Possible Reasons Bank Of England Put Interest Rates On Hold

The recent move by Bank of England to keep interest rate on hold on 0.5% was widely expected. Rates remain at all time low after 7 consecutive cuts since August last year

Source: BBC

There are several reasons for this:

(1) Realising that interest rate cut is not effective. Probably BOE took a lesson from Federal Reserve. Not even a 0% interest rates can reverse the contraction of economy. The nature of recession in this round is very much different than the previous. It is due to the fact that banks are trying to revitalise their balance sheet & also at the same time there is shortage of credit in the financial market. In short, banks are very much less willing to lend. Therefore, even though cost of borrowing is at attractive level much of the loan application would have to be turned down. Furthermore, there are lag effects & probably the impact won’t be felt, not until at next year

(2) Better alternative tool. It is called quantitative easing. This is a non-traditional monetary tool. It means easing the economy by increasing the quantity of money. How? By buying assets such as corporate & government bonds so that the bank will be flushed with liquidity & therefore can resume lending to companies & individuals as usual. Bank of England grew fond of this measure recently. It is optimistic that this will have an immediate impact. It has announced the creation money to buy £75 billion worth of bonds & will be done in 3 stages

(3) Protect savers. Keen savers have witnessed the return from their savings diminish sharply in recent months. Although the current level of interest rates is very low, some argued that it’s better than nothing. Also any further cut in interest rates will cause failure in attracting deposits. Commercial banks may still be haunted by liquidity problems & the central bank will have to print more money

(4) Wait & see. It could be very difficult to assess the impact onto wider economy if interest rates are continuously slashed. Also the Bank may need to investigate what is the optimal level of interest rate cut before economic activities begin to pick up? Is it 0.5%, 2.0%, 2.5% or 3.0%? Furthermore, by holding the rates on hold enable economists & policymakers to segregate the effect of these two measures

Video Lesson by Phil Holden: The Good, The Bad & The Ugly Sights For Global Economy

Consequences Of Ageing Population In Developing Countries

If there were to be another bigger problem for the global economy in the near future, it will not be another episode of global recession but rather the issue of ageing population. Recession is just a ‘sweetener’ to the crisis of ageing people within an economy. Furthermore, the problem seems to be ideally ‘permanent’ as improvement in economic performance is always followed by falling mortality rate & birth rate

The proportion of people aged between 60 years & above in the world will double between 2000 & 2050, an up from 10% to 21%. As a matter of fact, populations are ageing even faster in developing world as fertility rates have declined more rapidly in recent years than developed world.

Asia, Latin America & Caribbean are the world’s fastest ageing regions. Even Sub-Saharan African with lowest number of elderly people than any region (due to low life expectancy), is projected to see its older population grew 2.3 between 2000 & 2030 (refer diagram below)

Proportion of elderly populations around the world in 2000

Proportion of elderly populations around the world in 2050

Problems:

(1) Increase in dependency ratio. It is given by the formula of:

[ (number of children 0-15) + (number of pensioners, >65 years) ] / (number of working population, 15-65)

It is worth to take note that falling birth rates (lesser newborns) & falling mortality rates (people live longer) will inflate the numerator figure. Due to falling newborns, the number of people falling into the working age group will decline over time, putting a downward pressure onto the denominator. As such (bigger number) / (smaller number) will therefore increase dependency ratio. If the ratio is 1.2, it means for every 10 working individuals, there will be 12 dependents

Younger generations will be under immense pressure to provide sufficient financial support to the dependents, especially their parents. They are equally divided between working longer hours outside to earn more income & spending more time with the old ones at home. The financial commitment is potentially large since elderly people have poorer health & yet the cost of medication in developing countries is ballooning over the years. This problem will be more significant upon married people as there are other commitments too e.g. spouse, mortgages, cars, children’s education etc

(2) Non-productive labour force. Productivity is defined as output per worker. While it is true that retirement age can be extended, some quarters argued that elderly workforce will pose more problems. They are often forgetful, slow work pace, took many sick days leave & less motivated than young ones. AS curve will shift leftward. There will be lesser work done, thus lesser output within an economy

Evaluation: This is often not true. The argument above is more suitable to cater for manual skills like working on construction site & farm, which requires physical ability. With the emergence of services sector in developing countries such as healthcare & education line, elderly workforce is highly respected for their experience. Many of them are retained due to difficulty to find replacement of such ‘gold standard’ in human capital. Experienced senior surgeons can train more young doctors while experienced lecturers & professors are needed to conduct research & passing on their knowledge to younger generations. Therefore in these areas their productivity is very high

(3) Higher level of pension provision. This is never an issue as long as each successive generation is of approximately the same size (working age vs. retirees). A large group of pensioners with a smaller group of workers however means that sums do not add up. The only way to sustain the growing number of elderly people is to continuously revise tax levels upward, which is often very politically unpopular. The other way would be to reduce pensions. However, many feel that this would deprive pensioners of payments that they have committed for during their working lives & are entitled to

Domestics savings around the world

Evaluations. However, not all governments from developing world face immense pressure in pension provision. Consider East Asia with countries like China, Hong Kong, South Korea, Singapore, Indonesia, Philippine & Malaysia which have among the highest domestic savings rate in the world. It is also an indicator that elderly people in these areas can be self sufficient in their older days, reducing their dependency on government & their kins

(4) Greater demand for healthcare. Elderly people generally frequent hospitals more than the young ones due to deteriorating health. With a ballooning number of ageing populations in near future, governments will be under great financial constraint to build more hospitals, train more doctors & nurses, paying more wages, import more medicines & specialised surgery equipments which easily costs billions. Increase per capita health expenditure onto elderly adults is afraid to create opportunity costs to other sectors like education & infrastructures

Evaluation. Providing state-of-art healthcare centres are utmost important to ensure that ageing people can still contribute actively to the economy, thus maintaining the level of growth. Furthermore, it is an issue of universal basic rights. Besides, governments can collaborate with private sectors especially insurance firms to educate younger generation regarding the importance of owning a personal insurance & medical card. Doing so, will reduce its financial commitments of providing ‘subsidise’ medical treatments to the citizens

To What Extent Increase In Population Promotes Economic Development?

As the 21st century sets in, the world population was estimated to be at around 6.1 billion people. Projections by UN (United Nations) revealed that this figure will easily surpass 9.2 billion by 2050 & most of them will come from developing countries. The issue of ballooning population is not a new debate. It receives mixed blessings

Some countries like China used to encourage people to have lots of children in order to boost the country’s workforce. But in 1970s, it came to realise that the population growth rate would soon become unsustainable. Therefore, the one-child policy was implemented in 1979. On the other extreme, countries like Russia, US, UK & Japan would like to take immediate remedial steps to change its current demographic structure. Birth rates have fallen drastically. This too, will pave way to some other unimaginable problems

Population growth rate by region

So, increase in population promotes development?

(1) Greater output. Increase in population will ensure a steady supply of workforce within a country. With rising number of people who fall into the working age category, there will be more goods & services produced. Higher economic growth can be achieved. As a matter of fact, East Asia’s economic miracle coincides with its population boom. It accounts for more than one-third of its growth

(2) Attract FDI. Multinational firms especially from the West are largely attracted to developing countries. There are just too many reasons, but all lead to one-lower production costs. Large number of population will almost ensure downward pressure on wages. Cost saving is magnified when we take into account than many of them are educated & they are willing to endure long working hours. Inflow of foreign investment will boost country’s economic growth

(3) Greater savings. Due to the first two factors discussed above, levels of savings within an economy will increase in line with rising number of workforce. Pools of funds in financial institution are important as a source of financing for both domestic & foreign firms. In some very populous countries like China, firms have reaped the benefits from high savings ratio. Raising capital domestically is never an issue

(4) Higher tax revenue. Larger number of workforce will provide government with more income tax revenue. In fact for most governments, this is the largest source of revenue. Secondly, rising population positively correlates with number of firms established. Firms are set up to tap into the broadening market for their products. This means more corporation tax revenue for government. Lastly, VAT (Value Added Tax) from goods also contributes to the tax base. All these are important to ensure sufficient funding for development projects like building of schools, modern healthcare facilities, improve road conditions from rural to urban etc.

