Questions

3 main questions we need to look at this time:

1) How did this crisis happen?

2) How will we get out of this crisis?

3) What can we do to prevent another crisis like this from occuring in the future?

I’ll hopefully have a go at answering them soon.

Back

Hi again. My exams are all over now, so I can get back to posting.

Not really been tracking the markets much these last few months, but the FTSE100 index was at 3,983 points when I last posted, and today it has closed at 4,249 – a 6.7% rise. The general pattern has been a rising trend, although June has seen this trend stop – perhaps due to world news about the grim economic outlook.

For example this week, the Organisation for Economic Cooperation and Development (OECD) has warned that the UK’s recovery will be slow with unemployment rising to 10%.

Also today it has been revealed that the UK economy contracted 2.4% in the first quarter of 2009, the lowest for 50 years. To be honest, I am finding it hard to envisage how or when this crisis will even end at the moment. More to come on this topic on another day.

Meanwhile, I really recommend listening to some of LSE’s public lectures. In particular, Professor Paul Krugman (winner of the 2008 Nobel prize for economics) makes some excellent thoughts through his ‘The Return of Depression Economics’ lectures. There’s 3 parts to them, with the final part being of particular interest – he discusses what the current crisis means for the future of economics.

Finally I’ve been meaning to read some Keynes for a while now, and hopefully I’ll be able to borrow or buy his General Theory sometime this or the following week. I’ve then got an interesting looking book called Economic Thought Since Keynes: A History and Dictionary of Major Economists to look at. Now work at school is a little more relaxed it gives me a little more time to read, which is good.

Also been looking at university open days this month. Really looking forward to the application process and getting there to study economics. To be honest A-Level economics is ok, but in my opinion it’s too structured, closed and basic – I mean 1 third of the AS grade is multiple choice with the rest being essay questions that I feel are not possible to write a good answer to with the time limit you have. Hopefully A2 economics is better.

Hope to post again soon!

Quantative Easing – A Discussion

I intend to evaluate the potential success of the new policy of quantitative easing. I have an earlier post on my blog where I explain what this actually is, which you may want to read first as this gets quite advanced.

The current problem the UK faces is aggregate demand is very low, particularly in the areas of consumer spending and investment. With these 2 large parts of AD down, as well as exports (due to the economic problems being worldwide) this means we are operating at point A on the diagram below.

Here output is way below the optimum level, and at point R these will be large numbers of unemployed people. In fact there are officially 1.97 million out of work at the moment and this is predicted to rise to 3 million as firms lay off more workers.

The more traditional methods of lowering interest rates and increasing government spending will have some effect, but probably not enough.

Government spending is part of AD, and so increasing this will increase overall AD. Furthermore cutting interest rates to their current of 0.5% will also help by discouraging saving and encouraging borrowing and investment.

The problem is both these methods have long time lags, and so it could be a while before any results show. In addition they probably won’t have enough effect, and could boost AD to AD2, where R2 is the real output. Although this is good as this should increase employment, one can clearly see AD2 is not high enough. At point B we are still operating well below maximum output, which could be demonstrated as being inside the production possibility frontier. At these points the price level is low (shown as below 0%), and it is likely we are going to go into a period of deflation (a sustained decrease in the general price level), because of the low AD and weak pound caused by lowering the interest rates.

It is this fact that makes quantitative easing a plausible method of action, because inflation wouldn’t be a bad thing at the moment. As the general rate of inflation is low or even negative, there is not much of a risk of hyperinflation such as in Weimar Germany in 1923, as long as the policy makers are sensible. If quantitative easing was done when AD was much higher, it could be disastrous for the UK economy and so now is the best time to do it.

Quantitative easing means the Bank of England will buy assets in the market. And therefore, if it’s buying government bonds, it’s taking government bonds out of the market and putting cash into the market. And it normally starts off by buying those from banks, which increases the amount of money that banks have available to lend to companies and households in the wider economy.

