from Moody’s (rating agency) & is desperately in need of cash. Thereby it issues a bond worth $10m with periodic 10% interest payment & this is taken up by P1. Feeling insecure, P1 decides to insured against the risk with AIG which was highly rated by Moody’s, say AA. AIG in return would command for a premium say 1% ($ 100k) from a P1. Notice that AIG is in a very profitable position to do so. This is because, there could be many other firms that seek credit default protection from it & as such receiving premiums all over

Now, to make things interesting say a hedge fund, H1 would like to take a huge bet, say $100m that C1 will have high chance of default. Here H1 is not going to lend C1 any money but would like to buy a credit default swap from AIG. The hedge fund is now getting larger insurance for more than what C1 actually borrowed from. H1 is willing to pay 5% per annum to AIG

AIG begins to think that the deal is interesting since they can get $5m per annum from H1. On the other hand, H1 thinks that the company is more likely to default & thereby they will be getting those $100m. Now, say C1 really went into default after the second year. AIG will therefore need to compensate H1 the full amount of $100m. Paying such a huge sum of losses may attract the attention of Moody’s. Moody’s may now need to lower down the rating of AIG, say to B+ since now it is under-capitalised.

But don’t forget AIG does insured against other’s debt such as P1. Now that insurance of the pension fund is no longer worth AA but B+. This prompt P1 to wind it’s transaction & causing further liquidity problem to AIG

What happen then?

This has a serious chain-effect. Liquidity crisis & huge drop in rating, cause AIG share price to plunge from its 52-weeks high of $70.13 to $1.25 in 16th September. Its financial product head, Joseph Cassano was being labeled as the “10 most wanted culprits” of the financial collapse. Earlier it ran into financial panic, after nearly disposing of its aircraft leasing division called International Lease Finance Corporation, to raise capital

How Succesful Is Fiscal Policy In Preventing A Recession In UK? (forecast essay)

Fiscal policy: Defined as the manipulation of government spending & level of taxation to influence the movement of AD

"Preventing a recession" indicates that UK economy could be slowing down significantly. To prevent a recession, it is necessarily for the UK government to pursue expansionary/ reflationary policy by slashing tax & increasing public spending

How does this works?

(1) Slashing direct & indirect tax. Direct tax refers to income tax & corporation tax. By paying lower income tax, individuals will have greater amount of disposable income. As such this may increase overall spending into the economy. Lower corporation tax may put companies in higher retained profits position. As such this increases their incentive to invest such as acquire modern capital goods, build factories etc. This will increase I which is one of the component of AD. Lastly, UK government can reduce VAT on goods produced. Like now, the slash in 2.5% of VAT will make goods cheaper, thereby encouraging more purchases. All these shift AD curve right & thereby reducing the possibility for recession to take place

(2) Increase public spending. When government allocate more funding for public services, such as onto schools, hospitals, infrastructures, public transport, telecommunications etc, it has a direct effect onto AD. Also this may positively affect other components of AD. Firms will gain a windfall profit when they are engaged with government’s project. More money can be reinvested into operation later. Along the way, it will create more employment thereby increasing spending into UK economy. All these shifts AD rightward, thereby preventing the possibility of recession

Evaluations

(1) Lags. Fiscal policy suffers from all lags. Government tends to be too ‘careful’ in announcing a shock e.g. recession has happened in the economy. The sub prime mortgage time bomb has actually happened end of last year & only now they are aggressively countering it (recognition lags). When it comes to implementation, it may take months to years. The proposal will have to go through various legal procedures, departments & including securing a planning permission (implementation lags). Once executed, it further takes some time for the effect to be seen in economy (effect lags), e.g. increase in real GDP, fall in unemployment etc. Monetary policy is seen to be more efficient as it’s free from implementation lags

(2) Crowding out effect. Increased government spending may likely lead to deficit. As such government may need to get financing by issuing bonds. Private sectors will take up those bonds & as such have lesser allocation for investment. As such we say private sectors are crowded out. Another way to look at this will be, government increase borrowing from commercial banks. With greater competing demand for money, interest rates will be bid up. As such this will reduce spending & investment, leading to lower growth in long term

(3) Tax reduction may not work. Reduction in income tax may not necessarily induce spending into the economy if the reduction is insignificant. Furthermore it depends on which category of income bracket is affected e.g. lower-middle income or high income? If it affects those on higher income, spending will not increase much given the nature of their low mpc (marginal propensity to consume—tendency to spend). However one could argue that lower tax rate may reduce cases of tax evasion

(4) Limit on government spending. UK’s national debt is ballooning from its low in 2001 (29% of GDP) to its current high of about 44% of GDP. Economists predict that these figures are actually much larger than what it seems since its calculation exclude pension liabilities in future. This is worrying given the increasing size of ageing populations. Growing public debt also pose other problem such as higher taxes onto future generations to pay back all the moneys borrowed. However some argued that this is not much of problem since UK managed to recover from greater national debt of 70% of GDP in 1970s

(5) Consumer confidence. Perhaps, consumer confidence & house prices are 2 of the most important macroeconomic indicators. If consumer’s outlook is bleak & house prices continue to fall no matter what policies pursued by the government it wouldn’t work to steer the British economy forward. Consider Japan. The government has pursued deficit spending amounting to 194% of its GDP, slash in income tax & even interest rates maintained at 0%, yet it fails to revive economic activity

Happy New Year Wishings!

I would like to take the opportunity to greet all fellow readers & my students, Happy New Year! May the year of 2009 will be another great jump-start to all efforts that you have put in earlier. To my students, may you are blessed with great grades & get a good place in top universities. I know some of you are looking for MIT, Stanford, Cambridge, Oxford & LSE

Also to other readers/ business people, try to look at the economic downturn POSITIVELY. There could be blessings in disguise. This could be a good opportunity to seize your weakening business rivals, enlarge your market share & hire brains at your company at discounted wage. There are so many proffesionals coming back from overseas & desperately looking for job now. Who knows, maybe you could exert your 'monopsony' power

And to all my friends, sorry for not spending much time with you all. 2008 is the busiest year in my life that I wish I have 30 hours a day!