Perhaps not:

(1) Malthus prophecy. Malthus presented his theory of population in 1798. According to him, population will increase geometrically while food expands arithmetically. If nothing is done to slow down the population growth, the nature would apply its own crude method to reduce population from its higher level. This is known as ‘positive checks’ by him which includes natural disaster, epidemics, earthquakes, drought, flood & natural calamities. Well, I feel that he has his point. Volcanic eruptions & Tsunami in Indonesia had taken many tolls. Epidemics like AIDS & drought in Africa have contributed to millions of death every year

(2) No development. If population growth outweighs economic growth, there will be no development. National income will be shared among more people. Income per capita will decrease, thus deteriorating the standard of living

(3) Unemployment. In many developing countries, it is common to witness people migrating from rural area to the urban. Despite providing large job opportunities, the modern secondary & tertiary sectors are unable to absorb all these migrants. Hence it is said that rural unemployment is replaced by urban unemployment. Having no money to return home, many will be stranded up in shanty towns in the midst of city. Sau Paulo, in Brasil & Bombay in India are well known for this

(4) Famine. Although Western economists condemned Malthus theory of food production, to me his argument makes complete sense. Consider LDCs (Less Developed Countries) with high population growth rate like SSA (Sub Saharan African) countries. Famine is no new issue for places like Zambia, Uganda & Zimbabwe. Despite having comparative advantage in farming with large number of workforce & lands, food production is never enough

(5) Constraints onto scarce resource. Rising population is a sign of more desires to be fulfilled. There will be greater demand for oil to fuel economic activity, demand for steels creeping up in manufacturing & construction industry etc. It’s just a matter of time before these natural resources deplete. In the recent years, prices of commodities went up due to the strong demand from both China & India, two of the most populous countries in the world.

(6) Deforestation. It was estimated that 8 million hectares of forests are lost each year. More trees & animals will have to be victimised in order to pave way to rising population. These include the building of residential houses, offices, infrastructures etc. This has disturbed the atmospheric composition & worsening the event of global warming

(7) Civil unrest. There will be more conflict between states & areas due to the problem of overcrowding & fight for natural resources. People will also struggle to ensure their survival by fighting for the source of fresh water

How Crowding Out Takes Place?

Crowding out effect is a situation where increase in government spending to stimulate the economy which is in recession will eventually lead to a fall in both private consumption & investment. In other word, the initial increase in AD may be offset by the fall in the latter two

This is closely related to budget deficit where total government spending exceeds total tax revenue. In a period of economy slowdown or recession, public spending like construction of schools, hospitals, repairing roads & bridges etc will definitely increase. So a government will need more financial resources to accommodate this. Unfortunately, tax receipts will fall as many people will be laid off & firms incur losses. In a nutshell, budget deficit will widen in this period

In UK, the deficit is already standing at £8.99 billion as of February 2009 & this was 8 times the figure seen a year earlier. It is in conjunction with the fell in tax revenue by 10%. Total government debt is equivalent to 49% of GDP. However the worst is far from over as they yet to include the potential £1 trillion to £1.5 trillion debts from Royal Bank of Scotland & Lloyds Banking Group which they have to include, since they have taken stakes in these 2

How increase in government borrowing can crowd out both private spending & investment?

(1) Increase in tax. Ballooning deficit will have to be balanced in the future. This means as economy embarks on recovery path, government will have to reduce its spending & increase income tax, corporation tax & VAT. Public & firms expecting that future tax rate will be high are discouraged from spending as they know that they are worse off anyway. Increase in savings may offset the initial increase in AD (aggregate demand)

(2) Increase in interest rates. When a government borrows in large scale, they have to increase interest rates to attract people to hold bonds. However, increase in bond yields will be followed by increase in interest rates offered by commercial banks. This is because they have to compete with government to attract funds. The costs of paying higher rates to depositors will be passed on to people who hold mortgages & businesses that take financing. As such, consumers & firms will be discouraged from spending

(3) Lesser money to spend. As people buy bonds, it is said that they will have lesser money to spend. Also when firms buy government bonds, they have lesser funds to invest

Arguments on why crowding out is unlikely:

(1) High marginal propensity to consume. It depends on whom the tax is targeted at & which sector of the economy receives more funding. Generally, people with lower income have very high tendency to spend when there is an increase in their disposable income. Also if government increases public spending onto areas where salaries are relatively low, it will positively boost consumption

(2) Interest rates may not increase. In the period of recession, generally stock market is not performing. Demand for shares will fall, sending its price much lower. People are more attracted to bonds as long term investment which is also safer. The chance of government defaulting is very low. When demand for bonds increase, its price will escalate. Given that, bond yields & bond price are inversely related, interest rates will be kept low

Top 6 Reasons Why Dollar May Collapse

At the point of writing, the direction of dollar against euro & sterling is just too inconclusive. There were several ups & downs. However, in the long run there are some evidence that the dollar rally may not last long

Reasons:

(1) Large current account deficit. This has been an ongoing problem with US economy & it becomes worse in recent years. The trade deficit is caused by growing appetite among Americans to consume imported goods. Imports grow relatively at a faster rate than exports. Also it was exacerbated during the era of Greenspan where interest rates were so low, which then leads to housing market boom that raise the economic growth. Such huge trade deficit means outflow of money is greater than inflow, thus creating downward pressure on dollar. People are selling dollars to get hold of Chinese goods



(2) Falling demand for US securities. All these while, US is able to sustain its current account deficit & prevent its currency from falling with the help of capital inflow. China is undoubtedly its biggest & most reliable lender thus far. The Chinese is very willing to help US partly due to the strong trade interrelationship. Letting Americans drown will not do any good to China, which rely on US as its largest export destination. However there is growing evidence that China & some other major economies like Japan are slowly substituting dollar to embrace euro. Since inception in 1999, world euro reserves have been growing at the expense of dollar



(3) Foreign central banks unwinding dollar assets. In the event of global recession, US economy is perceived as the safest haven. Therefore selloff hit many countries around the world, especially emerging economies. The reversal of capital flow has caused some currencies like rupee to depreciate. As such India’s Central Bank is forced to use its dollar reserves to buy home currency. Increase in its demand will raise the value

Another possible reason large budget deficit in oil gulf nations. Oil producing nations like Saudi Arabia has engaged in lavish spending these few years due to their ballooning dollar reserves. Most of it comes from the period where oil price was skyrocketing. Now it runs into budget deficit. One of the ways they are going to finance it, is by selling dollar assets. Again increase in supply will weaken the dollar

Countries like Russia, Saudi Arabia, India & Japan have around $2 trillion dollar holdings. It is expected that if situation worsens, these countries will likely ‘dump’ dollar. Interestingly, who will probably buy all these assets? (Probably …….you know the answer)

(4) US can’t raise interest rates now. It will be ridiculous if one suggests that US should raise interest rates now to attract inflow of foreign money. With such record low interest rates 0-0.25%, average Americans are still frugal & cautious in their spending. Any upward movement of rates will instantly kill the economy. Price deflation is the last thing we would like to see

(5) Quantitative easing. It was introduced as the traditional monetary tool has failed to revive the economy. Basically, it is somewhat like the modern day of printing money to buy US government bonds. Somehow, there is fear that US government could be too immature with this unconventional tool. The effect of quantitative easing could be stronger than predicted. If it were to happen, large increase in supply of dollar will erode its value

