Wednesday, December 17, 2008

Unemployment has risen sharply, with the government's favoured (ILO) measure rising by 137000 this month. The claimant count measure has now risen above a million. These figures indicate that the recession is already hitting the labour market with some force. With the closure of large employers (such as Woolworths) anticipated over the next month, things are set to get worse before they get better.

On the preferred measure, unemployment remains below 2 million. But there is little doubt that it will rise towards 3 million over the coming year. And the rise in unemployment will not end once the recession is over - typically we need growth of about 2.5% per year in order to keep unemployment stable. This means that unemployment is set to rise well into 2010, and possibly beyond.

There are some bits of good news, though these are few and far apart. Both monetary and fiscal policy is going in the right direction, and the fall in the value of sterling makes our exports more competitive. Yet demand from overseas is weakening as the rest of the world faces recession too, so even the little good news that we have has to be qualified.
The US Federal Reserve has cut its interest rate target to virtually zero. This exhausts its ability to use this instrument as a means of kick-starting the economy. Policy makers will need to think outside the box if they are to find a way of providing further monetary stimulus.

Meanwhile rates of interest that banks are offering savers, and charging borrowers, remain relatively high. Savers in the US can, with not much shopping around, still get 2.5% or more. Borrowing is relatively costly still, and it is hard to find rates much less than 7%. If banks will not themselves bring these rates down, perhaps there is scope for government to tax interest on savings in order to subsidise borrowing.
The European parliament has voted to end the UK's opt-out on the 48 hour limit to the working week. The new regulations, limiting the length of the work week, are set to come into force by the end of 2011.

A widely held misconception is that limiting the length of the working week will ensure that work can be spread around more evenly, and so will result in a reduction in unemployment. Economists refer to this as the 'lump of labour fallacy' - the idea is that there is only a fixed amount of work to be done by however many people. In truth it is not the case that there is only so much work to go around. Attempts to reduce unemployment by limiting working hours have typically been ill-fated - the experience of France between 2000 and 2005 is a recent example. There, the working week was limited to 35 hours. Popular in some quarters, the policy was scrapped because it had no impact at all on unemployment.

A positive aspect of the limit to the working week is that it can prevent employers from demanding more hours from their workers than the latter would ideally wish to supply. This is likely to be a problem in areas where alternative employment opportunities are limited. On a crowded island with good communications and a culture of commuting, it is unlikely that many people are affected by this. But those that are are likely to be disproportionately drawn from the disadvantaged groups.

Sunday, December 07, 2008

Barack Obama has promised help for the US auto industry. The banks, of course, have already received substantial sums of money from the taxpayer. They have come close to collapse because of misjudgements made in connection with bundled packages of debts. They are a special case in that the rest of the economy cannot operate without them.

The case of the car manufacturers is somewhat different. Their predicament comes from a different source - healthy competition from abroad. And the predicament itself suggests that the rest of the economy is choosing to live, and live very comfortably, with cars supplied by other producers.

While the US car industry employs large numbers of people and certain areas would be hit hard if the industry were to vanish, supporting the industry would likely only prolong the inevitable. It has, ultimately, to face up to what the UK faced up to in the 1980s - it's a tough medicine, but it's one that has to be swallowed. Obama is vague about strings that would be attached to any rescue package, and so it is difficult to come to a definitive judgement at this stage - but it looks as though it could be his first bad call.

Friday, December 05, 2008

The London Inter-Bank Offered Rate (LIBOR) of interest on 3 month loans has fallen following yesterday's cut in the Bank of England's interest rate. But while the Bank's interest rate was cut by a full percentage point, the LIBOR has only fallen from 3.72% to 3.38%. This is important because the premium of LIBOR over the Bank's rate is seen as a measure of the risk that banks perceive in lending to one another - and hence of the general inertia in the banking system.

Following the November cut in the Bank's interest rate, LIBOR fell. This fall was gradual, and it took two weeks for the premium of LIBOR over the Bank rate to come down to the level it had been at before the cut. Some commentators have suggested that the relatively modest fall in LIBOR today suggests that it will not fall much further until the new year. They argue that, over the festive period, banks will prefer to hold on to their cash reserves rather than lend. But that simply has not been the experience of the past.

I would expect to see the time path for LIBOR following the most recent cut in the Bank's rate to be quite similar to that which we saw in November. If it does not fall in this way, then we should worry - after all, a cut in the Bank's rate of interest does not, of itself, indicate any increase in the risk attached to interbank lending.

Thursday, December 04, 2008

The Bank of England's Monetary Policy Committee (MPC) has reduced its interest rate by a further 1 percentage point. The rate now stands at just 2 per cent. The cut has been widely welcomed, though many commentators are suggesting that there should be a further 0.5 percentage point cut in January. One wonders: why wait?

Lags in the system mean that interest rate changes take several months to impact on the economy. We know that the patient needs treatment now and will still be desperately sick half way through next year. But the longer further interest rate cuts are delayed, the more we run the risk that they will impact on the economy at just the wrong time - after inflation has bottomed out.

The MPC (well, most members) appeared to be desperately slow in coming to an appreciation of the seriousness of the economic situation. Hopefully, over the year that is to come, the committee will do somewhat better than in the past when it comes to reading the writing on the wall.

Monday, December 01, 2008

I usually find it hard to disagree with the BBC business correspondent, Robert Peston. But there's always a first time.

The Royal Bank of Scotland (RBS) has announced that it will delay taking action to repossess the houses of people whose mortgages fall into arrears. Instead of repossessing at 3 months, they will repossess at 6 months. This is, I think, good news, and is a sensible response by a bank that is keen to look after its own investments. The fact that people fall into arrears now does not mean that they will not be able to repay in, say, a year's time. Recessions hit people hard, but are typically short lived.

Yet Mr Peston deems this to be bad news. And why? Because if there are fewer repossessions, there will be less downward pressure on house prices, and so a recovery in house prices will take longer. He misses the fact that such a recovery would be from a lower base. And he misses the fact that it would have been bought by the unnecessary suffering of people thrown out of their homes.

The move by RBS is welcome, and it is very much to be hoped that other banks will quickly follow suit.

Tuesday, November 25, 2008

Following leaks, the pre-budget report held few real surprises. The big news was indeed the cut in VAT. The big concern is that this was not the best way to stimulate demand. Given what we now know about future tax increases, higher income consumers will not go out and spend in response to the slight reduction in prices brought about by the VAT cut. They will, rather, save extra in order to help them pay the extra tax burden when it comes.

A boost to the incomes of people at the bottom end of the income distribution might have proved more effective. The propensity to consume is high amongst this group, so the extra boost to income would circulate all the better around the economy. Perhaps the best way to have achieved this would have been to reduce the rate of income tax back to 10 per cent.

This leaves just the merest hint of a feeling that the government is more concerned about saving face than about implementing the most effective policy. Given the gravity of the present economic situation, surely that cannot be?

Monday, November 24, 2008

The government's pre-budget report is due out today, and its contents have been widely leaked. We can expect a reduction in the rate of VAT from 17.5% to 15%, some twiddling of tax credits, and the promise of a higher rate of tax for high income earners after the next election.

Any extra spending by government should help, especially if targeted at those at the bottom end of the labour market who are often those most likely to suffer the effects of the recession. Recessions disproportionately hit a relatively small number of people - those who are thrown out of work are hit hardest, while others whose hours of work might be restricted also feel the pinch. Extra spending on benefits for these groups, especially if time limited, should help, not least because in straitened times such groups are likely to spend a high proportion of the extra benefit.