Consider the below diagram demonstrating demand and supply, modified for the market for loans and mortgages. With the interest rate being cut to 0.5%, more money will be demanded as it is cheaper to borrow. However there is a situation of excess demand, where mortgages and money are wanted by businesses but banks are not lending hardly any at this rate due to their amounts of toxic debt and fears of collapse. Hence, Q3 amount of money is demanded, but the banks are only lending Q at the new interest rate, which is very low.

With banks given more money, they should be able to increase their supply of lending, to S2 from S1. This, in theory, should create a new equilibrium with Q3 demanded and supplied, at 0.5%. This is exactly what the economy needs. People who want money can generally borrow it, and a lot more occurrences of lending will occur (Q3).

Now let’s look at the effect on the economy as a whole. With interest rates low, and importantly quantitative easing allowing banks to lend money, the consumption and investment components of AD (C+G+I+(X-M)) will increase, boosting AD to AD3. This has the effect of increasing real output and therefore employment in the economy and crucially bringing us back into inflation, over the 0% line.

It is important to note quantitative easing should be only used to boost AD to point C or thereabouts. At this point inflation is at the Bank of England 2% target, and this avoids this risk of running into damaging higher inflation rates. In addition, at point C there will be some unemployment, but I think this doesn’t matter, because I see inflation as the more important factor at this time, and those unemployed will be the least attractive to employers. The government should focus on educating these people to increase our long run aggregate supply curve. This would have the effect of increasing unemployment but not bringing about more inflation which is good for the economy. LRAS shifts to LRAS2, P1 moves to P2 and employment and real output increases.

Of course, this is all in theory, and there are many ways in which it could go wrong. The main one I think is if banks keep the money they get, and don’t lend it out. The Times has reported recently that more than £800 million of taxpayer bailout cash injected into Royal Bank of Scotland has been earmarked to shore up the bank’s gold-plated staff pension schemes including the infamous £703,000-a-year payout pledged to Sir Fred Goodwin. This I think is the real threat of quantitative easing. More money isn’t being lent out, and all the government gets in return is a huge government debt and inflation.

Leading on from this, there is also a chance the government miscalculates the amount of money it needs to ‘print’ and we go into high inflation. However I think this is less likely than the first scenario as we are currently in deflation – a long way away from high inflation.

In conclusion I think the current policy of quantitative easing the right one, and could really help us get out of recession if done correctly and the system works. The reason for this is it will boost aggregate demand, especially as it is coupled with extremely low interest rates. It is quantitative easing that, after all, ended Japan’s ‘lost decade’ of deflation and low growth, where other policies failed to work. With this example to work on, policy makers should utilise it correctly. The main problem I think is the chance banks might hoard the cash and not lend it out, and action needs to be done to enforce this not happening. There is also a problem that the policy, of course, won’t have an immediate effect, and we are stuck in recession for a long time. However I don’t feel there are any real viable alternatives.

The alternative options could be things like a massive redistribution of wealth, a nationalised banking system or even negative interest rates (as discussed in an earlier post here). But all are much more complicated, extreme, unpopular and risky.

Therefore I believe the current policy of quantitative easing is the best one to pursue, and it has a chance of getting us out of depression if coupled with monetary policy and fiscal policy to increase aggregate demand. However there could be long term consequences of ‘printing’ money in the short term which we will have to face in the future.

Quantative Easing – What is it?