(6) Large budget deficit. Basically, when a government runs a budget deficit it means for a particular year, its total expenditure exceeds its total tax revenue. Due to this, it has to borrow by issuing Treasury bills & long term government bonds. The situation is very chronic for US. It has to fund the on going wars in Iraq & Afghanistan, increase the size of bailout for banks & auto companies & bigger stimulus package from time to time. Also it is worth to remember that they have the biggest commitment of all, which are social security & Medicare for the baby boomers. I’m very unsure to what extent they can borrow & to what extent foreign countries are very willing to lend

It has many repercussions. Even US’ closest trade partner began to doubt its ability in repaying all these debts. Recently, Chinese officials have suggested that yuan should be considered as an alternative to dollar. But what ever it is, if other countries began to sell dollar assets or demand for bonds fall, dollar may be slammed to its knee

Improving Your Evaluation Skills

http://www.tutor2u.net/economics/presentations/ImprovingEvaluationSkills/player.html

Good one from Geoff Riley. Crucial for GCE candidates sitting for Economics exam in June 2009

As for me, I always recommend my students to ‘CONTRADICT’ what they have written initially. The previous statement could be a theoretical view that is sometimes right, BUT not all the time

Some random examples:

(1) Ideally, the recent cut in interest rates to 0.5% by Bank of England should be able to revive economic activities. However, there is an outweighing factor & that is lack of consumer confidence. This explains why spending & investment activities fail to pick up

(2) Cut in tax rate should be able to increase household spending. But given the current economic turmoil, the extra disposable income is likely to be saved for rainy days or use to pay off their mortgage debts. Therefore we may not witness a significant increase in consumption

(3) Privatisation as one of the supply side policies may no longer relevant in UK context. This is because many firms have undergone privatisation during the era of Mrs. Thatcher & was continued by her successor, John Major. Furthermore some economists argued regarding the wisdom of this policy since some firms were renationalise such as Railtrack in 2001

(4) Increase in tariffs may not necessarily cause the imported goods to be expensive if the firm is willing to absorb part or the whole tariffs. In this case, firms are still able to sell at their old price thus causing harm to domestic companies

It could also be some sort of ‘SUGGESTIONS’ or the issue of ‘SHORT RUN vs. LONG RUN’

(1) GM should not pass on the increase in the price of raw materials like rubber & steel to end consumers given that the car industry in US is so competitive. Any attempt to do so may worsen the situation as American consumers will substitute away to the more fuel-efficient Japanese cars

(2) In the short-run, increase in crude oil prices will cause companies to pass on the increase in production costs to end consumers. Somehow in the long run, these firms will likely attempt to mitigate the impact via an increase in investment onto capital goods. This will counter the backward shifts of AS

Why Price Of Tea Has Gone Up Recently?

Source: BBC (prices of tea have soared)

Refer to this link:

http://news.bbc.co.uk/2/hi/business/7973857.stm

The reported increase in the price of tea can be explained using a simple & yet powerful demand-supply diagram

Source: uri.edu

Evidence from text indicating fall in supply:

(1) Tea producers have probably cut production in 2008 given that there was surplus in 2007. In agriculture, farmers often make future decision based on the past. In this case, they expect 2008 to be in surplus too, which may lead to fall in price

(2) Kenya, India & Sri Lanka as the 3 largest tea producers in the world were hit by drought last year. As such supply of tea leaves fall

Source: uri.edu

Evidence citing an increase in demand:

(1) Tea consumption reached 3.85 million tonnes last year, an increase of 4.8% from 2007 & global demand for tea consumption is expected to soar

Why British consumers may need to pay more?

(1) Any increase in crude oil prices which lead to an increase in transportation costs, will have to be passed on by teamakers

(2) Pound is weakening against dollar recently. As such, consumers in UK will have to pay even much more on top of the already-expensive price

As a matter of fact, fall in supply & increase in demand curve can be put together under one same diagram. (I couldn't find a diagram that shows fall in supply & an increase in demand, so I conduct separate analysis)

Malaysian Perspective: Why Foreign Workers Are More Favoured Than Local Workers?

For many years, Malaysia has become the haven for foreign workers. Most of them come from places like Nepal, India, Indonesia, Bangladesh, Myanmar & Philippine. Some of them have permits while some don’t. There is also a general identity attached to all these workers.

For instance, Nepalese are often hired to work as the Gurkha security guards. Those from India are placed in Mamak (Indian-Muslim) restaurants, a popular 24 hours outlet in Malaysia. Indonesian men & Bangladeshi are very synonymous to construction sectors here. As for women from Indonesia & Philippine, they are often hired as domestic helpers like maid. Lastly Myanmar people, mostly refugees are employed to work as cook, waiter & waitresses in Chinese restaurant

Reasons to employ foreign workers:

(1) High productivity. Productivity is defined as output per worker. Although most of them do not receive formal education or complete secondary level, their productivity is comparable or even higher than the locals here who finished SPM (Sijil Pelajaran Malaysia) which is equivalent to O-Level. All because they have high willingness to learn & most important they don’t complain unlike the locals. They are fast & efficient too. They are able to endure long working hours, as minimum as 12hours a day, 7 times a week. This is very obvious for Nepalese guards, Indian workers in Mamak restaurant, Myanmar workers in Chinese restaurant & Indonesian maids.

This resembles a working attitude that is enviable by locals. I know a Myanmar worker who told me that he works from 9am to 11pm in a restaurant near my place. While I was at my friend’s place, I can see that his maid works all day long. I asked her, are there so many chores even in a house?

Source: economicshelp

(2) Minimise production costs. Perhaps this is the main argument. Most of them are overworked, & yet receive only a fraction of what the locals receive here. An Indian workers receive a meagre RM400 (about $110 or £80) a month, a third of what the local counterparts receive. A Myanmar worker who is a kitchen helper & also a waiter receives higher, at RM 1000 ($275 or £200) a month but still underpaid compared to locals. As for locals, they often shunned away from these types of jobs, after complaining about the pay & long working hours. Most locals have very bad attitude, they come to work late & leave early. Also the turnover is just too high by hiring locals. Once they found a new job, they will just move on

From supply side economics, employing immigrants can help to raise output in Malaysian economy & also since there is no wage-push inflation, employers can always reduce their production costs in restaurants, factories & construction sites. Therefore AS curve will shift rightward (refer diagram above)

Reasons not to employ foreign workers:

(1) Increase in local unemployment. Not all locals are unwilling to work for lower pay jobs. In fact there are many people who have been unemployed for a while or even inexperience working in a restaurant. Therefore they have no bargaining power. Sometimes it is those firms & restaurants that are unwilling to hire one. Excuse is often to slash production costs. For instance, if they can hire 2 foreign workers for the price of 1 & double their output, it doesn’t make any economic sense to employ locals at all

(2) Increase in crime rate. Many of those crimes such as robbery, breaking in or snatch theft are done by Indonesians. They become construction workers in the day & could do something else at night. For the sake of minimising costs, firms blindly employing them without knowing their background. They could be criminals running away from their home country. Also, clashes among foreign workers are common in Malaysia. For instance, Bangladeshi against Indonesian workers

(3) Not contributing to local consumption. Most of these workers, although low paid but are provided with hostel as well as free lunch & dinner, normally at the place where they work. Therefore salaries earned, are normally saved or remitted to their home country. As such, we say that they don’t contribute much for local consumption, which is also a driving force of economy

Student's Question: What Level Of Foreign Reserves Is Perceived As Healthy?