A general cut in VAT will encourage everyone to spend more, but does not have the benefit of being targeted at the hardest hit. A cut of 2.5% may help a little, but may make relatively little inroad when stores are already offering greater discounts with apparently modest effect.

It is widely understood that the tax breaks to be offered today will come at a cost in terms of extra taxes to be paid a couple of years down the line. Something that economists call 'Ricardian equivalence' is of relevance here - tax cuts are often not as effective in stimulating the economy as one might hope, simply because people believe that they will need to be funded by tax hikes in the future. People just save the extra money they find in their pockets rather than spend it, hoping that their extra savings will help them pay the extra taxes that are to come. Now, whether this Ricardian equivalence effect will come to pass as a result of today's tax cuts is moot. But it is worth bearing in mind that tax cuts for everyone may not be as effective in stimulating the economy as would be targeted spending.

Thursday, November 13, 2008

US Treasury Secretary, Henry Paulson, has announced that the $700 billion bailout of the financial sector which was passed through Congress just a few weeks ago will not, after all, be used to purchase toxic assets (derivatives comprising bad debts largely from subprime mortgages). Instead, it will be used to inject new capital into banks and other firms in the financial services sector. Some commentators have indicated that the change in plan is due to there being more toxic waste out there than anybody expected.

Perhaps so, but if so there is a silver lining in the cloud. Injection of new capital into the banks buys the government influence, maybe even control, over their future dealings.

Normally there would be no reason to expect the government to do a better job of running a firm than anyone else. But the wider impact of the financial crisis makes these exceptional times. If, by buying greater influence in the running of banks, the authorities can restore confidence and fix the lending bottlenecks that have paralysed the system, then that has to be a good thing.

Wednesday, November 12, 2008

The last two weeks have seen some action on the three month LIBOR. Up to nearly the end of October, this market interest rate - a crucial one, since it is the rate at which banks typically lend to one another - had been moving glacially towards the Bank of England's rate, having (unusually) risen well above the latter over the last year. It has taken some time for the government's rescue package to take effect, but there is now sign of some real progress on the LIBOR. If it continues to descend at the current rate, it will not be far above the Bank's rate by the end of this month.

That would be welcome news indeed - though the severity of the recession suggests that further steep cuts in interest rates are needed. I would expect the Bank's rate to be cut (and to be cut by more than a quarter of a percentage point) in December. Hopefully LIBOR will by then track the Bank's rate, and will respond quickly.
The Bank of England has produced new forecasts of for GDP growth and inflation which, for the first time, provide a plausible prediction for how the recession will pan out. They predict that the UK will pull out of recession in the last quarter of 2009 or the first quarter of 2010, and that the decline in GDP over the first four quarters of the recession will amount to 2%. Meanwhile, the Bank expects inflation to dip below 1% in the summer of 2010 - that is territory where the Governor of the Bank would have to write to the Chancellor of the Exchequer explaining why the inflation target of 2% is being missed - again.

The line from the Bank seems to be that things changed in August of this year, and that only then did the severity of the downturn become apparent. Thus, we are told, it was not appropriate to cut interest rates sooner. Things certainly did take a turn for the worse in August, but the fact is that there was a lot of writing on the wall before then. This recession has not been hard to predict. As long ago as the summer of 2007, I commented on this blog about predictions made by Ed Leamer about the American economy - and Leamer was not the first to sound alarm bells. Others commented on the nosedive in the ABX index of derivative prices - for poorly rated securities at the start of 2007 and even of AAA rated securities by July of that year - and they noted the implications for the real economy.

So, it would appear, some forecasting models need a review.

Friday, November 07, 2008

In the wake of yesterday's dramatic interest rate cut by the Bank of England, the LIBOR today fell, by a little more than one percentage point, to 4.49%. This is encouraging, though it still has more than a whole point left to fall before a sense of normality can return.

With LIBOR falling, more lenders should today adjust their interest rates downwards - mitigating yesterday's fears that the Bank's interest rate cut would not be passed on. The levers of monetary policy still work, despite a bit of rust in the joints.

Thursday, November 06, 2008

The Bank of England has announced a massive 1.5 percentage point cut in its rate of interest. This is an attempt to stimulate the economy in the face of recession. It quickly follows the publication of the latest International Monetary Fund forecasts, which predict a 1.3% contraction in the UK economy over the coming year.

While the interest rate cut should have a positive effect, there are two caveats. First, it typically takes at least 6 months for changes in the interest rate to have a discernible impact on the overall economy. Secondly, a cut in the Bank's interest rate needs to be followed by a fall in market rates. The three month LIBOR, in particular, needs to fall. While it has been falling in recent weeks, it has been doing so far too slowly. There is still a lot of inertia and fear in the banking system. As the government's injection of capital into the system takes effect, the market interest rates should come down quite rapidly. But we still need to wait and see.

While the cut in the Bank's interest rate is dramatic in itself, it is to be hoped therefore that it will lead to an even bigger cut in the interest rates at which commercial banks lend to one another and the rates at which they lend to businesses and households.

Even so, today's cut is unlikely to be the last.

Tuesday, October 21, 2008

The OECD today reports that income inequality has, since 2000, declined faster in the UK than in any other member country. This gain has been largely due to a rise in employment.

In other recent work, I have investigated what the current skill set of young people in Britain implies for the distribution of income over the coming decades. For the most part, skills of young people have risen by about 7 per cent since the mid-1980s and the mid-2000s. But they have increased by much less for those in the bottom 20 per cent of the skills distribution - and there is evidence that they have declined for those in the bottom 5 per cent. These findings suggest that the distribution of income is likely to widen over the coming couple of decades, as young people enter the labour force.

While the overall improvement in skill is, of course, something to be welcomed, more still needs to be done, and urgently so, to support those in the bottom tail of the distribution.

Monday, October 20, 2008

Here is some good news. The LIBOR has started to fall. The overnight LIBOR has fallen to just 0.19 percentage points above the Bank of England's official interest rate - a week ago it was 1.3 percentage points above. The decline in the three month LIBOR is slower - this rate now stands at 6.16% - but here too there is progress. This should mean an easing of the blockages in the market for credit that we have seen in recent weeks.

Recession still looms. But at least monetary policy - a major tool for dealing with recession - once again stands some chance of working.

Thursday, October 16, 2008

The London Interbank Offered Rate (LIBOR) of interest at which banks make three month loans to each other has, despite the massive bail-out programmes launched internationally over the last couple of weeks, stayed at over 2 percentage points above the Bank of England's base rate. This indicates that banks are still spectacularly unwilling to lend to each other - despite all the guarantees that government has now put in place.

With the LIBOR failing to fall much after the base rate was cut by half a percentage point last week, businesses are not encouraged to invest. Cuts in the interest rate at which the Bank of England makes overnight loans to commercial banks cannot stimulate the economy if they are not fed through to other interest rates like the LIBOR.

Fundamentally, banks are now holding on to their assets in the form of cash, rather than lending out. In the absence of confidence, this is a 'once bitten twice shy' approach - but it is not helping the economy recover.

Desperate times call for desperate measures. Perhaps we need to think once more of regulating the reserve assets ratio (the ratio of cash held by banks relative to the banks' total assets), stipulating a range (maximum as well as minimum) within which this ratio should lie.

