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.