Foreign exchange reserves (forex reserves) in its narrow definition refer to amount of foreign currency held in a Central Bank. In general, it also include bonds, gold & IMF reserves

Source: babypips (Dollar is still the most dominant, despite the rise of euro)

Source: epi. org (China's dominance of dollar reserves)

As of January 2009, China held $1.92 trillion worth of foreign currency mostly in the form of dollar, euro & gold. It had surpassed Japan ever since February 2006 to become the world’s largest foreign currency holder. In fact its dominance started when China joined as a member of WTO in 2001. This had allowed the Chinese economy to fully exploit the export-led strategy as they could get access into big economies of the West, which they once failed to penetrate

This is due to the status of MFN (Most Favoured Nation), where China will be granted trade advantages such as low tariffs as any other nation receives. Perhaps this is the biggest reason for its accumulation of foreign reserves.

Many countries could express their envy over China’s reserves position, but in general how much of foreign currency reserves is considered as enough for a country?

To be frank, there is no consensus among economists. There are indeed several methods to determine the adequacy of foreign reserves for every nation, but none of them can stand on their own. Furthermore the reliability of the measures depends also on macroeconomic outlook, credit ratings, trade positions, level of external debt etc

Indicators:

(A) Number of months of imports. Ideally, this measure determines how long a country can sustain its imports shall all other inflows of foreign exchange dried up. To ease understanding, ask yourself a question. How long can you sustain your monthly expenses using all your lifetime savings, after quitting/ retrenched from a job? The answer is simple. Of course, the longer the better. For many years, the guideline by IMF is 12 weeks (3 months) of imports. In Malaysia, our foreign reserves position can sustain 7 months of imports, which by far is considered as healthy. Countries like Sri Lanka which ran into crisis recently, have the reserves which can only sustain its imports to another 1.5 months

Evaluation for (A)

Capital account adequacy. This measure is of limited value. It focuses solely on the external current account which may be relevant in the past where capital inflows are limited & therefore countries may have problems in financing imports. However, due to globalisation many economies especially small & emerging have more open capital accounts these days & therefore received larger share of inflow. Therefore in a period of highly mobilise capital, the sufficiency of foreign reserves should also be based on rules that focus on the vulnerabilities of the capital account

In laymen, it’s not only how much I spend a month (imports), but also how much I can earn (all source of inflows)

(B) Depends on level of debts. The contemporary view is that, a country with ballooning debts may struggle to fulfil its debt obligations, unless it has sufficient foreign reserves. There are 2 popular measures. First, the level of debt service repayment as a ratio of exports of goods & services. It links to exports since that is also one of many channels a country can accumulate foreign currencies. Secondly, ratio of debt service to GDP. The latter is probably most heavily used. The lower the ratio the better

Evaluation for B

The latter is a blunder economics tool. It’s still in fashion probably due to its ease of measurement. But for sure, it addresses nothing about foreign exchange earnings. It is related more to the growth of overall economy. However, high levels of GDP growth do not guarantee foreign exchange growth. Unless, we are certain that that particular country’s production is geared towards export, which then explains for its growth & accumulation of foreign exchange e.g. China, India, Malaysia etc. For a country which is consumption driven, the accuracy could be questioned

(C) Guidotti-Greenspan rule. This measurement was introduced by Pablo Guidotti, the former Deputy Finance Minister of Argentina & was later publicised by Alan Greenspan during his speech in World Bank, 1999. According to this rule, foreign reserves should be equal to short term external debt with a maturity of one year of less. The rationale is that countries should have sufficient reserves to withstand withdrawal of short term foreign capital

Evaluation for (C)
Insufficient. Many economists have argued that the proposal of this measure has actually undermine many factors. Therefore they suggested that the targeting of reserve adequacy takes into account the amount reserves needed to cover short term debt as well as some mark-up to reflect unforeseen economic circumstances such as the potential widening of current account deficit or disturbance to the exchange rate

Video Lesson by Richard Pettinger: Quantitative Easing

Why Is Determining The Depth Of Global Recession A Difficult Task?

Sometimes I was mesmerised when I read articles written by economists, politicians & policymakers. Everyone seems to be very flair with the origins of global recession & the damage it had brought about. All economics quantum receive very convincing explanation. Nevertheless, there are still 2 questions permanently left unanswered by them

Firstly, when will this economic chaos end? Secondly, what is the proper mechanism? If you manage to come across any economists who are trying convince you that the recession is going to end by 4th quarter of 2009, rest assured his guess is just as good as yours

Have we rock bottomed?

To be truthful I’m no ‘voodoo man’ or a ‘fortune teller’. I can’t really offer a definite answer. One thing for sure, predicting the depth of global recession is increasingly difficult:

(1) Recognition lags. Economists & policymakers are often too slow to realise that recession had actually worsened. This is because many of them are relying on economics indicator such as GDP data which is produced quarterly, inflation & unemployment which is produced monthly, etc before taking any deliberate action which could be little bit too late

(2) Effect lags. Once the necessary policy changes are made, the result may be contradictive. For instance, the cut in interest rates by Federal Reserve & Bank of England should be able to revive lending since costs of borrowing has fallen. But until now, there is no sign that mortgage approvals have increased. Let’s consider tax cut. In theory it should be able to increase consumption especially among those lower-middle income earners. Nevertheless, what if all those tax cut are saved rather than spent? Hence, the great difficulty comes from predicting how consumers react. Nobody knows for sure, by when consumer confidence in US is making a come back

(3) Will there be any more bailout? That’s the most interesting question, but again no one can answer with high degree of certainty. But one thing for sure, large time bailout of financial institutions like Freddie Mac & Fannie Mae, AIG & auto industry potentially cause US government more than a trillion. Same action was taken by British government to nationalise Northern Rock. Massive bailout like these is often done at the expense of taxpayers’ money. They know that in the future, governments need to balance their budget especially in time of recovery by imposing higher direct tax. This creates the incentive to be frugal. But again, depends on how consumers look at in short to medium term

(4) Protectionism in US? We will know better after the G20 summit this 2nd April. At the meantime, there is just too much of speculation. Somehow, if US were to revive the protectionist measures as outlined in the recent stimulus bill e.g. use only American made steel & buy-only American goods campaign etc, means it is triggering another trade war. We have seen the damage done in 1930s due to the Smoot-Hawley Tariff Act. All countries especially major power like EU will be the first to retaliate. Global recession will be pushed deeper

I didn't talk about implementation lags due to the nature of recession this round. Countries around the world have been quite prompt in their execution of demand management policies as most economies shrunk more than predicted. This creates sense of urgency

In a nutshell, difficulty to predict depth of global recession stems from lags & uncertainty over US economic policies

Learning Economics Through Humour: Southpark on Bailout

Differences In Hyperinflation: Germany vs. Zimbabwe

(1) The origins of hyperinflation

Germany
The outbreak of hyperinflation in Weimar Republic in 1920s actually had its roots since World War I. The Germans had borrowed a large sum of money to finance the war. When the supply of funds proved inadequate, the Central Bank, Reischbank have no choice but to print more money to finance itself. The currency that time was not backed by anything, given the collapsed of gold standard in 1914. Therefore there was no limit on the amount of money that can be printed

Zimbabwe
There were 2 hypotheses built around the cause of hyperinflation in Zimbabwe. Firstly, critics argued that it originated from Mugabe’s controversial land reform policy. Lands were confiscated from the White farmers, further break down & ‘so said’ equitably distributed to landless peasants, when the primary beneficiaries are ministers & their nearest families. Having no experience at all in dealing with modern faming, farm’s productivity suffered a freefall. Exports revenue was jeopardised, giving them a hard time to settle their debt with IMF. As a last resort, they start to print more money

Secondly, the supporters of Mugabe argued that economic collapse is as a result of international sanctions by US, EU & Australia which target several ministers & companies loyal to Mugabe’s regime like ZDERA. As a result, foreign capital stops flowing in & Zimbabwean government will have to print money to buy foreign currency to settle its debt with IMF

(2) What makes it worse after that?