Monday, October 13, 2008

The government's bail-out of the banking system has taken shape dramatically this morning, with the announcement that the Royal Bank of Scotland, LloydsTSB and HBOS have all sought capital investment from the taxpayer. In the case of the Royal Bank of Scotland, the government's stake will amount to 60% ownership of the company - effectively a nationalisation. In the case of the other two banks, which are set to merge, the stake will be about 40% - enough to provide the government with considerable influence.

From the banks' perspectives, there are strings attached to these investments. Directors will not receive bonuses this year, and future bonuses will take the form of shares rather than cash. The Lloyds TSB and HBOS investment is conditional on the merger going through. The terms of the merger have, however, been renegotiated in light of the fall in the value of HBOS shares since the merger was announced - instead of receiving 0.83 Lloyds TSB shares for each HBOS share, shareholders in HBOS will receive just 0.605 Lloyds TSB shares.

The issue of bonuses needs a more thorough look though. One of the key underlying causes of the present crisis is that the incentives provided to senior bankers have not been properly aligned with the long term interest of the banks themselves. Perhaps these incentive mechanisms were designed by the wrong people - or at least by people who needed better to understand the information deficiencies (opportunities to hide unpleasant surprises) that accompany the new breed of financial securities.

The government intends to use its position as majority or large minority shareholder to restructure the banks, then to sell off their stake to the private sector. It is not clear how long the restructuring process will take, nor how long we will have to wait for the economy to reach a position where private investors see banks as an attractive investment. An optimistic estimate might be 3 years. It could take more than 10. Whatever, the restructuring needs to include reform of remuneration practices within banks.

This needs to take on board the lessons of principal-agent theory. One interpretation - and one that has been well understood in the past - of this theory is that it is all about how to incentivise people. Another aspect of the theory has been much less well understood, though - and that has to do with how to incentivise people in the presence of information deficiencies and uncertainty. There are some lessons that need to be translated into action.

Meanwhile, governments in the Eurozone have agreed a package that guarantees loans that banks make to each other, and which provides assurance that public investment of capital will be made in banks that are struggling. The package resembles the British solution - which released £200 billion for loans to banks as well as providing up to £50 billion for capital investment. It remains to be seen exactly how the European solution will work - inevitably the need to work across borders renders matters complicated here.

Markets have responded positively to these moves.

Wednesday, October 08, 2008

The Bank of England has cut its interest rate by 0.5% - a day ahead of the expected announcement of the Monetary Policy Committee's decision - in a coordinated move by central banks that includes similar rate cuts in the USA, the Euro area, China and elsewhere. The cut should provide help bolster the demand for credit, hence investment, and hence overall spending, as the downturn threatens to turn into a severe recession. It is a very belated, but nonetheless welcome, move. It is unlikely to be the last cut in interest rates of the year.

An equally serious problem, however, is that the supply of credit remains frozen. The measures announced by the government earlier today - which involve it in taking partial ownership of commercial banks and providing banks with access to a huge amount of extra loans from the public purse - still need to be accompanied by conditions that enable banks to have renewed confidence in each other. Providing an institution to insure debts, and financing that institution, is one measure that I have mentioned before on this blog. A wholesale reform of the regulation of the financial sector is another. These are exciting, albeit traumatic, times indeed.
Bank A wishes to take a loan from Bank B. In normal times, Bank B would love to make the loan, since rates of interest are attractive. But there is a problem. Call that problem a trust gap. Bank B simply does not trust Bank A to be able to repay the loan.

In normal times, defaults on loans are quite rare, and banks insure themselves against such defaults by way of a markup on the charges they make for all loans. Just as shopkeepers make an allowance in their pricing decisions for the fact that some goods will perish while in stock, banks make an allowance in setting their borrowing terms. These times are not normal, however, and there is a need for a more formal type of insurance to plug the trust gap.

We might expect the need for such insurance to be met by the creation of a company specifically to offer it. Surely such a company would offer an attractive proposition to investors. But solutions of this type are unlikely to work in the present climate, simply because banks are not lending, and so they would not lend to a company setting itself up to provide this sort of insurance.

The government has, this morning, announced its willingness to buy shares in the major banks, up to the value of £50 billion. Details of exactly how the scheme will operate have still to be worked out. There are hints that the money will be available to banks that agree certain conditions - including conditions on remuneration of their own executives. That is as it should be. But it is also crucial that the conditions should include a means of breaking through the gridlock that has thrown the banking system into its present state of sclerosis. A start might be to require banks, with government as facilitator, to finance the creation of an institution that effectively insures their own business.

Tuesday, October 07, 2008

The Bank of England's Monetary Policy Committee (MPC) meets again this week to decide on the Bank's interest rate. With the pressures of inflation starting to erode (with falls in oil and fuel prices), the onset of recession should surely be at the forefront of the committee's mind. That suggests that they should cut interest rates in order to stimulate the economy.

And indeed they should. But the beneficial effect of such a stimulus is likely to be muted. In normal times, the cost of borrowing is a major factor in determining the extent to which people and businesses will borrow in order to finance their expenditure. To some extent, the same is true today. But these are not normal times. Another huge barrier to borrowing is the availability of credit. People aren't borrowing now, not so much because loans are expensive, but because they are not even available in the first place. The banking system is largely gridlocked by a general lack of confidence.

The authorities have been making funds available to the banks in an attempt to get out of this gridlock. Probably too much of this help has been in the form of short term loans, and not enough in the form of medium to long term loan facilities. Curiously, monetary policy is now as much about such detail as it is about the interest rate deliberations of the MPC.
At its second attempt, Congress passed the $700 billion bail-out. The markets have not responded positively, as further bank crises and confused policy announcements in Europe have cast yet more gloom on the outlook.

The most recent policy moves in Europe have aimed at securing deposits - ensuring that people who save their money in a bank will be able to access their savings in full, whatever might happen to the bank. The authorities have also made substantial loans available to the banking sector. For the most part, these loans have been short term, day-to-day, loans. The American bail-out makes longer loans available. Perhaps European policy needs to be tilted a little in that direction too.

Tuesday, September 30, 2008

The American administration has failed to push through Congress its propsal for a $700 billion bail-out of the banking sector. This has profound implications for the economy, not only in the US, but throughout the world.

Members of the House of Representatives appear to have been lobbied successfully by their electorate, which appears to perceive the bail-out simply as a means of keeping some fat cats in the banking industry in clover. It does not take much thinking to see that that can, at best, be only a partial view. Bankers may, in large measure, have caused the crisis - but that doesn't mean that they have the resources to avert it. The need for a large bail-out doesn't come primarily from money that has disappeared into bankers' pockets - most of the problem is that the money was never there at all, and all of us, as Joe Public, managed to kid ourselves that it was.

There is gridlock in the money markets. Banks will not lend to each other because they fear that they will not be repaid. This means that banks themselves have little resource that they can lend to end users. House buyers find mortgages hard to come by. Firms find that they cannot raise the capital to invest in new equipment. The reduction in investment exacerbates the problem of a stagnating economy. With that, prices on the world's stock markets are plummeting, and that has adverse implications for people's pensions and other savings. So consumer demand is diminished. We are caught in a vicious circle.