On the 5th March 2009 the Bank of England cut interest rates down to a new record low of 0.5%. However this form of monetary policy is predicted to not really help combat the recession. This is because interest rates as a monetary tool have less and less effect the closer they get to zero per cent. In addition to the problem of the long time lag between any cuts and noticeable results, there is the problem that banks are not lending at the moment, so if someone wants a mortgage at this low rate, they probably could not get one. The exact reason why is complicated, but is partly due to the massive amounts of ‘toxic debt’ the banks have on their balance sheets. However the main announcement of interest on the day was that the Bank of England intended to start ‘quantitative easing’ where £75 to £150 billion of money will be created and injected into the financial system. The day the plan was announced the Times business and city editor, David Wighton said “Are you ready for some quantitative easing? It won’t hurt. In fact, you probably won’t feel a thing. At least for a while. Given time, however, it should help to get things moving.” Quantitative easing refers to when a central bank, in our case the Bank of England, creates money ‘out of thin air’ to inject into the banking system to increase the money supply. This method is most commonly referred to as ‘printing money’ however money will not actually printed; instead the central bank will buy assets – such as government securities (known as gilts) and corporate bonds. The point is the cost to finance this will not be paid for by the government borrowing money, instead the money will be created at the touch of a keystroke. Quantitative easing will (in theory) boost the amount of money in the system so commercial banks will find it easier to lend. Quantitative easing has the same immediate objective as interest rate cuts — to revive lending and spending. But it comes at the problem from another angle. Rather than reducing the cost of money — by cutting the official interest rate — it aims to increase the supply of money. This money is deposited in accounts in private banks. The private banks can then in turn create new money themselves through a process known as ‘deposit multiplication’. ‘Quantitative’ refers to the fact that a specific quantity of money is being created; ‘easing’ refers to reducing the pressure on banks. Quantitative easing was used notably by Japan to fight domestic deflation in the early 2000s. In Japan’s case, the Bank of Japan had kept interest rates very close to zero for many years. With quantitative easing, it flooded commercial banks with excess liquidity to promote private lending, leaving them with large stocks of excess reserves, and therefore little risk of a liquidity shortage. The system is seen as risky because of inflation. Everyone knows about classic examples of hyperinflation such as in 1923 Weimar Germany and modern day Zimbabwe. Both these scenarios arose from printing money, and therefore the Bank of England will need to be careful with how far it goes with this policy. However we are currently going into deflation and the money created is to combat this, not to pay bills or reparations as Zimbabwe and Germany did respectively. This helps explain the “It won’t hurt” as quoted earlier.

The Dubai Bubble?

From BBC News:

Dubai property hits the wall

More than half of the residential and commercial property projects in Dubai due for completion by 2012 have been put on hold or cancelled, a study says.

Property company Jones Lang LaSalle says a lack of funding, job cuts and a fall in population are the cause of the delays and cancellations.

Dubai’s property market has seen a sharp downturn recently after years of rapid development and booming prices.

The report shows vacant office space has doubled in the past six months.

Hotel occupancy rates have also fallen to a five-year low.

Jones Lang LaSalle expects the residential property market to suffer further in the next three months.

Very interesting. I remember watching a programme on Dubai quite a while ago and thinking this is the next bubble. Looking at the huge billion dollar projects, I thought, how on earth is this financed and is this sustainable? The answer is of course oil, but relying on such a volatile resource is risky.

Negative Interest Rates?!

So imagine if interest rates went negative. This would mean money is taken out of your bank account instead of interest being credited to it.

For example:

A negative rate of -1% would mean that someone depositing £10,000 would get back just £9,900 at the end of the year, effectively paying the bank £100 for the privilege of holding their money for them.

It would also affect loans. Imagine if your loans rate was negative.

For example

Interest paid on student loans is the Bank of England base rate plus 1% or the Retail Price Index, depending on which one is the lowest in the month of March.

The base rate currently sits at a record low 0.5%, meaning interest rates will be repaid at a rate of 1.5% currently. With the RPI likely to hit the negative figures very soon (lows of -2% have been quoted by Capital Economics) this would mean that students would get a return of -1.5% interest on each payment they have to make.

In theory, this would mean a standard £3,000 student load loan would be cut to £2,955 after all repayments have been made by the borrower. This means the borrower would save £45, not much but considering that in 2006 because interest rates reached a fifteen year peak of 5.75% the total costs to pay on a £3,000 loan would equate to £3202.50; that’s a potential difference of £247.50 in the space of just one academic year.

Interesting stuff. Perhaps this could help sort the economy out? Surely it would discourage saving, and make it much more attractive to take loans and mortgages out, which means more money spent in the economy increasing aggregate demand.

Unfortunately I see this as not impossible, but a very, very unrealistic scenario. It is a shame us economists cannot test things like these out like scientists do, because I doubt the negative interest rates would even work.