Germany
The new Social Democratic government after the war had an ambitious plan to improve the life of the poor in Germany. They were just too expensive to deliver. As such, more monies were borrowed & more currency was printed. At the same time, hyperinflation was worsened with the demand of reparations by the Allies, to compensate for all the damages done to their economies e.g. destruction of infrastructures & buildings. This forced Germany to print even more money Later years, the Germans decided to stop paying the reparations. In response the French & Belgian troops occupied Ruhr in 1923, the more industrialised area. They intended to get reparations in the form of goods & raw materials. The government ordered workers to stop working as a mean of boycotting. As governments had not much money to pay them, the only option is again-print more money

Source: economicshelp

Hyperinflation in this case can be easily explained using the quantity theory of money & AD-AS diagram. Hyperinflation happens when there is an imbalance, when the increase in the amount of money is not matched by the increase in output as in above case. Too much money is chasing too few goods, bidding up their prices. From AD-AS analysis above, it can be seen that rapid increase in spending when there is no increase in real output will cause an economy ending up with higher inflationary pressure

Source: sparknotes

Zimbabwe
Although having a different cause, its aftermath is the same. Zimbabwean government placed the blame onto businesses for recklessly raising the price of their goods. So they attempted to distort the working of the market via price intervention. In February 2007, central bank of Zimbabwe declared inflation as ‘illegal’. Prices of goods were capped (refer diagram above). Those which raised the price were arrested. From economics point of view, imposition of ceiling price further discouraged production. This was the starting point to worsening hyperinflation. More monies were printed & yet there is a bottleneck in supply of output (refer to AD-AS diagram)

(3) Solutions

Germany
In 1923, the German government issued a new currency called Rentenmark, which was backed by land & property. Each Rentenmark was exchangeable for 1 trillion old marks. This had successfully created confidence among the people. First, when the new currency was tied to something, it limits the amount of money that can be printed. So this was somewhat the new ‘gold standard’ around that time. Secondly, lesser zeros actually created a ‘psychological effect’ telling the people that things are cheaper. For instance, an item with the price of 4 trillion old marks (12 zeros) was available with 4 Rentenmark

Once people had faith with the currency, they will stop rushing to stores to purchase goods as they believed that the currency will no longer lose its value rapidly. To ease problems further, government expenditures were cut & more than 700, 000 public sectors employees were sacked. Having confidence with the new macroeconomic management, US & some European countries began to offer aid. Germans received loans of 800 million gold marks & therefore they issue a new currency called Reischmark which was then backed by gold. It was equivalent in value with Rentenmark. Amazingly, German government ran into surplus in 1925!

Zimbabwe
In the recent, there was an interesting development on solutions to hyperinflation in Rhodesia. Prices of essentials like cereals & breads had gone down for the first time. It seems that there could be a possibility of abandoning the Zimbabwean dollar which was increasingly worthless. A trillion Zimbabwean dollars now can’t even buy a loaf of bread. There is also talk rifling, either the adoption of South African rand or the American dollar into their economy, although the impact is very much subjected to debate. Nevertheless, it is still too early to tell. The newly formed government is still a lose-coalition. Anything can happen later!

What You Should Know About Trading Bloc?

EU map

Trade bloc refers to some form of agreement between member countries to reduce or eliminate barriers to trade among themselves. There are several types of trading bloc, all classified according to the extent of cooperation & interrelationships

The evolutionary path for trading blocs is:

(1) Free Trade Area
Member countries establish an agreement to reduce or eliminate custom duties, tariffs & non-tariffs barriers among themselves, so as to promote a freer trade. However, all these countries are still free to maintain individual tariffs against non-members. Therefore, this loophole is subject to manipulation. A country may first export to a country with lowest external tariff, before transporting the goods to a member country which actually has higher external tariffs. By doing so, they can avoid paying tariffs

To prevent this, member countries imposed local content law. In order for foreign goods to be considered ‘local’ & thus not subject to duties, certain % of the parts must be sourced locally. The intention is actually encouraging foreign firms setting up production facilities in these FTA. E.g. NAFTA (North American Free Trade Agreement) with members of US, Mexico & Canada

(2) Custom union
Happens when member countries add a common external tariff onto the provision of free trade area. The intention is to obviously prevent the evasion of tariffs by non-member. E.g. ASEAN (Association of South East Asian Nation)

(3) Common Markets
Once member countries have achieved higher level of cooperation & their economies began to complement one another, they can proceed to common markets. Here not only common external tariffs are applied, but also the elimination of all restrictive trade barriers & allowing free movement of capital & labour. So that’s why Santander bank (Spain) can buy over UK’s bank like Abbey International. Also, a Hungarian is free to look for job in UK

(4) Monetary union
It is the fourth stage of economic integration. Here member countries will adopt common currency & common Central Bank. The well known example is European Union. Now it has 17 official members, with more than half a billion of populations with combined GDP largest than that of America

Why Sri Lanka Is Likely To Borrow From IMF?

In picture: Sri Lankan President, Mahinda Rajapaksa

In the recent, Sri Lanka’s President Mahinda Rajapaksa in his stern voice mentioned that he will not bow to any conditions prescribe by IMF. The conditionalities or popularly known as SAPs (Structural Adjustment Programs) often requires the host country to slash its public spending, cut in public sector workforce, embrace privatisation etc

But we know it’s nearly impossible. Otherwise how will they get the financing they desperately need to cure the ailing Sri Lankan economy?

To me, he is in self-denial. President Mahinda will have to like it or not, sooner or later bow to all those conditions set by IMF. In fact there is already an increasing sign that Sri Lanka will need monetary aid:

(1) Falling foreign reserves. Its foreign exchange reserves have fallen from $3.5 billion in July 2008, to only about $1.7 billion in December. That’s an astonishing fall of 51% in just couple of months. Based on this figure, Sri Lanka is projected to be unable to meet the obligation of its current account deficit. The reserves available are only able to cover the most, another 1.5 months of import, probably the worst ever situation for any emerging economy (ours can sustain 7 months). This is probably the strongest reason why they need IMF assistance immediately

(2) Ballooning current account deficit. The deficit which once stood at only 3.5% of GDP, has shoot up to 8.8%. The biggest reason was due to large import bill on weapons from China, Russia, Pakistan & Israel. At the same time, there was a decline in export earnings due to the sluggish export in garments & tea, which are one of the backbones of its economy.

(3) Foreign investors pulling away. In the second half of 2008, there was a large outflow of $600 million, as foreign investors sold away rupee denominated assets e.g. government bond. This is also another reason for falling foreign reserves. There is growing fear that the government will be unable to cope with the crisis & also due to political stability e.g. military operation against the Tamil rebel. Despite, the successful sale of war bonds to Sinhalese expatriates, still it is insufficient to cope with the magnitude of fall in reserves

(4) Depreciation of rupee. This reminds me of the classical intervention of UK’s BOE in defending the pound against DM somewhere between 1990 to 1992. Here the Sri Lanka’s Central Bank is fighting a losing battle in defending rupee. It has spent about $200 million between September & November last year, in buying up rupee in foreign exchange market. Still, its value has depreciated about 6% up to date. In theory, this should become a great boost to their economy as exports become cheaper. However, the slowing market in its export destination is not helping this. Also, weakening currency has increase the value of its debt

(5) Rebuild the North & East. The current government is facing mounting pressure due to the declining standard of living on general & particularly on these two areas, where military operation heavily concentrates on. They desperately need a large sum of money for reconstruction, to build back those infrastructures that can attract foreign investors, schools & hospitals that will benefit the people etc. Furthermore unemployment is rising in recent months as many textile factories have shut down

It will be interesting to see what will happen this few days (up to 31st March), as it’s time for President Mahinda to declare his decision. I say YES, how about you?

