Economics in Minutes

by Niall Kishtainy

  The housing market

  Housing market trends are a weathervane of the economic cycle. During boom times, with the labour market buoyant, people feel more confident about the future and buy houses. With earnings growing, they believe they will be able to repay housing loans, and at the same time mortgage providers are keen to lend money – so house prices rise ever higher.

  Conversely, when the economy falters, people lose confidence and housing demand falls, arresting the price rise. Problems in the housing market were at the root of the global economic crisis that began in 2007. In the United States in particular, economic growth and the housing boom were driven by a confidence that eventually turned out to be misplaced. Rising housing demand was met by ever more liberal lending – borrowers who could only afford to cover their interest payments were being offered loans on the expectation that house prices would continue to rise. When the bubble burst, the housing market became the mainspring of the crisis.

  GDP and happiness

  In Bhutan, economic progress is measured in terms of national happiness rather than national income.

  Gross Domestic Product is the most popular measure of a nation’s economic fortunes (see GDP and its components). But increasingly, experts are asking whether it is the best indicator of well-being. For one thing, the fruits of an economy are not always evenly distributed among the population, but a more fundamental question is how closely material wealth relates to well-being.

  American economist Richard Easterlin looked at surveys of people’s reported well-being and found that although there were correlations between income and happiness, the picture was complex. The richest countries weren’t necessarily the happiest, and in some countries rising income did not equate to rising happiness. One explanation is the ‘hedonic treadmill’: people psychologically adapting to higher standards of living until they feel normal. Income is still an important determinant of well-being, but this new approach has prompted the invention of broader measures of well-being encompassing life expectancy, health and education as well as income.

  Stabilization policy

  To maintain steady speed, a motorist takes her foot off the accelerator when going downhill and puts it back on when going uphill. Stabilization policy is based on an analogous view of the economy. When the economy enters recession the government can stop output and employment falling by pumping in money. During a boom, as the economy races ahead and generates inflation, the government can slow it by taking money out. Just like the steady driver, active stabilization policy can smooth the ups and downs of the economic cycle.

  Stabilization can be done with fiscal policy (government spending and taxation) and monetary policy (interest rates and money supply). However, stabilization policy has been criticized: some doubt these policies are effective controls on economic output, and even if they are, the effects may come with a delay. Such lags, alongside the unreliability of economic forecasting, mean that by the time stabilization measures take effect, conditions may be very different from those planned for.

  Monetary policy

  Monetary policy is concerned with government control of the money supply: too little money hampers economic activity, while too much can stoke inflation. The government creates money by printing notes or by supplying deposits to banks who then lend out a proportion of these. Governments can also influence the money supply by setting a minimum proportion of deposits that the banks must keep as cash (see Money creation). If this ratio is increased, then deposits create less lending and so less money.

  The banks can increase their deposits – and hence the money they have available to lend out – by borrowing from the central bank, but when the central bank increases the interest rate it charges, the money supply is restricted. Finally, the government can extract money from the economy by selling bonds to the public – to increase money it buys back the bonds. Controlling money supply is difficult, since it can also be influenced by the behaviour of individuals and banks beyond government control.

  Quantitative easing

  The manipulation of interest rates forms a central plank of monetary policy: often during downturns, governments lower interest rates to invigorate the economy. But what if rates are already so low that they can’t be cut further, as happened in some countries during the recent economic crisis? Quantitative easing (QE) is an alternative means of loosening monetary conditions by rapidly increasing the money supply.

  The central bank effectively creates cash and, by purchasing financial assets such as government and corporate bonds, injects it into the economy. This lowers ‘retail’ interest rates faced by consumers and firms, boosting the economy. QE is a variation on a more traditional form of monetary policy known as ‘open market operations’, in which the central bank deals in short-term government bonds: with QE a broader range of assets are purchased. Since its primary aim is to bring down borrowing costs, QE should be distinguished from the printing of money merely to finance government spending.

  Fiscal policy

  British economist John Maynard Keynes advocated the use of fiscal policy as a tool for managing economic cycles.

  Fiscal policy concerns itself with government spending and taxation, and Keynesian economists in particular argue that it can be used to help pull economies out of recessions. If a government spends more or taxes less, aggregate demand rises, boosting output and lowering unemployment. By cutting taxes or raising spending, it harnesses a multiplier effect (see The Keynesian multiplier) – a boost to demand that is larger than the spending rise or tax cut itself because the extra money gets spent many times over as it circulates around the economy.