To my colleagues, well I'm truly optimistic we are in the A-Team & A Level higher than the rest. Thanks to my boss, Mr. Jahn for allowing me to be part of the maestro. To Datuk Dr. Paul, I always 'admire' (if not people will think otherwise) you from the back. Your business frontier is undeniable. Truly a great tycoon. I now began to look at things from businessman point of view! Everything! Cost saving, efficiency etc

To all other HELP colleagues, we need to push harder for sales! Our rival, is 'sewing us' if you know which college I meant. Anyway since they play dirty, we must play the dirty game too!!

Video Lesson by Phil Holden: Keynesian vs. Monetarist View of LRAS

Why Wage Differentials Exist In Labour Market?

In Labour Economics, it is often assumed that the labour market is perfectly competitive:

(a) There are many hirers or employers (buyers) & many potential workers (sellers). Each of them is small enough & thereby unable to exert any power onto the market. As such each market participant is a wage-taker

(b) All labours are homogenous

(c) Both employers & employees have perfect knowledge of market conditions

(d) There is no government intervention

However these conditions are just a proxy & a satisfactory model to the real situation. In reality, we know that labours are not homogenous. A farmer will not be able to become a doctor or a pilot. The same goes for wage-taking. In real life, some employers have monopsony power & as such they can command the wages that they are paying. Also we have strong labour unions that can restrict the supply of labour into certain market. Government also can intervene in the labour market e.g. imposition of National Minimum Wage (NMW)

Why wages differ so much between individuals?

(1) Age. Older workers are paid much higher salary since they are likely to have much experience over the young ones. Experience is important since it could lead to better knowledge of working conditions, effective decision making etc

(2) Sex. Women are traditionally paid lower than men due to many factors. For instance, women are highly concentrated in sales-related jobs e.g. shop assistant, in-out of job too often due to maternity, lesser education etc whereas men are more into professional areas e.g. specialist doctors, taking stressful jobs e.g. investment banker etc . Although the trend is less apparent in the present, still the concept of glass-ceiling appears everywhere. Women are denied the role of leadership in many positions. We will talk this in greater detail next posting

(3) Ethnic. Racial discrimination still appears in workplaces although governed by 1976, Race Relations Act & Commission for Racial Equality. The minority ethnics are very often denied the chance of climbing up corporate ladder. However one could also argue that other ethnics may treat English as their secondary language especially immigrants. Also they receive lesser formal education compared to the Whites

(4) Personality. Different people have different mentality, attitude & aptitude towards work. Some are hardworking while some others are lazy. Normally those who are highly capable will command great attention & care from their bosses. No doubt, one could also argue that political skills in office could be a much greater influence in determining one’s position

(5) Different MRP (marginal revenue product of labour). MRP means an additional revenue gained by selling extra 1 more unit of output. It is also the demand curve for labour. MRP is closely associated with MPP (marginal physical product) & MR (marginal revenue). It is given by MPP = MRP x MR

MPP means additional output by hiring extra one worker) & MR means additional revenue due to extra one unit of output sold. As such workers with higher productivity tend to get higher salaries. The same goes for those who produce profitable goods. For instance heart specialist or professional footballers like Beckham are highly paid due to their high MR

(6) Nature of jobs. Wages are only signal for allocation of labours. In reality when one choose a job, they will look at many other factors for instance level of stress, perks such as company cars, danger involved, health benefits etc. Other things being equal, jobs with unpleasant environment will have to pay higher to attract workers. For instance, working as an investment analyst in Swiss Bank will likely pay higher than a teacher given the challenging nature of finance e.g. high stress

(7) Backed by strong unions. Trade or labour unions are organisations where workers group together to further their interest. They often have strong influence over they pay of their members since they bargain collectively rather than individually. More often than not, this will result in exorbitant rise in production costs for employers. UAW (United Auto Workers) for the Big 3 is a good example. What they normally do is restrict the supply of workers in certain industries to drive wages up. Also union workers often have higher pay than non-union workers

(8) Powerful corporations. Meanwhile, there are also some firms which are very influential. They hold the monopsony power as the single buyer of labours. These types of firms are able to set their own wage rather than employing at the going-wage rate as in perfectly competitive labour market. They may have the power to drive down wages. Those employed in such industries may have a lower pay scale on the average

How Effective Is Monetary Policy In Countering Deflation In UK?

In Japan, price level is falling severely from the period of 1998. Inflation is negative for such a long period. The Bank of Japan begins to increase interest rate only in late 2006

Expansionary/ reflationary/loose monetary policy are pursued to prevent the price level from falling down

Monetary policy attempts to influence the movement of AD by manipulating the level of interest rates

Here, the deflation that occurs is likely due to weakening of spending into the real economy. As such, attempts must be made to move AD to the right via interest rates cut

How does monetary policy work to counter deflation?

(1) Consumption. In theory, cut in interest rates actually create a disincentive for people to save. Also with lower interest rates, more people will find that purchasing items by credit is now cheaper. As such it will fuel spending onto property, cars, plasma TV etc. Meanwhile for people with existing debt, they will find that mortgage interest repayments as a % of their income has shrunk. This means increase in disposable income & more can be spent onto other goods. All these 3 will lead to increase in consumption. AD will shift right, thus preventing the price level from further falling down

(2) Investment. Lower interest rates also encourage more entrepreneurship activities. More firms will be taking up credit financing to enlarge existing operations, to acquire other businesses, buy capital goods, build new factories etc. Their interest to do so increased, as lower interest rates translate to higher return on capital. As I is a component of AD, this will jump-start AD & thereby prevent price level from falling

(3) Export. Lower interest rates will cause pound to depreciate. High net worth individuals, hedge funds, pension funds etc will probably withdraw savings from UK to seek for higher return elsewhere, causing heavy selling of pound. Somehow, cheap pounds will help to boost demand for UK exported goods. As X increase (assuming M constant), this should help to push net export higher, thereby an increase in AD