IMF: The Devil Or Saviour?

IMF boss: Dominique Strauss Kahn

Basic facts about IMF (International Monetary Fund)

IMF is an international organisation that was founded in 1944. Its main aim is to promote exchange rate stability, helping countries to resolve their balance of payment imbalances & to provide financial loans to countries in crisis

The pool of funds in IMF comes from 185 of its member countries. The size of the fund can be increased by raising more from the existing members or with an increase membership. Also one should be aware that not all countries contribute equally to IMF. For instance, US have been consistently the largest contributor to IMF & thus having the largest voting rights

Are they the same? World Bank vs. IMF

By principle, IMF was established to help to stabilise international financial system by helping governments to overcome balance of payments (BOP) problems. Meanwhile World Bank or its proper name is IBRD (International Bank for Reconstruction & Development) has the role to give financial assistance for post-war reconstruction

Nevertheless, their role in the recent 2 decades have somewhat diminished. In 1980s & 1995, IMF had lent to Mexico, 1997-1998 to countries in Asia like South Korea, Thailand & Indonesia & Argentina in 2001. This are backed by additional funding from World Bank

Why IMF is so controversial?

Economists particularly from developing world condemned IMF for not having the pure intention of helping countries in trouble. Conditionalities such as SAPs (Structural Adjustment Programs) are viewed as the modern way of colonisation of local economy. It seems to be operating in the interest of large Western economies particularly US which has the largest veto rights & say. Also it seems that IMF has ‘profit motive’ more than anything else when they impose those changes

SAPs are policy changes implemented by IMF (also World Bank) onto developing countries as a condition for getting new loans, rescheduling of loans or negotiating for lower interest loans. Conditionalities are implemented to ensure that the money lent is spent in accordance with the objective of the loan that is to reduce fiscal imbalances

Among policy changes imposed on borrowers are:

(A) Fiscal austerity. This means countries receiving the loan must undertake initiatives to cut public expenditure such as reducing its allocation of budget onto education & healthcare sector. It is often coupled with higher tax rate. The overall intention is to downsize the government’s fiscal deficit

Evaluations on (A)

(1) Lower life expectancy. This is such an expensive price to pay. While meeting the objective of narrowing down the budget deficit, millions of people are made worse off. When the government reduce the funding onto healthcare sector, there will be lesser numbers of doctors trained, fall in the availability of medicines & drugs, no new hospitals built etc. It is not surprising to hear that life expectancy in most SSA (Sub Saharan African) countries is below 45 years of age. In Zambia, life expectancy has fallen from 50 to 32 years old. In Zimbabwe, maternal & infant mortality rates are increasing, even in capital city like Harare

(2) Lower literacy rate. Reduction in educational spending has translated to problems like erosion in quality of teaching, lousy infrastructures e.g. lack of computers & furniture, curriculum development, no new schools coming up etc. Over the years, existing number of schools is disproportionately matched by the increase in the number of children. This means many underprivileged will be denied a chance even primary education. Therefore, they are unable to write short & simple statements or perform basic arithmetic. The vicious cycle of poverty begins here

(3) Low productivity. Lack of access to basic healthcare & education are the prime cause. People who are sick will definitely have lower output. Also many of the working days might be taken off as sick leave. As for lesser formal education, these people will find great difficulty in operating machineries, solving difficult issues or understanding complex instructions. Their work pace is likely slow

(B) Privatisation of state-owned firms & services. By selling government entities to private sector, more money can be raised to finance its external debt. Also once having profit motive in mind, these newly created private entities will strive to become more cost efficient, innovative & competitive on a global scale

Evaluations of (B)

(1) Exacerbating unemployment. Privatisations of state industries have resulted in mass unemployment as firms now strive to be cost efficient. This actually worsens the situation. While I agree that governments may receive some form of payments from disposing these entities, the lost in the long run is even greater due to loss of potential tax revenue. Also unsettling unemployment, leads to civil unrest, riots & rise in crime rates

(2) Lower life expectancy & literacy rate. Once privatised, hospitals & schools began to impose some fees, although not that high but still unaffordable. Even exemption of fees are given to those very poor, somehow they need to prove their poverty. The process is usually long & cumbersome. Many are therefore discourage to seek treatment & take up education

(3) Private firms exploiting the poor. With the ultimate aim for profit & considering their own private benefits, some firms in Uganda have increasingly sold those expired drugs to patients. Others include various type of charges being levied for instance unreasonable consultation fees, medical prescription fees etc. These result in lower consumer welfare

(C) Currency devaluation. In theory, the weakening currency of home country should be welcomed as this will increase the demand for exports. It is one of the methods to increase price competitiveness other than privatisation mentioned above. Also farmers will be able to export their farm output in larger scale thus earning more revenue for themselves. As for country itself, increase in export activities enable it to earn more foreign exchange that can be used to pay off its debt. Not to mention, it’s also meant to narrow the deficit in BOP

Evaluations of (C)

(1) Decrease standard of living. Currency devaluation is consistently viewed as the most effective arsenal in reducing BOP deficit, by encouraging exports & discouraging imports. Nevertheless it creates some other problems. For instance, weakening power of home currency may lead to difficulty in purchasing essential goods like food, fuel, capital goods etc. This further deprives the life of those poor people

(2) Opportunity costs in other spending. With limited amount of income, households have to make wise choice. Spending too much on imported essential goods may denied them to other necessities such as healthcare & education

(3) Inflationary effects. Rapid devaluation which leads to ballooning exports can lead to higher inflation in local economy. This will worsen the existing standard of living. Also in future, I’m afraid that locally made goods will lose its appeal in terms of competitiveness. So, will there be another round of devaluation imposed by IMF?

(4) Possible distortion of exports. Agricultural production for exports tends to be heavily reliant on imported inputs, the price of which rises under devaluation. Farming activities such as in SSA countries are small scale & they may not be able purchase these capital goods. Furthermore government is not allowed to provide any subsidies to these farmers. As such, farm output for exports may not be that large as thought

(D) Holding down wages. Salaries are being cut or freeze & minimum wage policy is dismantled. This is applicable for both private & public sector. As for private, the intention is to help firms minimise their production costs which will ultimately be reflected in the pricing of their goods. For public sector, again the intention is to slash government’s current spending so that it can narrow down the budget deficit

Evaluations of (D)

(1) Fall in productivity. Due to labour market deregulations, wages have either been cut or freeze & minimum wage policy was abolished while allowing inflation to escalate at same time. According to ILO report, real wages (adjusted for inflation) in Africa have fallen more than 60% since 1980s. Economically, workers facing falling wages will have lower incentive to work hard

(2) Failed to resolve unemployment. Falling real income have destroyed demand for local goods too. In SSA countries, many women are made unemployed when the demand for their textile falls. These displaced women have been forced into informal sector e.g. prostitution in large numbers to compensate for their own income loss

(3) Exploitation of labours. Firms are reported increasingly taking advantage of labour flexibilisation & deregulation. Many workers are put to work for long hours & abysmally paid low wages which don’t reflect the current cost of living

(E) Trade liberalisation. IMF urged those countries to open up their market, with little to no restriction on imports & exports. Import tariffs are decreased to allow the flooding in of foreign goods. This will automatically force local manufacturers & farmers to be more competitive. Marketing board, an organisation created by many producers primarily to control price & help those farmers to sell their agriculture produce was abolished. Again the intention is eliminate the dependency culture among producers. There was also reform onto agriculture policy where more attention is given to cash crops which are more commercialised rather than food crops