• Imagine the outcry if banks started taking money away from people’s savings. People would be furious, and I can envisage now the front page of the Daily Mail saying how Banks are spending the money on bankers bonuses, parties and so on.
• This could lead to mass runs on banks, with everyone taking their savings out, and moving them elsewhere, be it abroad, into safes (interestingly sales of household safes have soared in the recession) or under their mattresses.
• This means no capital for banks, which means they won’t be able to pay people for having loans out (as discusses with the student loan example earlier). Oops.

The key to this is people would take their savings out of banks, and be angry and lose confidence in the financial institutions. Without no capital, banks can not gain any profits on the negative interest aspect of savings, and more importantly cannot give out loans. The whole chain would break, and instead savings would go down, spending would go down, pound sterling would suffer massive devaluation and we’d also have worse deflation.

A horrible scenario, not dissimilar from Japan’s so called ‘lost decade’ in the 90’s.

With deflation savers actually benefit. This concept can be quite difficult to get your head around, but essentially inflation means savers are worse off, deflation, better off.

Imagine I have £1000 saved. I can buy £1000’s worth of stuff today, but in a years time, say inflation is -5%, the £1000 worth of stuff will be cost £950. I can buy that and have £50 left over. This is the opposite to inflation, such as in 1923 Germany where hyperinflation meant people’s life savings now was less than the price of an egg.

One might argue that this means savers could benefit overall. Perhaps inflation is -5% and the interest rate -3%. This is equivalent to savers gaining +2% overall.

The problem is most people wouldn’t understand this. Imagine trying to explain it to a pensioner for example. Even if you got everyone to understand, one can assume they’d still be angry that money was being taken out of their account each month or year and none was going in.

Negative interest rates are unrealistic and not plausible. They would not work and would probably lead to a lovely combination of negative economic growth, deflation, unemployment and a very weak pound. The recent news that the government are moving to quantitative easing to combat the recession is evidence that negative interest rates are just an idea, and not a serious one at that.

Next post will probably be an analysis of the so called ‘quantitative easing’ policy we will all be hearing and reading a lot more of in times to come.

Rates down to 0.5%

The Bank of England announced interest rates will be cut to half a percent today, in further move to stop the recession.

Personally I think rate cuts lost their effectiveness a while ago, and this is just another blow for savers. Thank god I’ve got a current account and ISA on a 10% fixed interest rate!

We need to move increase fiscal policy and try more radical measures, such as quantitative easing. Extreme times need extreme measures in my opinion. In fact it has been announed the BoE with start quantitative easing today. I need to read up about it, but essentially it is similar to printing money to combat deflation, but they will buy assets – such as government securities (gilts) and corporate bonds, to (in theory) boost the amount of money in the system so commercial banks will find it easier to lend.

Market reacted badly down -2.56%. My trade of the day was with British Land, who were one of the few down yesterday. I thought they’d bounce back and I was right, netting me 5 grand. Shame it’s only virtual money though.

Bought Lloyds at 40.90p at the final minutes of the trading day. Hopefully it will open higher tomorrow.

Xtrata

Much better day for the markets today (04/03/2009), with the FTSE up 3.81%, recovering the falls yesterday.

My Xtrata shares I mentioned buying yesterday were up 15% today. I expect the market to continue to rise tomorrow, perhaps 2-3%.

Been thinking about inflation and deflation today. I’ll probably do a post about it later this week.

More Market Woes

The FTSE 100 closed at 3512.09 points on the 3rd March, down 3% following the 5% fall yesterday. This has extended the the six-year low, on concern banks may have to raise more capital as the global recession deepens. Incidentally I stopped trading with my virtual stock portfolio on Bullbearings.co.uk months ago. With so much turbulence, it takes a ridiculous amount of skill and knowledge (or mainly luck) to make any money on shares currently. Actually I’m going to take a gamble on Xtrata. With them being -44% down today surely there will be some recovery. I’ll post some updates soon. I leave you with a FTSE heatmap. Ouch.

FTSE 100 Heatmap

Sorry!

Forgot about this blog at WordPress and have only been updating at my identical blog at Blogger.

Therefore I’m going to copy my posts accross. Some will be out of date, and I apologize about this, but I won’t forget about WordPress in the future.

Greg.