The $700 billion bail-out was an attempt to break out of that. For sure, it was going to involve tax hikes in the future. But for sure, if there is no bail-out, people will be hit in the pocket in other ways - through their pensions and savings, and through a prolonged period of recession. We have lived beyond our means for several years, and now - through the tax system or otherwise - it's payback time.

The tax option is probably the best of a bad set of options available. It can at least ensure some degree of fairness. It should be accompanied by a new and much tighter form of regulation in the financial sector. Hopefully the proposal will, in one form or another, be revived later this week.

Monday, September 29, 2008

It's less than 2 weeks since HBOS was taken over by Lloyds, and now the Bradford and Bingley is nationalised, with much of the company being sold on to the Santander Bank. Santander also own Abbey, and so this move further increases the concentration of activity in the banking sector in Britain. In so doing, it makes even more necessary a wholesale review and reform of regulation for the financial services industry.

Friday, September 19, 2008

The US authorities are engineering a plan to stabilise the financial markets. From what we know already, it seems that this might involve legislation that forces lenders to renegotiate debt repayments with homeowners who have been struggling to pay their mortgages. So much, so sensible.

It is also suggested that the government might set up an agency that would take on the bad debt that has come from banks offering mortgages in the sub-prime market. This news has really cheered up the stock markets in a big way - with the FTSE100 gaining over 7.5% this morning. Such a big rescue may well be necessary, but it would not all be good news. It would have adverse implications for taxes in the future. People know that, and they will start spending less now in anticipation of a higher tax burden. That will slow down and maybe even postpone the economic recovery.

Such a rescue would also have implications for the regulation of the banking sector in the future. If government bails out banks, it takes away the disciplines of the market. If it does this, it must impose some rather stringent regulation in order to ensure that banks do not take excessive risks. The whole regulatory framework for financial services is set to change in a massive way.

Wednesday, September 17, 2008

The news on financial institutions keeps coming thick and fast. AIG has been bailed out by the US government, in what is effectively a nationalisation. Meanwhile in the UK, HBOS (the merged Halifax and Bank of Scotland company) has been hit hard by an assessment by Standard and Poor's (a major credit ratings agency) which deemed it to be the most vulnerable of the British banks. The value of shares in HBOS has collapsed dramatically in recent days, and early today had fallen by a further 40%. The latest news is that Lloyds are contemplating a takeover. Shares in HBOS have recovered somewhat since this news broke.

With rumours sending share prices of some banks spiralling downwards, it is not surprising that other financial institutions are quick to seize the opportunity of takeovers on the cheap. It is becoming clear that one thing to emerge from this crisis will be a massive increase in concentration in the banking industry, with far fewer banks competing against each other. The dilution of competition as a discipline on banks' behaviour will bring about its own issues of regulation.

Tuesday, September 16, 2008

After the relative calm of late July and August, stock markets have been thrown into a frenzy once more, with the FTSE100 dipping below the psychologically important 5000 barrier. This has followed the weekend's dramatic events on Wall Street, which saw the investment bank Lehman's being forced into bankruptcy, Merrill Lynch being taken over by the Bank of America, and the American International Group (AIG) of insurers widely tipped to be the next financial giant to come under pressure.

The troubles of the global financial sector are by now well documented, and the events of the last few days just go to reinforce the fact that we are now living through the worst crisis of this kind for many decades. The scale of the disturbance within the financial industry makes clear the fact that these events will have serious ramifications for the real economy.

Some observers are pointing to the Clinton administration's repeal of the Glass-Steagall Act which, until 1999, forced investment banks and commercial high street banks to be separate entities. This Act, while in force, ensured that bankers did not take inappropriate risks with funds deposited by the public. The repeal of the Act, following prolonged and intense lobbying from the banking sector, allowed banks to take advantage of economies of scale and scope, and also allowed American banks to become more effective in competing internationally. The repeal should not have introduced new hazards - credit ratings agencies (CRAs) should have been reporting on risks to the main financial regulatory body in America, the Securities Exchange Commission (SEC) who would then act on the information. In practice, the CRAs may have failed to maintain enough of an arms-length relationship with their clients, and the SEC may have failed adequately to anticipate this. Repealling Grass-Steagall hasn't helped matters for sure, but that fact should not serve to hide some pretty serious failures that have happened elsewhere in the regulatory system.

The key questions are: how these failures arise (I suspect that the incentives people face are not always aligned with what is best for society); whether the failures are endemic (I suspect not); and what institutions (regulations, mechanisms) can be put in place to prevent them. An overhaul of the governance of firms in the financial sector is needed, ensuring that the incentives that workers face are aligned with the broader need for these firms to conduct their affairs in a socially responsible manner. Economists with expertise in personnel economics (and the application of principal-agent models in the workplace) should be at the forefront in the design of these reforms.

Thursday, September 04, 2008

The Bank of England has kept the interest rate at 5% this month. As I have argued on this blog earlier today, I think a cut would have been timely. Downgrade your growth forecasts for the first half of next year.
The Bank of England's Monetary Policy Committee (MPC) is set to make its latest monthly decision on interest rates later today. Many pundits suggest that the MPC is unlikely to cut rates given the continued threat of inflation, but that cuts are likely in the months ahead.

We are on the point of entering recession. Inflation has risen to above 4%, and that is a problem in the eyes of many members of the MPC - they are, after all, briefed to keep inflation close to its target level of just 2%. But oil prices have fallen back quite sharply over the last month, and the recession is likely to dampen price increases further in the domestic economy.

It takes changes in the interest rate about 6-9 months measurably to affect economic activity. The MPC needs to be looking ahead to the spring of 2009 - by which time the threat of inflation should have receded and - without a fillip - the economy will likely have suffered three quarters of non-positive growth. Given what has happened in recent weeks to the price of oil, the Committee should not delay further in cutting interest rates.

Tuesday, September 02, 2008

A stamp duty 'holiday' has been announced. This means that, for the next year, people buying houses costing up to £175000 will not have to pay stamp duty on their purchase. Up to now, stamp duty has been payable on all houses costing over £125000. For the next year, the 1% rate of stamp duty will kick in at the higher £175000 level.

According to the Nationwide Building Society, the average house price in the UK is (to the nearest thousand pounds) £175000. The move on stamp duty is therefore clearly aimed at helping most directly people in the bottom half of the housing ladder. Others will benefit from a ratchet effect: as first time buyers decide to buy their own homes, sellers will find that they can trade up, and so on up the chain.

The stamp duty change is just part of a package of measures to breathe new life into the housing market. Households on incomes below £60000 per year are to be offered loans that are interest free for the first five years. At the end of the five years, they will have to pay a fee - and the success of this initiative will doubtless depend crucially on the (hitherto unknown) details of that fee.

It is to be hoped that this package of measures will deliver the stimulus that the housing market badly needs. Ultimately, though, people will start to buy into housing once they believe that house prices are no longer falling. They are unlikely to be impressed by a tax break worth £1750 if they think the value of their new home is likely to fall by more than that amount over the coming months. And they will not respond to a tax break if they think that it is still going to be available in the future. So we may have to wait till towards the end of the tax holiday (and the tax holiday will indeed have to come to an end) before many people decide to take advantage of the reduction in stamp duty.

Monday, September 01, 2008

Chancellor of the Exchequer, Alistair Darling, has hit the headlines over the weekend by claiming that the economic situation may be the worst that we have faced for 60 years. At the same time, David Blanchflower, the most dovish of the members of the Bank of England's Monetary Policy Committee (MPC), has gone public on his views that unemployment could top 2 million by the end of the year, and that the Bank needs to cut interest rates further.

