Sunday, 19 April 2015

Stop hammering nails in with shoes: Why debt is good and unsustainable debt is bad.

If you watched the recent UK election debates you would have seen that the most pressing issue facing the UK appears to be tackling the UK debt. When we hear the word debt we have all these negative connotations: people going bankrupt, falling into poverty and generally being irresponsible with their finances.  This means debt must be bad right? However, we need to make a distinction between unsustainable debt and debt. 

Unsustainable debt is when you owe someone something but you may not be able to pay it back – this is bad. Debt just means you owe someone something – this is neither good nor bad. In fact, I am not sure I would like to live in a world without debt…

Imagine a world with no debt

To understand why debt can actually be good, imagine a world where there is no debt (this was one of the lyrics to a popular John Lennon song until he realised how bad a world without debt would be). So in this world, no one can borrow any money. What you have in your bank is all you can use to pay for things. On the face of it, this seems great: no one will become bankrupt, no maxed-out credit cards and everyone has to be financially responsible. However, what if you wanted to start a business?  What if you wanted to buy a house? Well the way to go about it would be to save up for years and years before you have enough money. This sounds like a responsible thing to do surely?

The important thing to remember here is that without debt you won’t get any interest on your savings. You would just be stockpiling money under your bed; the money would sit there and do nothing. Banks would only exist as a safe place to store your money. It would actually cost you to store your money!  And if inflation happens you are completely screwed.
In reality, there is a reason why banks give you interest on your savings. This is because they are able to lend your savings out to people who want to borrow. 

People talk about having debt as being like a “slave” to the lender, that the lender owns you. But it might be better to think of it as savers investing in you. These savers are the lenders. They don’t want to own you: they want you to succeed so they can get a return on their investment (or interest on their savings). If you go bankrupt and can’t pay the money back it isn't good for the lenders because they cannot retrieve the money they invested in you!  This is why economists talk about savings being essentially investment, without this, the economy won’t move forward. Without debt some of the UK's most successful companies would never have been created as most entrepreneurs start out with just a small business loan.

In a world without debt, the only way you could obtain finance would be via a gift. So unless your Mummy or Daddy have enough cash to give you to start your own business or go to university, then it isn't going to happen.

What about government debt, isn't that too high?

The UK Government debt is currently £ 1.51 trillion. That is 1,510,000,000,000. Wow, look at all those zeros! It is too high, we are in too much debt - PANIC! Quick, what is the number for that company who consolidate your monthly loans?

OK, deep breath…and calm. We have seen that debt isn't a problem as long as we can pay it back. In fact, debt can be quite good. What matters is the relative size of the debt compared to your income.

Imagine if I told you I was going to buy a house for 2 million. You would think that debt is pretty high. But if I told you I was a professional footballer earning 6 million a year then you would think that 2 million doesn't seem so high after all.

But wait, what is the income of the government? Well, the income of the government comes from tax.  What affects how much tax revenue you get is basically how much the economy is growing. Think about VAT, the more purchases there are within an economy (which would increase if the economy is growing), the more the government will take a part of whatever is spent.

So what matters is not the size of debt for governments, it is the size of debt relative to output. Economists call this the debt to GDP ratio. But for use we can think of it as the size of the government debt to the government income (from now on, whenever I refer to output, think of government income).

The output of the economy is standing at £1.7 trillion. That is 1,700,000,000. Wow, look at all those zeros, we are rich, rich I tell you! We have so much money- PARTY! Quick what is the number for a travel agents?

As you can see, thinking of the debt in absolute terms is a silly as looking at output in absolute terms. This is why we should always talk about debt in the context of our ability to pay it back. Talking about debt without talking about income is like a Saturday night ITV show starring just Ant (apologies to non-British readers).

So looking at the debt as a percentage of output, the total debt is about 90% of output. The big question is this debt level unsustainable? Italy has been running with this percentage of debt to output at over 100% since the 1990s. So what is the right level of debt to output? This is a bit of a tricky question and if you are interested you may want to read this. But let us just say that our current level of debt to output is unsustainable debt and we need to bring it down.

So how do we make this debt to income ratio smaller?

There are two main ways for governments to decrease the size of debt as a proportion of income. One is to stop borrowing as much and start repaying back the debt. This is why the coalition government has been saying we need austerity. In other words, we are going to have to stop borrowing as much and cut some of our government spending so we can start repaying back the debt.

This is why politicians are saying they want to “balance the books“ and reduce the deficit. The government deficit is just like a bank account. If you spend more than you earn you have to borrow. So any defect adds to the total amount the government owes which is the total government debt. The coalition government has reduced the deficit, but they are still having to borrow to fund the deficit and hence are increasing the overall level of debt.

However, there is another way to decrease the proportion of debt to government income - increase output. As mentioned previously, increasing output increases the government’s income. And the way a government can increase economic growth is for the government to spend.

But wait, hold on a minute, isn't this a contradiction? I have just said that governments can fix the debt to income problem by cutting spending and also by increasing spending.
This seems a little counterintuitive so let’s think of it as an example. Say you are a builder with unsustainable debts and you want to bring that level down relative to your income. 