  Some economists are sceptical about the usefulness of fiscal policy. They doubt whether increased demand can really raise output, particularly in the long run. They also argue that higher demand as a result of government spending ‘crowds out’ private investment, because high demand pushes up interest rates and dampens investment. In the wake of the recent economic crisis, the debate about the effectiveness of fiscal policy has re-emerged with a new urgency.

  Policy discretion versus rules

  When Ulysses sailed towards the sirens, he ordered his men to tie him to the mast of his ship. Ulysses wanted to hear the sirens’ song, but knew it was so intoxicating that if he was in control of the ship he would sail to their island and crash on the rocks. He knew the best outcome – keeping control of his ship and hearing the song at a safe distance – was impossible, so the best thing would be to relinquish control.

  Some argue that economic policy faces the same sort of dilemma. Like Ulysses in control of his ship, full discretion over policy by government is self-defeating. The government promises to deliver low inflation one year, but the following year the temptation to pump up the economy to increase employment will be irresistible, resulting in higher inflation. Some recommend that the government ‘ties itself to its mast’ by committing to a fixed policy rule, come what may. One way of doing this is to hand over the levers of policy, for example, to an independent central bank.

  Monetarism

  Monetarism is a school of economic thought that stresses the importance of the money supply. Led by the American economist Milton Friedman (opposite), monetarists argued that in the short run there was a link between the money supply and economic output, but in the long run more money would simply lead to inflation. Attempts to fine-tune the economy through active monetary policy – boosting the money supply during downturns, for example – would be futile: even though there might be some short-run impacts, the lags between different variables would make it hard for the government to successfully harness the effects and in the long run the result would be higher inflation. Monetarism says that rather than fiddling with the money supply in response to the economic cycle, governments should set a fixed level of money growth and stick with it regardless of economic conditions. This was tried for a time in the 1980s, but it proved hard for governments to control the money supply quite so strictly.

&
nbsp; Inflation targeting

  During the 1980s, many countries’ monetary policies were based on targets for growth of the money supply that proved difficult to hit. Since a key aim of the targets was to achieve a stable and appropriate rate of inflation, why not target inflation directly? US economist John Taylor proposed an inflation-targeting rule based on the adjustment of interest rates by the central bank in response to economic conditions.

  Suppose the inflation target was 3 per cent. The rule would require a rise in the interest rate if actual inflation exceeded 3 per cent. This would cool the economy and bring inflation down towards its target rate. The rule also required a rise in interest rates when employment was above its long-run ‘natural’ level, and a decrease when it was below it. In recent decades many central banks adopted policies along the lines of the Taylor rule. Some economists argue that this fostered the relatively stable, low inflationary economic environment that lasted up until the economic crisis that began in 2007.

  Inflation targeting in New Zealand, 1988–2008

  Targeting policies frequently aim to keep inflation between upper and lower limits.

  The Lucas critique

  In the 1970s, US economist Robert Lucas criticized standard economic policy in what came to be known as the Lucas critique. This formed part of a school of thought that introduced ‘rational expectations’ (see Rational expectations) into economics. Lucas pointed out that policy is devised assuming stable relationships between variables – for example, that lower unemployment goes with higher inflation. He argued that the introduction of a policy would actually change the relationships forming the basis of the policy. This is because people, having rational expectations, would accurately anticipate the impact of the policy and change their behaviour accordingly, often undermining the original goal of the policy. For example, if the government tries to boost employment, people anticipate the higher inflation that results and realize this will reduce their real wages, discouraging them from working more. The critique, while fundamental, depends on rational expectations, an assumption that some call into question.

  Crowding out

  One prescription for curing recession is for government to spend more: the hope is that this leads to a large enough boost in demand to stimulate growth. However, government spending can have knock-on effects that counteract the higher demand. The danger is that public spending can displace private spending if the former is a substitute for the latter. If so, then the increased demand caused by government spending might be partially or fully neutralized by a fall in some areas of private-sector spending. Even spending on defence and roads – public goods that can’t easily be carried out privately (see Public goods and free riding) – can lead to crowding out. The increase in aggregate demand causes interest rates to rise as more money is demanded by individuals and companies. Higher interest rates dampen private sector investment, so the initial boost to economic activity is offset. The issue for economists, then, is whether crowding out is a large enough effect to completely dissipate the impact of government spending.