Evaluations of (E)

(1) Income inequality between gender. Transition of food crops to cash crops like tobacco, cocoa, coffee, bean & cotton for export purposes obviously benefit male farmers more than women. Interestingly, it is due to men owning larger plot of land than women. Furthermore, women in SSA countries play a major role as food producer & as such having small land is good enough to be self-sufficient. This obviously leads to widening income equality between gender

(2) Worsening hunger. Production of cash crops is very much dependent on the market price. For instance, if the price of cocoa is high more lands will be allocated to plant cocoa. This is obviously detrimental especially in countries where famine is widespread

(3) Local firms can’t compete. The lowering down of import tariffs allows more cheap goods from outside to flood the local market. Local businesses which are not cost & price competitive are waiting to be perished. For instance, many textile mills in Zimbabwe & Tanzania have shut down as they can’t compete with the cheap Taiwanese imports

(4) Loss of markets for farmers. The abolishment of marketing boards worsens the situation. There is no longer price control or organisation that help small-time farmers to market their goods both locally & abroad. It’s like losing sense of direction as these farmers have no connection with any importers from abroad

General criticism:

(1) Lack of involvement & transparency. IMF should negotiate with recipient countries on the terms & conditions of loans before implementing any changes. Also those countries must be given some flexibility & opportunity to reshape the economic mess. Due to immense pressure, later years through PRSP (Poverty Reduction Strategy Papers) these countries can participate by outlining policies they are going to implement & will be reviewed by IMF

(2) Ill-suited policies. IMF seems to implement standardised policies to all affected countries regardless of their macroeconomic conditions. Most often than not, these policies may be good for one but bad for all

Conclusion:

As for me, I understand the strong resistance from developing world particularly Sub Saharan African (SSA) countries. While I couldn’t be more than agree with them on all the grievances these policies have caused, I’m somehow still very supportive of many of those programs outlined, except slashing public expenditure on healthcare & education. There is nothing wrong in fact with those programs, it’s just the implementation!

To me, all those reforms can be made BUT gradually, allowing one after another rather than simultaneously at one go. I would say that something need to be done to increase literacy rates & life expectancy first before the rest

Slower posting

Greetings to all fellow readers. There will be slower posting in these 2 weeks as I'm making HUGE preparation for my students to face the GCE A-Levels examination in June. So, I couldn't spend so much time blogging like I used to do

Nevertheless, there will be at least 1 new posting in 2-3 days. So do log on from time to time. Also please drop some constructive suggestion & queries.

Cheers

Lawrence Low

Video Lesson: Quantitative Easing

What You Should Know About Quantitative Easing?

The term quantitative easing has some sort gain a wider publicity in the recent weeks. It is now standing on par with horrifying economic terms like recession, depression & deflation. In the very near future, I strongly believed that many economics textbook will be rewritten. Economics authors will need to consider whether to still classify US as a capitalist-based economy. Also unconventional monetary tools such as quantitative easing will probably be absorbed into the new curriculum

The Bank of England (BOE) has in the recent announced its effort in increasing the monetary base by £75 billion. Somehow Chancellor Alistair Darling has given green light to extend it to £150 billion

What is actually quantitative easing?

Basically, if we view it from the layman term, it means something like “easing the economy by increasing the quantity of money”. The BOE will use those money it created ‘out of thin air’ to finance the purchase of government bond & corporate bond. Financial institutions such as commercial banks & insurance companies will sell these bonds, hence flushed with ample of liquidity in their account. In theory, they should be able to resume to lending as usual & this should kick start the economy then

Why such a desperate measure?

(1) Sharp contraction. UK is now facing its worst ever financial shock & recession ever since the 1929 Great Depression. Economic activities have slowed down markedly & these translate to lower aggregate demand (AD). Price level falls at its fastest rate triggering the potential risk of deflation, something that all economies will always try prevent. This is because deflation will create a cycle of frugality that will lead to a greater contraction in economic activities when people keep on delaying spending. The Japanese economy has experienced it from 1990s to early 2000s

(2) Low interest rate doesn’t work. In theory, lower base rates should be able to revive the economy since the costs of borrowing had fallen. Rates had been cut for 6 consecutive months & are now standing at 0.5%, the lowest in 315-years. Unfortunately, there is no sign of increase in lending-borrowing activities. Banks have been quite reluctant in passing down the lower rates to customers. The main reason is because they want to protect their thinning margin, reshuffle their balance sheet & of course to attract savers. On the other hand, borrowers are afraid to enter into large commitment in period of uncertainty

(3) Running out of ammo. In the period of rising price level, interest rates can be increased indefinitely to slow down the movement of AD. However, in recession like now there is not much the monetary authority can do since interest rates cannot be slashed below 0%. Also, since the base rates is already low at 0.5%, MPC will probably soon be running out of ‘bullet’

How does it work?

(1) The liquidity effect. BOE will purchase corporate bonds & government bonds from banks, thus increasing the amount of money available in banks’ account. This may increase the willingness of financial institutions to lend to companies & individuals

(2) Interest rate effects. Increase in demand for bonds will send the prices of these bonds to a higher level. Since bond yields & bond prices are inversely related, these mean the interest rates (yields) will be pushed down, thus encouraging borrowing

Will it work this time?

I’m sort of pessimistic. Quantitative easing is something very new to UK policymakers. As can be seen, UK is actually consulting both Japan & US pertaining this policy. At the moment, anything can go wrong. But if judging from history, quantitative easing showed very little success in uplifting the Japanese economy. Having said so, some economists argue that its absence would probably prolong the stagnation

UK is actually facing twin problems here. First is the liquidity within the financial system. Secondly, the rapid-falling consumer confidence which largely explains for the slowdown in various economic activities. Therefore, I argue that even commercial banks may have restored their accounts, but who will be the borrowers? So it is not the issue of how much money the system is being flushed with, but rather its velocity of circulation. In other word, how rapid is money exchanging from one hand to another? The analogy is:

“I may have more money now, but if I choose to be frugal still there will be no spending & the recession will stay as it is or probably worse. So what’s the difference with before & after having more money?”

What are the potential problems?

(1) Lower value of pound. Quantitative easing will set to increase the money supply within the economy, causing the value of pound to fall. Another way of seeing this will be, rise in demand for bonds will cause interest rates to fall (negatively related). As such, it will be less attractive for some wealthy foreigners, pension funds etc to save in UK. Demand for pound will fall

(2) Inflation. Depends on how much the BOE inflate the economy with. If the money supply is more than necessary, soon it will be the problem of ‘too much money chasing too few goods’. In other word, increase in money supply is not match by the increase in real output. Goods will have to be priced higher then. Worse case scenario will be something like hyperinflation in Weimar, Germany back in 1923 when German government resort to printing money for reparations to Allies. It could also be something more recent like hyperinflation in Zimbabwe. A bunch of banana cost several millions Zimbabwean dollar!

(3) Fled of foreign investors. Investors are discouraged from investing in an erratic environment. In period of fast-rising inflation, costs & profits will becoming increasingly difficult to predict

(4) Bond bubble burst. Quantitative easing causes the demand for bond to increase & its supply to fall. This in effect leads to increase in its prices. Investors will soon join the mania, thus potentially driving its price to record high. High prices are often unsustainable. It will soon fall again, but driving interest rates up harming the economy at point of recovery

Does Weaker Exchange Rate Improves BOP?

At AS level, students were taught that weakening exchange rate be it depreciation or devaluation can help in narrowing down the current account deficit.

How does that suppose to work?