Other members of the MPC may feel as though there is a pincer movement here, and that, for the first time since the Bank was given independence, we are seeing some real political interference in the process of setting interest rates.

Mr Darling's comments have had an immediate effect on the exchange rate, with speculators selling sterling like hot cakes. The value of the pound has collapsed to a two year low against the dollar. This, in itself, should do something to help the ailing economy, as our exports become cheaper relative to those of other countries.

The Chancellor has received a bad press following his comments. Perhaps he has indeed been politically naive. But perhaps, given the (sensible) decisions made in 1997, he is now using the only means left open to him to influence monetary policy - without being seen to do so.

Life is tough when someone makes you the captain just as you head for the rocks, especially when you aren't given control of the rudder. As the Welsh say, 'poor dab'.

Thursday, August 28, 2008

Recent work by Dimitri Ballas and Mark Tranmer on the geography of happiness in the UK has received a lot of attention in today's press.

Ballas and Tranmer are careful researchers. In common with other studies, they find that factors such as age, gender, health, employment status, and family composition have significant effects on happiness. They also obtain some new results - they find, for instance, that people who have been living in the same place for more than 5 years tend to be happier than others. (Presumably it's because they're happy that they haven't moved on.) They find that experience of unemployment causes individuals more misery in areas with low unemployment rates than in places where the unemployment is more common.

Since some places are, and others are not, populated by people with characteristics that tend to make them (relatively) happy, the media has suggested that a league table can be constructed that ranks places. Hence, it is suggested, people from (say) Wrexham might consider moving to (say) Wycombe to become happier. But Ballas and Tranmer clearly state that only 'a very small proportion of the variation of the wellbeing measure is attributable to the district level'. Differences between places can be identified, but, once the researchers control for individuals' characteristics, these are not (apart from a very few extreme cases) statistically significant. This is unsurprising - the British Household Panel Survey, on which the results are based, is a very small survey to use when employing a detailed level of geographical disaggregation.

It is the people who make the place. Perhaps, with the housing market being so sluggish, we should welcome the news that we don't, after all, need to move to be happy.
The Nationwide Building Society has announced that house prices have fallen by over 10% in the last year. This is a dramatic adjustment, but it is likely that the collapse in house prices will not end there.

How much further prices will fall is a matter of conjecture. It will depend in part on how vendors, who may be caught in a negative equity situation (where they owe more on their houses than their houses are worth), react. Many may choose to tough out the slump. In this case, houses will stay on the market for a long time, but prices will not fall much further. The recovery in house prices, when it comes, will be slowed down as a result of the stockpile of houses still for sale.

Other factors come into play too. At the moment, with inflation running at over 4% and rising, there is not much immediate scope for interest rate cuts. But the oil price has fallen quite sharply in recent weeks, and there are reasons to hope and believe that inflation will ease off by the end of the year. If interest rates fall, demand for housing could be stimulated, and that could buoy up the market somewhat.

My guess is that house prices will fall, on average, by about 15% in total before they start to recover. And the recovery will be a long drawn out affair. It may be several years before your house is again worth what it was worth a year ago.
A recent report by the World Health Organisation draws attention to the sharp international differences in life expectancy. Not surprisingly, people in rich countries tend to live longer, on average, than people in poor countries. More surprising, perhaps, are the differences within countries - and even within cities. The contrast between two areas of Glasgow has hit the headlines - in one, life expectancy at birth is 82 years for boys, while in the other it is just 54 years. People in both areas have access to the same national health service and face the same environmental conditions. These are shocking statistics.

The figures are explained in part by the tendency for people to self-select into certain residential areas. Calton, where a high proportion of housing is owned by housing associations, tends to attract people who are economically disadvantaged - those in receipt of housing benefit and likely to live in rented accommodation. Relatively poor people have less opportunity than richer people to be well nourished; so much is obvious. There are high levels of heroin abuse and prostitution - both of which are activities that attract people who are at high risk of experiencing health problems to live in the area. (You go where you can buy the drugs; you go where you can work.) Meanwhile, house prices in Lenzie ensure that only those who are economically advantaged can afford to live there.

For a given person, therefore, living in one area or the other may not make all that much difference. But the gaps between the rich and poor are huge. The right investment in our poorer areas could yield a massive social and economic return - through people living longer and working more.

Tuesday, August 12, 2008

It would be difficult to view the jump in inflation, now up to an annual rate of 4.4%, as anything but bad news. While some analysts are suggesting (or hoping?) that this is a blip and that the rate will start to fall again by the end of this year, the danger now is very real that a wage-price spiral could be set in motion.

A critical difference between now and the 1970s could be position of trade unions. Union membership has collapsed over the last couple of decades, following a raft of legislative measures brought in by the Thatcher government to reduce the impact of trade union power and influence. The levels of price inflation that we are now seeing provide a real test of the effectiveness of these measures. If wage pressure can be contained, then there is certainly the prospect that inflation could fall back quite quickly. But this will depend on the ability of employers to resist wage demands. This, in turn, depends on the strength in practice of the policies introduced a generation ago. While those policies give some grounds for optimism, they haven't been tested in a period of stagflation before now. So inflation may be blipping - but I'm cautious enough to keep an open mind about that. If it turns out to be a more chronic problem, a return to the 'cold turkey' policy prescription of the early 1980s - unpleasant though that would be - may have to be on the cards.

Thursday, July 24, 2008

Several large internet service providers (ISPs) have reached an agreement to work with the music industry to deter illegal file sharing. The issue of file sharing has generated controversy over the last decade (almost), since Napster was set up in June 1999. Napster did not introduce any new principles - for many years music fans had been exchanging tapes, itself a breach of copyright law. But the arrival of digital technologies did mean that such practices could become very widespread, with each sharer making files available to millions of other computer users. At this point, the music industry clearly faced a significant new challenge.

The economics of all this are not clear cut. The creators of any intellectual or creative property need protection in order to ensure that they receive sufficient incentive to produce. On the other hand, consumers are clearly better off if they can access music at little (or no) cost than if they cannot. Once the music has been created, it is economically efficient for file sharing to take place.

The catch, of course, is that if musicians and the industry that supports them do not receive remuneration then they will not have the incentive to continue to produce new music. So there is a need for some protection. That is exactly what copyright laws (and, for inventors, patent laws) are there to do. The problem with the law, however, is that it has not kept pace with changes in technology.

Nor can it. Napster was replaced by a host of programs based on smaller *nap networks, gnutella, and torrents. The creative community of computer users is likely to remain at least one step ahead of the legislators. Yet the music industry still seems to be set on using old legislative technology to combat the new threat. Many would claim that it has also shot itself in the foot by charging too much for legal downloads and by adopting an unworkable position on digital rights management.

Now that the music industry is at last working with the ISPs, a far more effective system would be based on the recognition that file sharing happens and will continue to happen. ISPs could agree to charge their customers an additional amount per month, with this being transferred to the music industry. If ISPs do not agree, then this is a system that could be enforced by government. Better government involves itself in this way than by tinkering with laws that are doomed to fail.

It would then be for the industry itself to devise a new way of remunerating musicians using the monies they receive from the ISPs - but it would need to be one that ensures that creative talent is remunerated sufficiently well to keep it creating. Indeed a little redistribution from the superstars towards the support of new talent might well be regarded as a good thing.