Evaluations

(1) No implementation lags. MPC had gained independent since May 1997 from Labour government & as such its operation is said to be free from political influence. Also they conduct meetings every first week of the month & interest rate decision is made a day after that. As such it is fast & efficient

(2) Effect lags. Monetary policy may suffer from effect lags. It is said that any effect onto the real economy can only be seen in 18 months time. In other word, the recent interest rate cut may not produce any result at least until June 2010. This is because many people are switching to fixed rate mortgages, especially in the period of early 2000s where interest rates are steadily rising. Therefore their consumption pattern may not change immediately

(3) Consumer confidence more important. Interest rate cut may not produce desirable result, if consumer confidence is falling drastically owing to the property market slump. Japan is a good example. In the period of economic depression, all have been done including driving interest rates to 0%, cutting income tax & explosive government spending up to 194% of their GDP. But none of them work. As cut in interest rates fail to stimulate spending, we call this phenomenon as liquidity trap

(4) Undermining effectiveness of traditional tool. There is a limit into the working of traditional monetary tool. For instance interest rates can’t fall below 0%. In UK, key rates standing at 2% means there is still room for MPC to manipulate the rates. Unfortunately, in US the official rates are now at between 0%-0.25%, which doesn’t make much difference by saying that it stands at 0%. Therefore, we say in US monetary policy has completely lost its effectiveness since rates are so low & it fails to kick-jump the economy

(5) Quantitative easing. There are still other monetary tools that can be pursued by MPC if the rate cut is ineffective. It’s called quantitative easing. This refers to large scale of buy-backs of government debt by BOE. The purpose is actually to increase liquidity in financial system, hoping that banks will eventually resume their operation as usual. This was an option considered by the Japanese government during the period of depression in late 1990s. Although this is said to be possibly contributing to high inflation or hyperinflation, the possibility is remote

(6) Positioning of UK economy. In the current period, very likely there is high spare capacity in the economy. As such any cut in interest rates, in theory, will be able to give a large boost to real GDP without causing much inflationary fear in the future

(7) Banks not co-operating. In the current period, banks are seizing opportunity to rebuild their balance sheet e.g. recoup some of the earlier losses. As such, they are reluctant to pass on the full interest rate cut. For e.g. fall in 1%, only 0.25% will be given to borrowers. As such costs of borrowing remain high & therefore this defeat the objectives of monetary policy. Also costs of interbank lending (LIBOR) remain high & this further tightens the credit crunch

(8) Deflation not necessarily bad. If the falling price level is due to increase in competition, higher level of investment in technology, greater productivity etc then the outcome may not be bad. This is because, as AS curve shifts rightward price level will fall & yet there is an increase in real GDP. Also consumers’ welfare may increase as they are now paying lower price & yet enjoy more goods

(9) Couldn't be targeted to certain sectors. Monetary policy could be argued as a blunt policy tool. Once the decision is being made, it actually affects all sectors of the economy. On the other hand, fiscal policy changes can be targeted to affect certain groups such as means-tested benefits for low income households, reductions in corporation tax only for small-medium size enterprises, investment allowances for businesses to set up in certain region etc

Is Deflation Good Or Bad?

Economics always create wonders out of nowhere! It was not long ago, when everyone on the street was talking about the danger of inflation, particularly oil price peaked to $147 per barrel on July 11th. Somehow, just months after that economic scene have totally changed. Inflationary pressure is no longer on the radar when oil price fell below $40. Now, it’s the D-factor & I’m referring to deflation

What is inflation-deflation?

Inflation is the sustained increase in general price level. Meanwhile, deflation means a fall in general price level. It’s just the other way round. Price level is falling fast in UK now, led by slump in housing market. Economists predicted that the real impact of deflation will be fully felt next year

You may argue, isn’t a good thing when everyone can buy things cheaply? Well, my answer is YES & NO. Yes, if it lasted for months. No, if it lasted for years like in Japan. In short, inflation & deflation are both equally dangerous to economic health

Before we proceed, I would like to show an important calculation here. Say, nominal interest rates 0% (like in US now) & inflation is 5%, so real interest rates = 0% - 5% = -5%. Therefore it serves no point saving your money in bank account. But in period of deflation, say inflation is -5%, therefore real interest rates = 0% - (-5%) = 5% had increased

Why deflation is bad?

(1) Defer in spending. Deflation creates a disincentive for people to spend now. This is because people expect the price to further fall in the near future. Why buy a house now, when probably one can buy it at 10% cheaper next 3 months? When everyone thinks the same, the economy will contract faster, driving the price level lower. Then, again people will wait rather than spend, since they saw further space for the price to rock bottom. This is particularly true in UK & US since the economic growth is consumption-led. In this period, savings will also increase. This is consistent with scenario in Japan. The ‘long-lost decade’ experienced in 1990s to 2000s shows how danger deflation is. This is also the period where the Japanese stack up their savings to the extent of the US’ GDP

(2) Borrowing is expensive. As shown in the calculation above, deflation causes a rise in real interest rate when the nominal interest rate remain constant (0%). As such, it means costs of borrowing have increased. Households will reduce their consumption on huge items on credit such as plasma TV, cars, houses etc. Meanwhile, firms will cut their spending significantly on acquisition of capital goods, building of new factories etc. It makes economic sense for firms to do so. First, there is great uncertainty as to when they can breakeven. Second, there could be a shift in customers’ mindset, therefore changing the consumption pattern

(3) Increasing debt. In the period of rising inflation which is normally followed by rise in wages, the real value of mortgage will be progressively reduced. A monthly mortgage payment of $ 600 will become attractive since it becomes smaller as a % of our income. However, with deflation & period of falling income, the value $ 600 as % of our income grew larger. This means increasing burden, fall in disposable income which lead to fall in consumption & contraction in GDP. The same applies for firms

(4) Higher wages cost for firms. Depending on how this is argued. In current period, workers especially those backed by unions will seek to prevent a cut in the nominal wages. It has 2 impacts which are equally bad. First, firms that are unable to maintain at such wages will resort to sack workers, thus creating real wage unemployment. Second, firms may not be able to sack many of those workers to reduce operating costs significantly if they are backed by strong unions. As such, their profit margins will become thinner or even make losses. GM, Chrysler & Ford typically face such problem. Their workers are backed by strong union called UAW (United Auto Workers)