  Supply side economics and the Laffer curve

  During the 1980s, government policies to manage the level of demand in the economy fell out of favour. The focus shifted to enhancing the supply side of the economy – that is, to making firms and workers more productive. One idea was that high taxes blunted incentives and so hobbled the supply side – the implication was that cutting taxes would stimulate the economy. American economist Arthur Laffer proposed a relationship between the tax rate and government revenue that came to be known as the Laffer curve. One might expect a cut in tax rates to reduce government revenue, but in fact the Laffer curve suggests this might not always be the case. When taxes are very high, people have less incentive to work and so economic output is restricted, lowering tax revenue. From this point, a reduction in the tax rate is outweighed by the increase in output that is stimulated, so increasing overall tax revenue. In practice, things aren’t quite so simple and supply side policies often involve broader measures such as regulatory reform and privatization.

  Ricardian equivalence

  A government can fund spending by borrowing or by raising taxes. Keynesians believe that governments can pull economies out of recessions by borrowing and then spending the proceeds. Purely tax-funded spending would not be effective because the spending boost would get offset by the tax hike. The theory of Ricardian equivalence, named after the 19th-century English economist David Ricardo (opposite), contradicts this reasoning: it says that the way a government finances its spending makes no difference. In particular, individuals will not respond to a boost in public spending funded by borrowing because they anticipate that the government will have to raise taxes later to repay its loans. Recent versions of the theory have shown that, for Ricardian equivalence to hold, people must be rational and make precise calculations about their future consumption and the likely impacts of government policies – conditions that are unlikely all to hold in practice. Nevertheless, the theory raises useful questions about the possible limits to government spending and borrowing.

  Independent central banks and time inconsistency

  In recent decades, many countries have elected to make their central banks independent. When central banks come under government control, monetary policies (interest rates and the money supply) are drawn up by politicians. Under independence these policies are set by a non-political committee of experts. The argument for independence comes from the insight that in achieving the aims of monetary policy, government is often its own worst enemy. Suppose that the government promises to keep inflation low. Such a promise is not credible because the government dislikes unemployment: it will end up boosting demand to reduce unemployment, and therefore pushing up inflation (see Policy discretion versus rules). Individuals expect inflation to be higher, and anticipate that higher wages will be offset by higher prices, so the demand boost has no effect on unemployment: the outcome is just higher inflation. In this situation, the aim of low inflation is said to be ‘time inconsistent’. Giving power to an independent committee that people believe to be committed to low inflation is one way of resolving the policy conflict.

  Budget deficit and surplus

  When a government spends more than it collects in taxes, it runs a budget deficit. When tax revenues exceed spending, it has a surplus. As an economy goes into recession, unemployment rises and welfare bills go up, while at the same time tax revenues fall as economic activity declines, so the budget tends to move into deficit. Conversely, during booms tax revenues are high and total welfare payments low, generating a surplus (see Automatic stabilizers).

  The portion of the deficit caused by the economic cycle is the cyclical deficit. Over the cycle, such deficits should be offset by surpluses. The structural deficit, meanwhile, is the part of the deficit that goes beyond cyclical factors. It can arise if the government makes infrastructure investments that are not funded out of tax. Economists take different positions on the budget: some believe deficits are a useful way of fine-tuning the economy; others worry about the debt that builds up through continued deficits.

  The relationship between deficit and debt

  The balanced budget

  Politicians often extol the virtues of ‘balancing the budget’, ensuring that government spending equals tax revenue so that there is no budget deficit or surplus. A strict version would have the budget balance in every year, but this is hard to achieve: the budget automatically goes into deficit during a downturn as the government has to spend more on unemployment benefits while collecting less in tax, reverting to surplus during periods of high growth.

  Most economists would not advocate balancing the budget year by year. Some recommend balancing it ‘over the cycle’, meaning that apart from these cyclical effects the budget stays in balance. Deficits imply a build-up of debt that future generations have to repay. They mean that less resources are saved, leading to higher interest rates and lower investment. Other economists
are much more sanguine about deficits, arguing that cuts to certain kinds of expenditure, such as health and education, might actually reduce growth.

  Government debt

  It is sometimes said that a country is like a person: it must live within its means and pay back its debts. One difference, though, is that an individual retires and dies, but a country produces indefinitely: this means that countries don’t have to wipe clean their debts. A country’s debt is sustainable when it can meet today’s interest and other payment obligations, and it can do this if its debt stays at a reasonable proportion of GDP. As long as its economy expands over the long run, it can take on more debt.

  Problems arise when the share of debt in GDP is so high that the government is unable to repay. Even before this, though, there are reasons to be concerned about the build-up of debt: it allows more consumption today, but less gets invested, hurting future generations. Some economists argue that debt doesn’t even make individuals consume more today, because of their expectation of future tax rises. Too much debt may also stoke inflation, or damage a government’s creditworthiness.