This proposal might penalise internet users who do not share files. But it is already the case that light internet users pay as much as heavy users, so inequities are already there. Of course, it would be possible to iron these out by extending the use of charging per byte. That is for the ISPs to decide.

There is nothing particularly new in this proposal - something similar has been used for decades in the context of written works that can be photocopied, where the Authors' Licensing and Collecting Society has made sophisticated arrangements with users. In the context of music, it has been proposed by numerous economists over the last decade. It would be nice to think that the music industry and ISPs might at last be ready to listen.

Friday, July 18, 2008

The Treasury is considering a rewrite of its own rules on fiscal prudence, in order to allow itself to raise national debt above 40% of national income. There are two interpretations of why this relaxation of the rules is necessary. First, the government would otherwise struggle to meet its expenditure commitments, since tax revenues are falling as the economy slows down. Secondly, the slowdown itself needs to be countered by a fresh injection of government spending, and borrowing is the primary means of financing this.

It has become clear that the government has run ahead of itself in terms of its spending commitments. During the boom years it should have spent less, and paid back more of the national debt. Unfortunately, though, the time to cut back has passed. Nonetheless, when the economy starts to pull out of the downturn, it will become necessary for the government to reassess its spending. Expect some retrenchment at that time (probably after the next election) - and consequently a slow bounce-back from the downturn.

Monday, July 14, 2008

The Federal National Mortgage Association ('Fannie Mae) and Federal Home Loan Mortgage Corporation ('Freddie Mac') are two government sponsored but privately owned corporations in the United States, both of which are heavily involved in the housing market. Fannie Mae makes loans and provides loan guarantees, and thus underwrites much lending activity. Freddie Mac buys mortgage debt from banks, repackages it, and sell it as securities to investors. The consequences of either company failing would be catastrophic to the economy. The value of shares in both firms almost halved over the last week, following fears about their ability to raise sufficient funds to continue their operations - a ramification of the current credit crunch. This has led to the US government putting forward a package to support both companies that would involve huge government lending to the firms and also bolstering of their share prices.

As long as 5 years ago, Greg Mankiw highlighted the risk that comes from having such firms buoyed up by implicit subsidies. These subsidies come from the knowledge that the companies are too important to be allowed to fail, and the existence of the subsidies encourages an inappropriate degree of risk taking by the companies themselves. Now it seems that the chickens are home to roost.

Thursday, July 10, 2008

The Bank of England has held the interest rate at 5% this month. In the wake of several indications that the economy is weakening and that a recession looks increasingly likely this may seem perverse. But inflation remains well above target, and the maintenance of stable inflation is the bank's main role in setting interest rates.

So long as inflation does not get built into wage increases (and there's a big 'if' in there), it should fall back over the next few months. If this happens, there may be scope for interest rates to be cut again later in the year in order to ease the impact of the downturn. The Bank faces an unenviable quandary - they can't cut interest rates now for fear of stoking inflation, but they should not leave the next cut too late.

Tuesday, July 01, 2008

House prices fell by 0.9% in June, following a 2.5% fall in May, according to figures released by Nationwide. This is the first tentative evidence that the fall in prices is slowing down - but 0.9% is still a big fall in one month, and the fall might have been even more pronounced were it not for the fact that trading is slow, with mortgage approvals substantially down on this time last year.

When house prices adjust downwards, they can either fall dramatically for a short time, or fall more modestly for longer. They have already fallen by over 6% over the last year, and it looks as though they will keep falling until they are at least 10 or 15% lower than they were at their peak. That's a substantial fall, but even after that we might expect the recovery to be slow. Between 2000 and 2006 the average house price divided by GDP per capita rose from 4.6 to 8.0, and this suggests that the drop in house prices needs to be sustained as well as pronounced.

What does this imply for the wider economy? As the value of people's houses stagnates, wealth declines. People's access to credit declines, and so consumption is likely to be less buoyant than in the recent past. In other words, the outlook remains one of economic slowdown - despite the rising oil and food prices. We've had some good years, but at the moment economics is earning its 'dismal science' moniker.

Tuesday, June 17, 2008

Inflation has risen above the 3% mark, and Bank of England governor, Mervyn King, will have to write a letter of explanation to the Chancellor of the Exchequer, Alistair Darling. Indeed, the increase, to 3.3% is higher than most pundits expected. It is not too difficult to find explanations, but it is somewhat harder to find fixes. As we all know, prices of oil and foodstuffs have risen dramatically owing to international conditions.

The policy tool that is available to the central bank is the headline rate of interest. Hiking the rate of interest reduces demand and so puts downward pressure on prices. The trouble is that the general condition of the economy is not one in which interest rate hikes are a particularly attractive option. This is because, by reducing demand, they would make a recession - which already looks to be more than a remote possibility - increasingly likely, and all the more severe.

Faced by the threat of both inflation and unemployment, government needs to use more than one policy tool. The obvious second tool to use is fiscal policy - interest rates could then be used to control inflation while raising the government's budget deficit could ensure that the consequences for employment and growth are not too adverse.

The problem with this is that the government's budget deficit is already large. Indeed, as a share of GDP, it is larger than that of any other major country except Hungary and Pakistan. The scope for extra borrowing to be effective is limited therefore. People would know that the borrowing would have to be paid back out of future taxes, they would start saving up for those heavier tax burdens, and the demand taken out of the economy by these extra savings would cancel out much of the benefit of the extra demand generated by the borrowing. That said, the government did recently inject an extra £2.7 billion into the economy as a means of defusing the political revolt over the abolition of the 10% rate of income tax.

A stronger candidate for second policy tool, as things stand, is for the government to operate directly on people's expectations of inflation. The price increases of the last year have been pronounced, but they will become truly inflationary only if wage settlements are raised in line with (or ahead of) the increases in prices. To keep inflation down, wage deals need to be kept at levels that are sufficiently modest to ensure that we do not enter a wage-price spiral.

I am not advocating an incomes policy here. Such policies have, in the past, tended to be ad hoc and so have typically failed after a couple of years. But there is much to be gained from senior and credible politicians stating the facts clearly. Prices have risen. This is because there are now more people competing to consume the finite supplies of oil, and there are more competing uses for the produce of agriculture. We can catch up with the purchasing power that we had a year or so ago by becoming more productive. We can't catch up by giving ourselves pay deals that just wind up pushing prices up further. In particular, a monetary policy that simply involves printing more money to accommodate inflation - repeating the mistakes of the 1970s - is (or at least it should be) a non-starter.

It's time for the politicians to talk tough reality.

Friday, April 25, 2008

There has been a lot in the news lately about anti-competitive practice. Today, tobacco manufacturers and retailers are accused of price co-ordination. Last week, construction companies were accused of collusion in securing tenders.

Anti-competitive practices are subject to regulation because they can serve to reduce economic welfare. While companies engage in such practices in order to increase their profits, this increase in profit is achieved by exploiting their trading partners. In many cases, the exploited lose more than the exploiter gains. So on balance, the anti-competitive behaviour is a bad thing.

How is it that the exploited lose more than the exploiter gains? The gain in profit is usually achieved by raising prices; when they do this, firms find that they can sell less output. The increased price for which each unit is sold more than compensates them for the fact that they are selling fewer units. For the consumer, however, not only is less consumed, but more is paid for each unit that is still consumed.

