Monday, February 23, 2009

Northern Rock is to offer £5 billion of new mortgage loans this year, with a further £9 billion to come over period to 2011. The funding for this move comes partly from government (though much comes from repayments and deposits that have come in to the bank). It had originally been intended that the bank would not issue new mortgages, so this represents a major attempt to inject new resource into the housing market. As such the move is very welcome.

The housing market is not the only one in which credit has been constrained, though. Businesses need loans too, and action is still needed to ensure that they have access to funds. Many of the finer details of the second banking bailout will be published later this week, and hopefully there will be some relief for businesses there.

Friday, February 20, 2009

Casey Mulligan has produced a provocative article which suggests that the recession in the US is driven by supply side factors. I have repeated his exercise for the UK, and find that the recession in this country is very much driven by demand factors. Between the last quarter of 2007 and the last quarter of 2008, the fall in employment was very marginal - just 0.1%. The fall in productivity over this period was relatively large, however, at 0.7%. Unsurprisingly in the context of global slowdown, the demand curve for labour has shifted down.

Wednesday, February 18, 2009

Recent movements in the three month London Inter-Bank Official Rate (LIBOR) give renewed cause for concern that things are not improving in the banking market.

In normal times, the LIBOR settles at around 0.1 or 0.2 percentage points above the base rate, but in the first half of last year it has rose well above that, indicating high levels of fear in the banking sector. At its peak, the gap amounted to a massive 1.3 percentage points.

From the middle of last year till January of this year, the gap narrowed, albeit at a sluggish pace. Before the January change in the base rate, LIBOR had fallen to less than 0.6 percentage points of the base rate. It seemed that, slowly but surely, normality was returning. Since then, however, the gap has widened again, and little of the most recent cut in base rate has fed through into cuts in LIBOR. The LIBOR currently stands at 2.06%, more than 1 percentage point above the central bank's base rate. And yesterday, the LIBOR actually rose slightly, indicating that any significant further convergence with the base rate is unlikely at least in the short term.

Recovery from recession cannot begin until the financial markets are operating at something approaching normality. The evidence provided by the recent behaviour of LIBOR suggests that there is still, even after the bailouts, a considerable amount of anxiety in these markets. In the presence of that anxiety, the banks will remain reluctant to lend, and investment cannot therefore be relied upon to provide the economy with the stimulus it needs. The situation is perhaps exacerbated by the revelation of the extent of losses at HBOS, and the impact that this has on the merged Lloyds/HBOS group. The sooner we can establish what further help this group needs from the public purse, and the sooner that that help is guaranteed, the better.

Monday, February 16, 2009

The Confederation for British Industry has published its latest set of forecasts for the UK economy. They make gloomy reading, with GDP expected to fall by 3.3% over the course of 2009. The recession is expected to end in the first quarter of next year, but with growth in 2010 being extremely slow. Over the 6 quarters of recession, the CBI expect output to fall by a total of 4.5% - this would put the severity of the recession somewhere between the recessions of the early 1980s and the early 1990s.

These forecasts look about right. By the middle of this year, the benefits of reduced interest rate, the fall in the value of sterling, and the dramatic decrease in fuel costs will all have started to take hold. In addition, any fiscal stimulus aimed at shovel-ready projects should be in place. While being very plausible, the global nature of the current recession means that what happens in the UK depends crucially on what happens elsewhere, and, this being the case, any forecasts must be made in a very uncertain environment.

A striking feature of the CBI forecast is the prediction that the rate of inflation, as measured by the consumer price index, will dip slightly below zero in the third quarter of this year. The CBI expects this deflation to be very mild and temporary, not least because VAT is due to rise back to its previous level of 17.5% in the fourth quarter.

Thursday, February 12, 2009

An interesting angle on the debate about whether the Bank of England should now engage in 'quantitative easing' (QE) - in effect printing money - is provided by a comparison with experience in Japan.

One of the difficulties with QE is that releasing more money into the economy does not necessarily mean that that money will be used. At a time of very low inflation, people might wait for the real prices of goods and services to drop before spending. So the extra balances of money just lie idle, and fail to stimulate economic activity. In 1999, Japan tried to finesse this problem by way of an innovative form of QE - they issued time-limited shopping vouchers to members of the public (children and some old people). The fact that these vouchers carried an end-date meant that people could not wait long before spending them - and so the economy should experience an instantaneous stimulus.

In a fascinating paper, Masahiro Hori and co-authors find that this experiment did indeed lead to an increase in economic activity in the short run. Over a longer period, the vouchers displaced other spending that would have taken place, though, so that the longer term impact of the scheme was limited. In effect, the scheme encouraged people to prepone their consumption.

There is much that can be learned about QE from this experience. A crucial issue concerns the way in which it is phased - if QE has an immediate impact, but one which wears off quickly, achieving a more sustained impact over the duration of the recession will likely require a sequence of voucher (or new money) issues.

Thursday, February 05, 2009

The latest house price data from Halifax points to a slight rise in prices over the most recent month. This goes against the expectations of many commentators. But I have consistently argued that the necessary downward adjustment in house prices is more likely to be realised partly by way of a slow recovery from a more modest price fall than that predicted by more pessimistic observers. See for example my blog entry of 28 August last year.

The correction has some way to go and it is far too early to suggest that house prices have bottomed out. If they have, then that is good news. But the good news has to be qualified by the observation that prices are unlikely to rise by much for a good few years yet.
The Bank of England has again cut the interest rate, this time to 1 per cent. With very low interest rates, concerns arise that the economy may have entered a 'liquidity trap'. This occurs when commercial banks, faced by a low return, become unwilling to lend money that is made available to them through the operations of the central bank. It can also occur when interest rates are so low that individuals and firms prefer to hold idle balances of money, rather than deposit them in the banking system where they could be recycled in the form of loans and thus create new demand. When there is a liquidity trap, further cuts in interest rates fail to stimulate the economy, simply because they do not lead to more money being released into the economy. The money is 'trapped' in the banking system (or under people's mattresses), and is therefore ineffective in raising the level of demand for goods and services.

In such circumstances the authorities are, in effect, denied the use of a major (and, in recent years, the major) tool of economic policy. There remain other levers of policy that can and should be used, however. Fiscal policy should be especially effective during such times, although many commentators have concerns about how long government spending policies take to have their full effect. There is therefore now a desperate need for a large fiscal stimulus in the UK. This should be focused primarily on spending projects that can be implemented quickly and tax cuts that put extra disposable income into the hands of those most likely to spend. The package should ideally be part of a coordinated international policy effort. Of course, the VAT cut was a nod in the direction of fiscal expansion (and, for reasons I have alluded to before, not a particularly effective one) - but what is now clearly needed is a much bigger stimulus, along the lines of the recently announced US package.

Another lever is for the central bank directly to increase the supply of money. Typically this is done by purchasing government securities from the commercial banks, so that these banks have more money. Under some circumstances this might have little effect - the banks have simply swapped low interest securities for zero interest money. But if, by raising the money supply, the central bank can persuade commercial banks that inflation might rise in future, the commercial banks may become more keen to lend out their extra money balances, and hence the liquidity trap can be finessed. This is known as 'quantitative easing' (QE). Whether QE can be effective in the current situation is moot - inflation does not at present seem to be even the remotest threat. But, that being the case, it is at least likely that QE could do no harm, and might even do a little good.

In sum, we are reaching the point where further cuts in the interest rate are futile. Other policy levers, including QE and, especially, fiscal policy now have to come into play in a much bigger way than heretofore.