(5) Falling share prices. In period of deflation, where real economy contracts at such speed it is norm to see company making smaller profits or even make losses. At such they may need to cut dividends payout to shareholders. This caused a bad valuation upon the firm. More people will be dumping its shares. Heavy selling will drag the price lower. This explains why Dow Jones & FTSE fell in the recent months, although there could be other factors. This may pose a greater threat to US economy than UK, since only a fraction of Britons actually store their wealth in shares

(6) Undermine the ability of monetary policy. Monetary policy has always been an ‘effective’ tool to boost spending into the economy & to control price level. Since the outbreak of contagious deflation, its effectiveness has come to an end. Despite the aggressive stance taken by the Fed to cut rates from 5.25% (September 2007) to now 0%, it doesn’t seem to work at all. The same goes for MPC. Interest rates had went down from the peak of 5.75% (September 2007) to 2% in December 08, but fail to prevent the housing market slump in UK. For States, we said that the monetary policy has run out of ammo!

Good thing about deflation

(1) Narrowing income inequality. Income gap has always been large in both UK & US. In the period of economic contraction, usually those executives with fat pay checks will be the first to go, as firms are reducing costs. But no doubt this argument also depends on which industry we are referring to. This could be more applicable to financial sectors in both UK & US. Wall Street wizards are now poorer. Share brokers really go broke due to thin transactions in financial market

(2) Bargain hunting. It often happens at the turn of all business cycle. For those who accurately time the market, will enter & buy good shares at ‘discount’ prices. The same goes for property market. If plans work out, normally those middle income people will turn themselves into high-income bracket once the market fully recovers. High share & property prices mean greater wealth, which will steer the economy. The only problem is, no one can actually time the market, not even Wall Street gurus

(3) Build up savings. From the calculation above, it is obvious that deflation can actually increase the real value of savings. It would be appropriate for Americans & Britons to consider building up their financial position once again. From the PPF argument, increase in savings can be channeled for investment which will shift the curve outward in future. Also, banks will have more cash to lend out & they will reduce their exposure to money markets just like before

(4) Good opportunity to expand through mergers. In the current period of credit crunch, many smaller firms but with great growth potential have problems in their balance sheet. Larger firms which are cash-rich may take this opportunity to acquire good firms sold at attractive prices. Furthermore, there are likely be lesser competitors bidding for it

Public Goods & the Failure of Free Market

Public fireworks, sample of public goods . We are not talking about fireworks in closed parks

Streetlights, another example of public goods. The man on the left does not reduce the lights available to the next person. Neither does he can exclude that person

Over the years, the British government has embarked an ambitious spending on public goods which amount up to billions. To really appreciate the topic of discussion, it would be appropriate if we understand how is a good being classified as public good?

Public goods must have 2 characteristics:

(1) Non-rivalry: The consumption of the good by one individual, will not reduce the amount available for someone else to consume

(2) Non-excludability: Once the good is provided, no one can be excluded from benefiting it

Examples of public goods: fireworks, BBC television program, national defence, street lightings

I would pick fireworks since we are moving to New Year. Fireworks are considered as public good since it fulfil both the characteristics. First, it is non-rivalry. If I stare into the sky & I saw 20 blasts, I don’t reduce the amount of blasts watch by another person, say to 10 blasts

Second, non-excludability. If I get to watch & enjoy the scene of fireworks, I can’t stop someone else standing next to me from watching it

Let’s consider street lights. If I was standing under the street light momentarily, before moving on, I do not reduce the amount light available for other passers-by. Second, I can’t prevent someone else from standing below that streetlight

Market failure

Why public good is considered as a form of market failure? Simple, because the private sectors will not have the incentive to provide it since there is no certainty over the economic profit. This is due to the characteristics of public goods mentioned above. Once provided, the private firm will not be able to prevent someone who is not paying for it from using it. In other word, free-rider problem

Theo Fennell & Income Elasticity of Demand

In the recent (23rd December), Theo Fennell, the British prime jeweller had reported its first ever loss in 3 years amounting up to £ 840,000. Its sales dropped by 20% for the period of six months to 30th September

Why is it so?

Before going into that question, I would like to introduce the economic tool of analysis called income elasticity of demand (YED)

Definition: YED measures the responsiveness of quantity demanded due to the change in income

The formula is given by, YED = (% change in quantity demanded) / (% change in income)

Application of YED

While PED (price elasticity of demand) is used to determine how sensitive certain goods towards price changes, XED (cross elasticity of demand) to determine relationships of 2 goods (whether it’s substitute or complements), YED is meant to identify the types of goods or services

(1) YED less than 0

We normally refer them to crush grain, Tesco brand bread, instant noodle etc. Here inferior goods are something that we consume lesser when our income increases. This explains why the outcome of calculation can be negative since (-% demand) / (+% income). Of course, it works vice versa. In period of difficulty or running a tight budget, our consumption on these inferior goods will increase. So (+% demand) / (-% income)

(2) YED, more than 0 less than 1

Necessities are normally clothes, toothbrush, newspaper etc. Here demand will rise along with income but less than proportionate. Therefore it yields a positive figure which is less than 1. For instance, (demand + by 30%) / (income + by 60%) = 0.5. Of course it works the other way round

(3) YED greater than 1 (luxury goods)

We often refer luxuries to things like international holidays, jewelleries, designer clothes etc. In the period of economic slowdown like now, normally businesses selling these items will be the first hit. Households would be more concern with their savings & family balance sheet. Here demand will fall along with income but greater than proportionate. Say, (demand -60%) / (income -50%) = 1.2 (positive figure). Of course it works the other way round

Back to our analysis, here Theo Fennell is in jewellery business. As such what they sell is classified as luxury goods. No wonder, their sales dropped significantly

Bernard Madoff-Ponzi Scheme

Charles Ponzi, in tribute of him

Mr. Madoff in his office, Bernard. L Madoff Investment Securities, LLC

After a series of economic & financial shock from US, we were lambasted with another big news that swept across newspaper’s headline in the West. It is non-other than Bernard Madoff. This name could be alien to my fellow Economics students, but he is a well respected figure. His legacy of helping investors to consistently earn 11%-13% on top of their investment is no secret, even in times of turmoil. He is even been made the Chairman of Nasdaq

This man had a very humble beginning as a lifeguard & installing sprinklers. He started his company in 1960 with an initial $5,000 & then called it Bernard L. Madoff Investment Securities LLC. His reputation is so strong, that he had an ego of turning down some of the richest man that courted him for access to his miracle investment scheme

There are few things that amazed me:

(a) How does an ordinary lifeguard & sprinkler installer know so much about the working of the financial market, regulatory framework & its loopholes?