The news about tobacco is not particularly surprising. The news about collusion amongst construction companies is more so - because of the sheer number of firms alleged to have been involved. Collusion between large numbers of companies is rare. This is because each firm has an incentive to cheat on the deal, and it is difficult to be caught cheating when there are many companies involved.

Thursday, April 10, 2008

The Bank of England has today cut the interest rate by a further quarter point to 5%. This is intended to stimulate the economy in the face of the anticipated downturn. The question is: will this be enough of a cut for a while, or can we expect further cuts in the months ahead?

The first thing to observe is that the Bank's interest rate is having a less focused impact on the real economy these days than has been the case in the past. While the Bank has been cutting the interest rate at which it lends to other banks, the squeeze on credit has meant that the interest rates that people pay on their mortgages (and that businesses pay on their borrowing) have not come down. The Bank's decision to cut its interest rate today is good news in that it might prevent the cost of mortgages rising, or it might ensure that more mortgages are available. It is also good news in that sometime, further on down the road (who knows when?), the cost of mortgages should come down - and this will give a boost to the economy.

At the same time, oil prices have reached another record high, and the consequent effect on prices more generally needs to be heeded. The threat of inflation may be sufficient to render any future cuts in the interest rate less likely.

But we are in a 'play it by ear' situation. The very least that can be said for economic policy at the moment is that it is interesting.

Tuesday, April 08, 2008

House prices have fallen by nearly 3% since they hit their peak late last year. Prices are still higher (just) than they were a year ago, but only because of the sustained increase in prices through most of 2007. It now seems likely that the year-on-year rate of house price inflation will turn negative at some point during the current year. The question is: how negative?

A downward adjustment of between 5 and 10 per cent seems to be the likeliest outcome. Prices are currently dampened by the effects of last year's interest rate hikes and the current difficulty that people are experiencing in getting mortgages. But the Bank of England has already cut interest rates, and more cuts are in the offing. These have not, in the main, fed through to mortgage payers yet, owing to nervousness surrounding the credit crunch - but they will. And as confidence returns to the banking sector (which may happen after or, hopefully, without another blip or two), mortgages will become easier to find. A moderate adjustment of house prices, followed by a gradual and modest recovery, would not be comfortable. But neither would it cause much real damage.

Meanwhile, in a fascinating recent study, the International Monetary Fund reckons that house prices in the UK are 27% higher than is justified by the fundamentals. Perhaps. For sure that kind of gap could be fixed either by the 'soft landing' that I have described above or by something more drastic.

A more drastic realignment would introduce problems of negative equity on a large scale - where people find that the value of their house does not cover what they owe as a mortgage, thereby making it difficult for them to move house. This has to be seen as a less likely - but nevertheless possible - outcome than a more moderate readjustment.

Tuesday, April 01, 2008

The House of Lords Economic Affairs Committee has today published a report on immigration to the UK. It concludes that the recent wave of immigration has had 'little or no impact' on the economic position of native Britons.

To be sure there are pros and cons of migration. The sharp increase in population that has resulted in certain parts of the country has put (upward) pressure on house prices and local services. It has also put (downward) pressure on wages, particularly at the bottom end of the labour market. However, this last fact has meant that it has been possible to sustain relatively high levels of growth, and so maintain low levels of unemployment, without setting off inflation. This has been a huge benefit of migration that the Committee seems to underplay.

A further benefit is that when a downturn comes, much of the impact can be absorbed by migrants returning to their home countries. We may already have seen the start of this process, as movements of workers from Britain to Poland are reported, in the last couple of months, to have exceeded those in the other direction.

Migration has already given us growth we could not otherwise have enjoyed. Over the next couple of years, we face a serious downturn if not a serious recession. Migration is our biggest source of hope that the impact of that downturn will be moderate.

Monday, March 17, 2008

The collapse, and subsequent takeover by JPMorgan Chase, of Bear Stearns investment bank has sent more shock waves resonating around the world's economies. The climate in the banking sector is clearly one of fear. Banks, which routinely lend to each other on a daily basis, are no longer doing so - so fearful are they that today's loans could turn out to be tomorrow's bad debts.

In a move designed to ease these fears, the Fed has already cut the rate at which it lends money to commercial banks, and is expected to cut the more general interest rate (yet again) tomorrow. Whether these interest rate cuts will work or not is moot, however - the worries are about whether loans will be repaid at all, not about how much interest is charged on the loans. In this context, the discount rate cut is a tinkering at the margins. (That's not to say that the economies of the US and UK don't need interest rate cuts to ease fears of recession - they do, but that's a slightly different albeit not altogether unrelated matter.)

More radical moves are under way with the coordinated approach of several central banks to ensure that loans can be made to the banking sector. The Fed is making up to $200 billion available, the European Central Bank up to $15 billion. The Bank of England is making £11.35 billion available as 6, 9 and 12 month maturity repurchase agreements (repos). The question is: will this be enough, or does the fact that the central banks are doing this just serve to make the whole system yet more nervy?

Wednesday, March 12, 2008

In light of the fact that inflationary pressures are still present, while the economy is turning down, it is clear that separate policy instruments are needed to ensure that the objectives of low inflation and high employment are met. In the recent past, monetary policy, in the form of interest rate adjustments, has been much to the fore. The announcement in today's budget that fiscal policy will be used to bolster the economy is therefore welcome.

Borrowing by government will rise to £43 billion over the next year. The government remains committed, however, to keeping to its 'golden rule' that borrowing for current expenditures should be neutral over the business cycle. This being so, the government projects that its budget deficit will fall in subsequent years.

Growth forecasts have been adjusted downwards, but the government is still anticipating growth of 2% (give or take 0.25%) this year. It expects a growth to pick up next year. This seems optimistic, and a delayed recovery could threaten adherence to the 'golden rule'. But the threat of recession now is quite severe, and it seems appropriate that - whether the 'golden rule' is met or not over the course of this cycle - fiscal actions should be taken to bolster the economy at this time.

Friday, March 07, 2008

An interesting story has broken today about the antacid medicine Gaviscon. The patent on this drug ran out several years ago, but Reckitt, which manufactures the product, has effectively precluded the marketing of generic equivalents by objecting to suggestions put forward for a name by which the unbranded product can be known. This has allowed Reckitt to sustain profits, but has cost the National Health Service (or, more accurately, the taxpayer) millions of pounds that could have been saved if an unbranded equivalent had been available.

Patents exist to give innovating companies protection from competition for a limited period. If there were no patents, companies would be reluctant to invest in research and development because imitators would come along and reduce the profits that the innovating company has earned as a result of its research. So it is right that patent protection should be available.

For a company to attempt to extend monopoly power beyond the life of a patent is understandable - it gains extra profits if it is successful in doing so. But this does also deny society the benefits of competition.

What really beggars belief about this story is that the authorities have allowed prevarication about the name of a generic product to go on for years. It is this failure to get to grips with an issue that has really been costly.

Monday, February 18, 2008

Northern Rock is in the news again. The government has decided that a 'temporary' nationalisation of the company is the best route forward. Whether they are right or not remains to be seen.

The economic literature on auctions has highlighted the existence of something known as the 'winner's curse'. In any bidding war, it is usual for some bidders to underestimate the value of the lot, while others overestimate it. By choosing the nationalisation option, the government is implicitly suggesting that the various private sector bidders for Northern Rock were all undervaluing the company, and were therefore not willing to bid enough for it.