Say the exchange rate between dollar & pound used to be $1.53 per £1. Now it stands at $1.33 per £1. This clearly shows that dollar has strengthened against pound or we can also say that pound has weakened against the dollar. To purchase the SAME £1, the Americans used to need $1.53, but now they only need $1.33. So weakening of pound here is something like British goods are given discount

So weakening pound will cause the demand for UK goods to increase. As a result, exports (X) increase. At the same time, weaker pound means more expensive for Britons to purchase American-made goods. So demand for imports (M) will fall. The widening gap between exports & imports will lead to increase in the value of net exports (X-M). This not only improve the standing of the current account deficit but also sets to boost economic growth as (X-M) is a component of aggregate demand (AD)

Is it true all the times?

Well, not necessary. It depends on both the price elasticity of demand (PED) for export & import. In most cases, PED for exports & imports tend to be inelastic in the SHORT TERM. This means, weakening exchange rate which translates to cheaper price will only help to increase demand for British goods by a small proportion. Total value of exports will fall.

Simultaneously, weaker exchange rate translates to more expensive American goods. So British will need to pay higher to acquire these goods. Since the demand curve is inelastic, an increase in price will lead to just a minimal fall in the quantity. However this translates to increase in total expenditure on imported goods

Hence, due to factor of inelasticity current account deficit will initially widen. The phenomenon is called J-curve

Souce of diagram: bized

Why inelastic?

Companies or countries have entered into an agreement to import & export stipulated amount of goods

It takes time for US consumers to switch from local goods to cheaper imported British goods. On the other hand, British people may take some time to adapt from more expensive American goods to cheaper home-made goods

Due to this reasons, weakening of exchange rate will always cause the current account to be temporary in deficit, before moving towards surplus

This is embodied under Marshall Lerner condition that states:

"Provided that the elasticities of both demand for exports & imports are greater than 1, fall in the exchange rate will reduce a deficit & a rise will reduce surplus"

If the condition is not met as I have discussed earlier, then the deteriorating pound will lead to the worsening of current account deficit

Source of diagram: tutor2u

UK experience?

From the diagram, there is some evidence that suggests that Marshall Lerner condition is applicable to UK context. In 1992, when UK exited the ERM (Exchange Rate Mechanism) & pound was devalued by 16%, the current account deficit widens

Only at later stage somewhere 1993-1994, the deficit narrowed down significantly. Also when pound further fell in 1995, the value of current account deficit widens again before the narrowing down of deficit. However, this time the effect is short-lived

How George Soros Profited So Much When UK Was Defending Its ERM Position?

Initially, I thought of writing about how people like George Soros & other currency speculators had played the market out back in early 1990s. At second thought, since the Edexcel A-Levels examination is around the corner, thought it will be nice for those taking the examination to know something about UK economic history in brief

What had happened much earlier?

Margaret Thatcher inherited the ‘sick’ British economy from her predecessors Harold Wilson & James Callaghan in 1979. During that period, second oil shock due to Iranian revolution swept the whole world. Oil price increased to another unprecedented level, causing UK economy to face one of the worst recessions in history. Inflation that time was about 27% & was made worse with union militancy. Riots were seen everywhere especially in Birmingham, Bristol, Brixton, Manchester & Liverpool

On coming to power, she pursued a very strict deflationary approach towards the economy. To reduce the inflation rate, she increased interest rates (which wasn’t suitable for cost-push inflation). Simultaneously, all government expenditures were slashed. As a result, she managed to combat inflation by bringing down AD. But there were other repercussions. Increase in interest rates caused pound to appreciate which was deemed unhealthy towards the already-declining manufacturing industry. Exports continued to slide. Current account deficit widens. Through the negative multiplier effect, real GDP contracts further & unemployment was exacerbated, reaching around 3.5 million. It stays that way until 1986

Within the same period, she introduced many legislations that were in favour of firms e.g. giving firms more power to sue their workers, casting a ballot before strike etc. Some quarters argue that Thatcher’s policy was too harsh & stronger than necessary

What happen then?

Things went for a turn in 1986. The Conservative government decided to pursue policies that will inflate the economy. As can be seen (refer diagram) interest rates were cut from 14% to just around 7% to facilitate growth. It was very effective. Even the October 1987 stock market crash didn’t produce any damaging effects to UK economy that time. The bull run continued shortly after that fuelled by high consumer confidence in its housing market. The wealth effect was just too strong. Equity withdrawal increased to record level. It’s a common phenomenon where people borrow more money secured against the rising value of their property.

Source: BBC

Source: BBC

Populist approach like cutting income tax rates for both low & high income also contributed to the fast but unsustainable growth. UK was growing at 5%, twice its normal growth rate. Meanwhile, policymakers were ‘fooled’ thinking that their supply side policies such as the privatisation & trade union reform were a big success and was fundamentally sound. So they did not bother to increase interest rates. The period is called the Lawson Boom. However, rapid growth was followed by high inflation after that. It crept to 11% in 1990. Also current account deficit widens

Is ERM the way out?

Thatcher-led government decided to join ERM (Exchange Rate Mechanism) in 1990 as a way out to combat the horrifying double digit inflation. At that time, pound was pegged against deutsche mark (DM), as Germany was the largest economy in Euro-land that time. The pegged was DM2.95 to £1. In theory, pegging (fixed exchange rates) creates certainty for traders & should not be subject to currency attack by speculators. However, this still depends on how high it is pegged at

Unfortunately, UK government made another costly mistake. The pegging was indeed at too high a level & currency speculators predict that it will not be sustainable. As mentioned earlier, inflation rate was high that time, causing pound to quickly lose its worthiness & weak on the foreign exchange market. Conservative government was forced to increase interest rates to protect its value. Higher rates managed to cool down the economy. But since the main agenda was to maintain the exchange rates more than stabilising the real economy, economist claimed that the increase was overdone. Houses being repossessed hit the headline as many couldn’t afford to pay at such high rate. Consumer confidence decline. UK economy went into deeper recession

However, UK government did not reduced interest rates still. Emphasis was just on stability of exchange rate. At that time interest rates were already at 15%. Speculators, mainly people like Soros predicted that UK will no longer be able to sustain at such high exchange rate & will collapse any time. So he & other speculators persistently sold pound heavily on the market causing value of pound to further fall. UK responded by further increasing interest rates to attract inflow of foreign capital which temporarily led to increase in the demand for pound. Also they intervene in the foreign exchange market to buy pound, using foreign reserves

Somehow, they soon realised that they are fighting a losing battle. There is no way UK alone can contain the market force of continuous selling of pound. It will just worsen domestic recession & drain out foreign reserves in defending sterling. At last it took the decision to leave ERM. That happened on 16th September 1992, popularly known as the Black Wednesday

So how currency speculators played the market?

Soros was well known after the incident, after he sold short more than $10 billion worth of pounds & profited $1.1 billion from the transaction. How it works?

I will present an oversimplified model here:

Say the current market rate is DM 3 = £1. Traders like him borrow say £1000 & with this he obtained DM 3000

Now, let’s say that pound weakens & we have a new exchange rate DM 3 = £1.80. Soros will sell his DM 3000 & gets £ 1800. He returns the £1000 borrowed earlier & still make a clean profit of £800

People like him & many other speculators who successfully predicted the downturn of the pound, will borrow pound in a large quantum & sell it a later date, making profits as shown above. In fact the cycle can get more vicious if he chose to dump the £800 (above) rather than cashing it out

The intention is to further depress the value of pound, & he will again repeat the process, making a larger profit every round

That’s the complexity of financial world! But it’s interesting & I’m amazed how people made money out of thin air!

Video Lesson: Is Globalisation Good Or Bad?

Here are some questions for readers to brainstorm:

(1) What are the causes of globalisation?

(2) What are the advantages & disadvantages of globalisation?