(b) How come his sons are not aware of their dad’s activities?

(c) US has the best & yet the most sophisticated financial market regulator called the SEC (Securities & Exchange Commission). How come it fails to detect the financial fraud much earlier & letting it operate for nearly 4 decades?

(d) Why are those big banks with world most talented brains & management such as Swiss Bank can be swayed into trusting the Ponzi scheme (in recognition of Charles Ponzi) & earning superior returns even in period of difficulty?

How does Ponzi scheme work?

It’s rather easy. There is no hassle to earn CFA (Chartered Financial Analyst) title or PhD in Finance, or becomes a well-known Wall Street figure. The organiser didn’t actually invest any of the money handed to him. What he did was, to use new depositors’ money to pay off the earlier depositors

Let’s consider a simple scenario of 26 investors, labeled A-Z. At first there will be 3 investors, called Mr. A, B & C. Then the organiser will fool Mr. D (which is very rich) in joining the scheme. Eventually, the money handed in by Mr. D will be used to pay off earlier investors (A, B & C) without actually investing it. Say in the end when Mr. X, Y & Z joined the scheme, the money they threw in will be used to pay the so called ‘profit’ made by investors A-W

However you may argue, in order for the scheme to work does it mean that Madoff has to continuously look for richer investors so that earlier investors can be paid off? My answer is not necessarily. If he successfully found one, it will be good as it means more cash in circulations. If not, it’s not a problem anyway. Why? Those investors at the earlier chain are probably driven by greater greed now. Greed dominates their rationale. In reality, most of them reinvest the paycheck they got hopefully they can earn more superior returns

Say, initially Mr. A threw in $ 5, 000. As promised earlier, a 20% return would give him $6,000 next year. Driven by greed & confidence with the organiser, he will choose to reinvest that $6,000 rather than cashing. He hopes that by another year, the amount will further grow to $7,200. This carries on

In what circumstance the scheme will come to an end?

(1) Time to get out. Once the organiser feels that he had made a considerably fortune for himself, he will leave the game & disappeared with all those monies

(2) Outnumbered. If participants are increasing abnormally, the organiser could find great difficulty in paying off the existing ones. More time will be spent onto managing existing accounts, leaving him lesser time to lure new ‘victims’. At the end of the day, there will be lesser monies coming in & he may liquidity problem. Words of fraud may begin to spread. It works incredibly like multiplier effect. Later more investors will want to withdraw, causing tighter liquidity for him

(3) Regulators. If the scheme is so successful, he may attract regulators to probe him. Regulators will ask for accounts of transaction, something that he may not be able to provide. Surprisingly, Madoff escape this. Miracle isn’t it, after SEC letting this slip of from their hand?

(4) Credit crunch. The main reason why Mr. Madoff fails in the end is due to credit crunch itself. Due to period of difficulty more investors want their money back. After all, having cash in hand now is perceived the safest. Secondly, he fails to attract more people to join the scheme in current period. Third, even those big guns who want a shot, may find difficulty to get credit from banks. All these lead to shortage of cash & yet people who demanded their money back is on increasing scale. The scheme's life cycle has come to an end!

Among well-known victims of Madoff:
(a) Steven Spielberg
(b) Frank Lautenberg, US Senator
(c) RBS (Royal Bank of Scotland)
(d) Swiss Bank
(e) BNP Paribas
(f) Aozora Bank (Japan)
(g) Abu Dhabi Investment Authority

In Malaysian, we have similar scheme which was given the name ‘Pak Man Telo’. The one who organised it was called Osman Hamzah, a part time reporter in Perak. He started the scheme in 1972 & cheated nearly 50,000 investors with value of money at RM 99 million in hand that time.
Perhaps, he could have made much fortune just like Madoff if he operates in US or maybe even longer due to loopholes that exist.

Types of Unemployment & Solutions

People registering themselves at JobCentres

Unemployment: People who are in the working age (16-65) & economically active, but couldn’t find a job despite active search for it

That is a very general term to refer to people who are unemployed

However, unemployment may not be as simple as it seems. In fact we do have a branch of economics called Labour Economics (Unit 5A) but unfortunately Edexcel scrapping it soon. Final exam will be in June 2009

Types of unemployment & solutions

(1) Frictional unemployment. Time taken for individuals to move in between jobs. Suppose Mr. A has been out of job for several months & as such he is looking for a new one. In between, he registered himself as unemployed & entitled himself to claim jobseeker’s allowance. Sometimes, ‘the dole’ could act as a strong disincentive for someone to look for job if the claim is high. Also sometimes they took longer than necessarily to look for jobs, is due to imperfect information, not knowing which local firms that offer vacancies. Both these actually worsen the frictional unemployment

Solution: Like UK, they have set up JobCentres, a government-funded agency (something like Jobstreet in Malaysia) that helps people to look for suitable employment & firms to fill in vacancies. Also the government can cut unemployment benefits, to increase the opportunity costs of staying idle

(2) Cyclical unemployment. Also known as Keynesian unemployment. Closely associated with economic growth. Like now, the period of recession, clearly businesses no longer need so many workers since the demand for their goods & services had fallen.