Perhaps the government is right. But equally, perhaps the government has got its own sums wrong. After all, while there were only two players in the game at the end, other private sector bidders had pulled out much earlier. Could it be that they were all wrong? Or is it more likely that the government's estimates of the financial commitment that will be needed to bail out the Rock will prove to be overly optimistic?

Monday, February 04, 2008

I was reading a fascinating paper by Eli Berman and David Laitin last week. This suggests that terrorists' choice of method - overt insurgency or suicide attacks - depends upon a number of factors. These include the terrain (with insurgency being favoured in mountainous areas), the extent to which an attack might be expected (with insurgency being favoured if the attack is a surprise), and with the level of resourcing of the security services (with surprise attacks likely being more successful than overt insurgency where there is generous resourcing).

In Iraq, overt insurgency has been the norm. But over the last month or so, suicide attacks have been getting more common, the latest case being particularly disturbing, involving as it did the use of two mentally disabled women as carriers. The surge, which has improved the resourcing and numbers of US armed forces in Iraq over recent months, has rendered conventional insurgency less fruitful for the terrorists, and this may be what has led them to turn increasingly to suicide attacks as a means of operation.

Wednesday, January 30, 2008

Just a week after cutting interest rates by 0.75%, the Fed has cut US rates again by 0.5%. The US economy is certainly in need of stimulus. In the last quarter of 2007, growth was barely above zero, and it looks likely that growth will turn negative this quarter.

It is too early yet to assess how the markets have responded to the move. New York markets initially responded well, but by the end of the day have fallen back considerably. The interest rate cut itself is good - the signal it sends about the severity of the malaise to which it is a response is bad news.
In an attempt to avoid further bank runs similar to the Northern Rock experience, it is being proposed that the Bank of England should be able to lend banks money without the loans being made public. There are clear benefits and drawbacks associated with this proposal.

The benefit is that, in the case of Northern Rock, the bank run was precipitated by disclosure of the fact that the company was in sufficient trouble to require special help from the Bank of England. Much in this sphere depends on confidence, and it was disclosure that eroded the public's confidence in the bank. So, the argument goes, take away disclosure and you take away the thing that saps public confidence and causes the bank run.

There are two drawbacks. The first is that taxpayers, if they are to make sensible choices at the ballot box, should know how their money is being spent. If bailouts of banks are to be kept secret, we won't know. So long as disclosure is required after a certain time period has elapsed, this problem need not be severe. The shorter the period, the less serious the problem. But also, the shorter the period, the more likely it is that the bank being helped is not yet out of trouble. Nothing has yet been said about how long this period should be - but it is clearly a crucial issue.

The second drawback is that an information vacuum tends to suck in rumour. This carries the risk that the next victim of a bank run will be an organisation that is financially very secure. The problem is that we need information about banks so that we know that we can trust them - but we need not to have information about banks that might fail. Unfortunately, though, the absence of information would mean that we knew everything that we need to know. Now there's a paradox.

And it implies that the true source of the problem lies elsewhere - in the fundamentals of banks' balance sheets. Tinkering at the edges, making information secret, is cosmetic surgery. The system needs more than that to put things right.

Tuesday, January 22, 2008

The US Federal Reserve today cut interest rates by 0.75% points. This is a week before the time of the month when the Fed would normally be expected to adjust rates, and has come int he wake of a significant crash in the stock market. Is this a timely and appropriate response to current economic conditions, or does it reflect panic?

Curiously, the answer is both. For the Fed walks a tightrope in deciding by how much to cut rates. Clearly the American economy is in dire need of a big stimulus. But the bigger the stimulus, the clearer the signal that things are not going well, and the more sapping is the effect on consumer confidence - and hence on spending. It is not yet clear on which side of the tightrope the Fed has trodden today - or whether it has got things exactly right.
The markets have got the jitters. Actually that's something of an understatement, with the FTSE having experienced its largest one-day drop since 9/11 yesterday. The panic amongst equity sellers is fuelled by fears of a recession in the US - something that I have been flagging on this blog for many months now. The signs are that the American economy is heading for a sharp reverse. While some of the more complacent observers note that the UK economy is in better shape (and indeed it is), the old adage that when America sneezes the rest of the world catches a cold remains true - at least when America sneezes with the kind of gusto that one can expect now.

As recently as this weekend, the Telegraph was arguing that higher interest rates should be the order of the day in the UK. It is certainly the case that inflation is a threat - given higher fuel and food prices. But, so long as wage pressure can be contained, the much more serious threat is recession. To stave off this threat, it is likely that both further interest rate cuts and a fiscal injection (an increase in the government's budget deficit) will be necessary. There are some (really) tough times ahead.

Thursday, January 10, 2008

The Bank of England has kept interest rates on hold this month. This is in the face of mixed signals about where the economy is heading.

Inflation has remained steady at 2.1%. But prices for food and fuel have been rising, and there is concern that this might stoke up some inflationary pressure. At the same time, the housing market has slowed considerably, and important trading partners (including the United States) appear to be heading for recession.

In normal times, monetary policy (conducted primarily through the central bank adjusting the interest rate) can be used to regulate the economy, and it does a pretty good job. When the economy is overheating, inflation is a threat and unemployment is low - and an interest rate hike can serve to reduce demand thereby curtailing inflation. Likewise, an interest rate cut helps to stimulate demand when unemployment threatens.

The problem we have now is that we are not in normal times. Both inflation and unemployment are viewed as threats on the horizon.

Which way then for the interest rate? I would argue that it should come down in order to protect the economy from recession. There are hazards in this - most obviously, cutting the interest rate could fuel inflation at a time when prices are rising anyway. But the price rises that we have seen are one-shot increases due to specific factors - so long as wages are kept under control, there is no reason for these to generate a sustained increase in inflation.

The prime minister has, this week, stressed the need to keep public sector pay settlements down. This does not signal a return to the ill-fated incomes policies of the 1970s, but it does operate on people's expectations. The chances of a wage-price spiral occurring are much reduced if people do not expect large wage hikes.

To sum up, the direction of change for the interest rate should still be downward - though this month the Bank of England is probably right to wait, if only to ensure that the government's warnings on pay settlements are heard over the coming period.

Friday, January 04, 2008

Chancellor of the Exchequer, Alistair Darling, has announced new powers for the UK's Financial Services Authority (FSA). These come in the wake of the UK's first bank run for over 100 years - the now infamous case of Northern Rock. The new powers will allow the FSA to protect customers' cash if a bank gets into financial difficulties, hence giving customers priority over banks' other creditors. The FSA will also have new powers (and duties) to ensure that banks in difficulties do not suffer cash flow problems.

The new powers will become part of legislation to be passed in May of this year, following a consultation period. Broadly they are to be welcomed. There are some gaps that need to be plugged, however. Currently, responsibility for the security of the banking system is shared between the FSA, the Bank of England, and the Treasury (headed by the Chancellor of the Exchequer). That nebulosity of responsibility did not facilitate decision making in the face of Northern Rock. The new legislation needs to make very clear exactly who is responsible for what, and how the three bodies should work together. Mr Darling's preferred model is one in which the FSA and Bank of England have input, but where the final responsibility is the Chancellor's. This is a good model in that someone has clear responsibility. What needs to be worked out, though, is the nature of the input of the other two bodies - they each have information and the institutions need to be in place to ensure that each is heard.