Solution: Government has to increase public spending & reduce taxes. Increase in G will jump-start the economy since it’s part of the component of AD. Hopefully through the multiplier effect, will lead to a secondary increase in AD. Cut in direct tax will induce more people into work since it increase the level of disposable income

(3) Structural unemployment. Unemployment that results due to mismatch of skills. The problem is these workers are just too specialised & they may find difficulty to move in between jobs. For instance, a welder is displaced by a robot or a nuclear engineer is no longer required in a lab.

Solutions: Government provides incentives to firms to train these employees to make them more marketable for other jobs & also incentives for those unemployed to join the training scheme

(4) Geographical unemployment. Unemployment caused by difficulty to move from an area with low demand to areas with high demand for labour. This is often caused by social factors like family ties, cost of living etc

Solutions: Government can consider giving incentives to firms e.g. tax breaks, investment tax credit etc to set up businesses in areas with high unemployment. Also, they can actually reduce barriers to free movement. Notably, EU has reduced the border controls thereby enabling workers from e.g. Hungary to come in easily & work in UK. However, there could be other barriers like language

(5) Real wage unemployment. Unemployment that is caused due to high wages in the economy. It could be caused by any of the combinations such as strong trade unions, wage rigidity & minimum wage. Strong trade unions can cripple the whole economy. UAW (United Auto Workers) is a good example of how a union nearly destroyed the Big 3 & subsequently put US in the mercy of Japanese & Chinese (to buy their bonds). They often ask for wages that are absurd even in period of difficulty like now. Secondly, there are some wages that could be difficult to be adjusted downwards, e.g. workers with long term contract. Lastly, high NMW (national minimum wage) can lead to unemployment as firms will demand for lesser workers if per hour pay is high

Solutions: The US government can follow the stance adopted by Margaret Thatcher in paralysing the strong labour union. However it is very politically unpopular

Consequences of Unemployment

Unemployment in US on the rise since 2007 is at accelerating rate in 2008

Unemployment in UK had reached all time high of 6%. Also going up at accelerating rate

Implications of unemployment

(1) Fall in real GDP. Labours, just like land & capital is considered as factors of production. Higher unemployment rate means lesser labours are being hired in the market. Therefore this necessarily translates to lesser goods & services produced in an economy. The fast rising unemployment in major developed economies such as France, Germany, US, UK & Japan largely explains why these countries are already officially in recession (unemployment & contraction in GDP are inter-related actually). Recession is defined as 2 successive quarters of negative growth
However, if job losses are due to firms becoming more capital-intensive (use more machineries), then real GDP may not fall

(2) Loss of income. Unemployed people may have lower standard of living. This is because, they no longer have sufficient means to maintain their living style as before. Even if they get Jobseeker’s Allowance it is of minimal amount & it actually erodes their purchasing power. Although one could argued that sometimes the unemployment benefit (which is not same to every individuals) provides more income than working & the increased free time may be considered more valuable than working, rest assured this falls into minority case

(3) Negative multiplier effect. The jobless state could eventually spread into the whole economy. Think of this. Woolworths is about to go into administration. It is going to shut all its 807 stores with the workforce of 27, 000 people in January if it can’t find a suitor. Say all these workers are laid off simultaneously. It will immediately cause a fall in consumption which triggers a contraction in real economy. Firms earn lower profit or even losses or even go bankrupt. In return, they are firing workers too. The cycle just repeats itself

(4) Loss of tax revenue. Unemployment will immediately cause a fall in direct tax & indirect tax. As lesser number of people is working, government receives lesser income tax. As firms felt the impact of negative multiplier effect, they make lesser profit or losses. So government collects lower corporation tax. Also since lesser people spend money onto buying goods & services, there would be fall in VAT

What government can do is increasing the tax onto those existing workers or cut government spending. Rest assured, both are viewed as politically unpopular stance.

(5) Increase in unemployment benefits. This resembles an opportunity costs of how government can spend their money. It is argued that those monies are better spent productively to stimulate the economy by creating employment through the building of schools, hospitals, motorway, infrastructures, telecommunications etc. Workers which receive ‘the dole’ may become complacent & might just rely on the benefit rather than making an effort to search for jobs

(6) Social costs. Being jobless, can pressurised an individual to commit offenses such as snatch theft & robbery. If prolong, other things may happen. In the period of Great Depression in 1929-1939 people are unemployed so long that the suicidal rate actually increased. Also being jobless for so long can degrade an individual self-esteem & fall in productivity. From other angle, children from unemployed households often had poorer education & hold fewer skills on the average, upon entering work

Media & Its 'Contribution' To The Paradox of Thrift

Fall in house prices ‘welcomed’ –11th May 2008
House prices dropped 1% in June –28th July 2008
House prices double digit fall –4th September 2008
UK house prices continue fall –2nd October 2008
UK house prices to fall by 30% --15th December 2008
Mortgage arrears to hit 500, 000 –18th December 2008
Lender axe house price forecast –19th December 2008
Mortgage lending shrinks again – 23rd December 2008
House prices will fall further –24th December 2008

I guess I don’t have to do much explanation here. All those news were taken from BBC & in fact these are just an insignificant portion of the broader coverage on how the UK housing market performs. We still have Telegraph, Financial Times, Guardian etc

Source of diagram: BBC

If you observed both from the news & the graph, price of houses in UK is continuously nose-diving. There are many factors contributing to these particularly on the demand side. The fact is that increasing number of people have chosen to shun away from the property market. Why? Because they are waiting for a period ‘comfortable’ or low enough as an entry point. In other word, people are deferring spending onto big items.

Here comes the relevant concept-paradox of thrift, propounded by the great British economist, John Maynard Keynes in the early 1930s during the period of Great Depression

According to him, recession or even depression can be self-reinforcing. If individuals think that in the current period of recession, increasing personal saving is the best thing one can do, then ultimately this will do more damage to the whole economy & to that individual itself. To further support, it makes huge economic sense to save & defer current spending since there is much space for house prices to fall. Why buy now when one can buy at a cheaper price later?

But if everyone thinks the same, demand for houses will fall. Dipping house prices will hit nation’s newspaper headline & people will continuously think that house prices are yet to rock bottom. As such spending is further postponed. This brings substantial damage to homeowners’ wealth since UK has large proportion of people storing their wealth in property market. Many have went into negative equity & that is amount of loan greater than value of house

This will further reduce economic confidence & aggravate contraction in economic activity. Therefore DEPRESSION is the word! UK economy is one the worst hit in Eurozone given huge contraction in economy is heavily owed to falling property prices.

Perhaps, the Britons may need to learn from the Great Depression in Japan & avoid the same thing happens again

Well, we can’t blame the media for ‘indirectly causing’ the recession. They are just doing their job anyway

How Does Negative Multiplier Effect Works Into Whole Economy?

Negative multiplier effect: An initial fall in AD which subsequently leads to a much larger fall in GDP

To see how damaging the effect towards the entire economy, let me illustrate with an example:

We begin with the ailing financial institutions. Due to the collapse or near collapse of many large firms such as Lehman Brothers, AIG, Citibank, Goldman Sachs, Freddie Mac & Fannie Mae, many had begun to restructure their operations. Among the most common measures taken are to retrench workers to minimise the operating costs, especially in the current climate of heavy losses

The first round of large scale unemployment had caused humongous drop in private consumption (C). Since C is a component of AD, therefore AD must necessarily fall. In reality, real GDP begins to slow down & inflationary pressure starting to ease. Since these people spend lesser on the High Street, businesses begin to see losses or fall in profitability. Since the demand for their goods or services fall, it makes no economic sense to maintain those workers who are now idling around in a quiet shop. Therefore this leads us to second round of retrenchment. Unemployment rate increases again. C further fall, economic growth rate is slowing down at a faster pace & price level shrinks again.

This creates fear even among those who still have a job. As such fear over job insecurities lead to their cut in spending. Unemployment is reported on the rise again next month & this is the third round of retrenchment. Does it stops here or just affect people or businesses in certain area?

Let’s look at how this spreads. Inability of bank to generate lending due to credit crunch also caused demand for housing to fall. As property market becomes gloomy, they will in return retrench their workers causing the same effect as mentioned above. As no one turns into buying house, this has a negative spill over effect to other related industries such as kitchen companies, furniture shops, lawyer firm, mortgage advisors etc. Therefore the effect is magnified through rising unemployment once again

Is that all? Wait. Difficulty in generating lending, had also caused large banks to turn down the appeal of GM, Chrysler & Ford to access funding to restructure their operation. It is well known that the Big 3 were not making much (even make quarterly losses) in the recent years due to the fast falling market share compared to Japanese car makers. If assistance is not given, their collapse will add about more than 1,000,000 workers to the unemployment statistic. Don’t forget, many industries are relying on car such as wind screen & gearbox manufacturers etc

Basic Understanding of Bond

Usually, when we talk about investing, people will be so excited (or sad) to tell you how much they have made from stock markets (or how much they have lost). If you brought up the topic of investing in bond, people will be shunned away from the conversation. Well, given the broad publicity & coverage about stocks/ equities in all major newspaper as well as investment magazine, I wouldn’t be surprise that bonds do not generate the same sex appeal as stock investing

I’m not that certain about bond market here in Malaysia, but in more developed financial market such as US, the financial institutions do provide their clients with the service of buying government securities. What they need to do is to open an account with a bond broker which normally requires a minimum of $5000 deposits

Investors often overlook bond investing as normally the return is not that high compared to stock market. But in the bearish period such as now, it’s just too risky to throw our hard earned money into the wave of volatility. Not even investing in unit trusts fund is save for now (I lost nearly 70% of my investment). So in US, increasing number of people have chosen to throw their money into buying government securities, even though the interest rates are near to 0%. They do so as they perceive the chances of government to go default is very low. Why is it so? This is because government can always payback bond investors by the way of higher taxation. As such government bonds are also popularly called risk-free assets

Who & why issue bonds?
Government issues bond for various purposes. From infrastructure development to welfare programs or even to the extent of bailout. Firms issue bonds as they may want to expand the business, purchase of capital goods etc. The thing is, large organisations often need more cash than an average banks can provide. Therefore they also seek funding from the investing public

How bonds & stocks differ?
In bonds we are the lender/ creditor to government or firms BUT in stocks, we are the shareholders & we own part of the corporation (most of us are insignificant shareholders). Also shareholders are entitled to voting rights & profits of the firm, and as such are given dividend payments depending on the profitability of the company

For bondholder, they have a higher priority in claiming the assets than an ordinary shareholder. In case if any bankruptcies, a bondholder will get paid before shareholders. Although they do not entitled to dividends, they to get periodical coupon/ interest payments plus the principle amount
Types of bonds
I’m not that certain about the variation of bonds that exist in US market but generally there are 3 types. First is Treasury bill with maturity period of 1 year or less. Another is Treasury note with maturity 10 years or less & finally Treasury bond with maturity period up 30 years. This is what the US government often issued & the Japanese & Chinese government often take up

For corporate bonds which are riskier, are assessed by Moody’s & S&P. They will give a credit rating to these bonds. I’m sure you have seen somewhere signs like AAA, Aaa, CCC etc. Blue chip firms normally have higher ratings while risky firms may get poorer ratings. This will help investors to assess their risk appetite

How it works?
Interest rates & bond prices are inverse in relation. Say, if interest rates increase, bond prices will fall & vice versa. Why? Let me illustrate with figures (this is an over-simplification)

Bond with 10% coupon rate & at par value of $1000. Bondholders will get $100 every year (10% x $1000) which are paid semi-annually $50 & $50. But if the price goes down to $800, then its interest rates will be 12.5%. This happens because bondholders MUST GET the same guaranteed $100 ($800 x 12.5%). Conversely if bond goes up to $1200 the interest rates will drop to 8.33%

The ultimate return at the end the period is called YTM (yield to maturity) which equals to all the interest payments bondholders receive PLUS any gain (if bought at discount-below $1000) or loss (if bought at premium-above $1000)

Market force of demand & supply also play vital role in determining the price of bonds. In US, since there is no reliable form of investment at the moment, therefore most people throw their money into bonds. As demand for bond increase, therefore it pushes its price to higher level. As such this reduce its interest rate. Remember the interest rate & bond price works in different direction

Bonds also called as fixed-income securities typically because investors income are known & fixed (periodic payment of interest rate)

Video Lesson by Richard Pettinger: Deflation

Are They The Same? Low inflation vs. Deflation

Not to the question. This always causes an interpretation problem to students & laymen on the street.

What we meant by lower inflation say 6% (September 08) vs. 5.5% (October 08), is prices of goods & services are increasing in October BUT at a SLOWER rate. Another thing, never ever develop the thinking that inflation has fallen by 0.5% (6%-5.5%). That is very wrong!

Deflation is a general fall in price level of the economy. Here it means general prices of all goods & services used to construct the CPI index are really FALLING. An illustration will help the understanding:

Say, CPI in 2008 = 179.9 & CPI in 2009 = 177.1. Therefore,

Rate of inflation = (177.1-179.9) / 179.9 x 100 = -1.6%

Here -1.6% means falling price level. Goods & services have fallen by 1.6% in general

What Will Happen If Interest Rates Fall To 0%

Base rates in UK as in December 2008: 2% (lowest since 1951)

US base rates: 0%-0.25% (the lowest since 1954)

It is ‘interesting’ to see how US government & the Fed react to the economic doldrums in States since they are the main causal of all this mess around the world. The experience, skills & wisdom of policymakers are tested once again, after an economic slowdown short after the 9/11 event.

Recently, one of the boldest move taken by the Fed is slashing the key rates to as low as between 0% - 0.25%, a level lower than in 2002. Having said so, one should not be misled to think that now firms & consumers can go to banks on high streets & borrow money to expand business, acquire capital goods or buy property for FREE

What this means is that, commercial banks itself can borrow money from Fed for a very limited period of time without paying much interest as before. But since it is standing at such low level, from practical point of view whether it is 0.1% or even 0% doesn’t matter anyway

What do 0% interest rates mean?

(1) Carry trade activities. The most famous event is yen carry trade. It happens throughout the long lost decade in Japan, in 1990s where interest rates were held at 0% up to last year where interest rates are still very low at 0.5%. It is a situation where borrowers or investors taking advantage by borrowing cheaply in yen to save or invest in countries that yield much higher interest rates such as Euro, UK or even in US. If the exchange rate is stable they could easily profit 4% to 5% after deducting all those transaction fee. Perhaps this could happen to America, if the situations in States worsen while Eurozone begins to show sign of recovery & other emerging economies remain robust

(2) Traditional monetary policy has come to an end. Monetary policy has always been an effective tool to combat inflation, to manipulate how people & firms spend, managing the exchange rate, prevent unemployment rate etc. In period of rising property prices such as early 2000s to mid 2000s in both UK & US, interest rates were raised to cool down the economy. In US it went up to 5.25% while in UK 5.75% before coming down. But in period of downturn, rates will be aggressively adjusted downwards to prevent deflation. Now it is standing at 2% in UK & I believe that it will go down further in coming months. In US, it makes not much difference by saying that now it’s at 0%. Therefore we say, traditional monetary policy tool can no longer boost the economy. It runs out of ammo

(3) Quantitative easing. The Fed will have to turn to unconventional tools like quantitative easing. This means an attempt to increase money supply in circulation, hoping that it will encourage greater lending & greater economic activity over time. In modern terms it is equivalent to printing more money. What the Fed will do is buying up all those government bonds or debts & mortgage backed securities issued by Freddie Mac & Fannie Mae. This is somewhat similar to Japan’s effort to combat deflation. Increase in money supply, will always ensure that the interest rates are kept low. Although some economists argued that this will lead to inflation or even hyperinflation, it is not much of our concern now. My argument is that velocity of circulation had fallen steadily. Second, the threat of deflation is seems to be the more realistic picture due to fast contracting economy

(4) Difficult to generate lending. One of the methods for commercial banks to generate lending is by using depositors’ saving. In fact one of the causal for the financial crisis is due to low savings ratio among Americans & Britons, which force banks to seek funding from money market. But given the interest rate is virtually 0%, in theory, banks saving will fall & as such again banks may find itself difficult to generate lending. However this may not be the case. The US & UK government had pumped lots of money into the financial system to increase liquidity. Besides, although base rate is at 0%, banks will likely keep savings & lending rate above 0% to attract depositors. As such the fall in lending rates is not so much of banks’ inability to do so, but rather their stubbornness to improve the balance sheet & recap some of the earlier losses

(5) Greenspan-Bernanke legacy. Economists blame Greenspan for all these financial mess. It was his policy to keep Fed rates as low as 1.25% in the early 2000s which lead to an era of cheap borrowing, which saw leap in house prices. The problem was aggravated by banks’ generosity to lend money even to lousy paymasters & people with irregular jobs. That time, they were too optimistic that the inability to serve repayments will be offset by the rising value of their houses. In short, all comes from a long period with low interest rates. Now, Bernanke seems to be of similar interest to Greenspan. In the medium term, will we witness another credit bubble burst? Will it help US to realise its dream to become an empire of huge debt due to another round of bailout & massacre spending? The next Fed reserve chairman will have to address these

(6) Deflation is almost inevitable. In general, hardly we hear any central banks decision to cut interest rates to even 1%, what’s more at near 0%. This is a sign that those policymakers are desperate since the economy is fast dying, threat of recession is stumbling in & period of deflation is almost imminent. One may think that since inflation-the period of sustained increase in price level is bad since it erodes our purchasing power, then what’s wrong with falling prices? Well, answer is no either! In period of deflation where prices continue to fall, people will postpone spending as they expect future prices will be cheaper. When everyone thinks the same, consumption & investment will be very low. This will pose a threat to major developed economies which are mostly consumption driven. Nearly 70% of US & UK’s GDP consists of private consumption