One way to fix this problem is to stop spending as much on your building materials and tools. This seems sensible, but what if you get offered a job to build a new house. You don’t have enough cash to buy a hammer so what do you do? You could try and hammer nails in with your shoe, but borrowing a little more now to get a hammer would be much more effective in the long run. This will increase your income and hence your ability to pay back the debt.
So what should we do? Cut or spend? Well this all depends on how much of a problem the debt to income ratio is…

But who decides what level of debt to income becomes unsustainable?

The people who really decide whether this becomes unsustainable are the people who lend the money in the first place. The government’s logic for austerity was that if we didn't show a commitment to paying back the debt now the markets would get worried we couldn't pay the cash back and it would become really expensive for the UK to borrow any more. This is what happened with Greece, the market (lenders) were worried that Greece’s debts were unsustainable so charged Greece a higher price to borrow.

This is what the “calming the markets” arguments is all about. But as I said, if I am a lender, I really want you to pay back the money to get a return on my investment. If I force you into bankruptcy by paying back the debt too early than I am not going to get my money back at all! Greece has had austerity for a long time now and it is still struggling to meet its debt obligation. This is why the leather-jacket wearing Greek economist Yanis Varoufakis  has tried to achieve a debt repayment based on when they start growing and earning an income again.

How fast do we need to repay back the debt?

This really is the key question. When the crisis hit in 2008, this made our debt go up (we had to borrow more to bail out the banks etc.) and we also entered a recession (growth in output was falling).

I remember watching David Cameron in the 2010 TV debates arguing that the debt was too high and we had to pay it back. This obviously was annoying to me as he failed to mention what the cut in government spending would have on our income, hence our ability to pay back the debt.

On the face of it, it seems like Cameron’s argument is the most sensible argument, have a quick burst of pain, like ripping off a plaster, and move on. British stiff upper lip and that sort of thing. Unfortunately, no party said what effect cutting the government spending would have on output, and hence government income, on the economy.

Austerity’s effect on growth is as much use as a cold shower is to a broken leg. This is especially so when our air conditioning is switched off and interest rates are already as low as they can go. (As an aside, I feel there is an element of hypocrisy if you are arguing that government debt is bad but at the same time encouraging private borrowing by setting interest rates close to zero).

Mr Cameron went on to compare the economy to a household that when faced with hard times had to cut back a bit. If only someone took this analogy one step further and said that if the income earner was a builder then cutting back might actually be like trying to hit a nail in with a shoe then we may have not had such a long recession.

We cannot pay back the debt back straight away. Even under the Conservatives plans it will take till 2030 to get the debt to output ratio back to the level of when the financial crisis hit. We may have ripped off the sticky plaster with austerity but the debt wound has not healed.
Debt is not a short term thing, recessions, however, are a lot shorter in comparison. This is why myself and most other academic economists think the coalition was wrong in their plan to impose austerity.

What I am really concerned about is that this view has not been broadcast to the public as the media has generally spouted the view of government. However, this is another blog for another time but if you can’t wait for my next blog, see Simon Wren Lewis.

In a nutshell

Debt is not a problem, only unsustainable debt is. Do not let anyone talk about debt without mentioning income -it is completely meaningless. If the current government debt to government income is unsustainable, then we need to bring it down. How fast we bring it down should depend on circumstances that we currently face. As we currently face a problem where interest rates are ineffective (our air-conditioner is off and it is getting colder) it is not the time to fix the debt.

Wednesday, 1 April 2015

Air conditioning is useless when it is cold: Why zero inflation is not "good news".

George Osborne tweeted recently that zero inflation is "good news". Prices not rising can only be good thing surely? But if zero inflation is so good then why is the target rate of inflation set at 2% inflation, why not 0%? And also, didn't George Osborne recently reconfirm the inflation target of 2% in his budget? 

In short, zero inflation is not "good news". George Osborne is hoodwinking you and making you look like a chump.

Although there are some great bloggers in the UK discussing this issue (see Tony Yates and Simon Wren Lewis), their blogs may be a bit advanced for those who have not suffered through an economics course. This blog is for the man/woman on the street, a person who doesn't know economic jargon but cares about what is happening to the economy. So with this in mind, let's start with some basics...

What is Inflation and why is it bad?

Inflation is the average rise in prices within an economy. If a pint costs £5 and inflation is 100%, the price of a pint of beer is likely to rise with inflation and now costs £10 (I teach university students who for some reason seem to have a good grasp on the price of beer). If your wages stay the same then it is a bit like getting your wages cut in half! In a similar way, inflation is also bad for savers as if you have £50 in your bank account you can now only buy 5 pints instead of 10. On the other side, inflation can be good for people with debt, it is analogous to paying less back than you borrowed. Most importantly, understanding inflation ruins your Grandparent's stories of going to the pub with a penny and leaving with 2 thrupney bits.

So this means deflation is good right?

Deflation is the opposite of inflation - it is the average fall in prices. If a pint costs £5 and inflation is minus 50, your £50 in your bank account can now buy you 20 pints! This seems brilliant right? Well this is what George Osborne and a lot of the media have been saying. But it does beg the question if deflation is so good why not set the target rate of inflation to minus 2% rather than the current 2%?

The first reason is to do with wages. If your wage stays the same then deflation will be good for you. But it is likely that firms will want to start cutting your wages if prices start to fall. If you have wage cuts of 2% and prices fall by 2% then nothing has really changed for you. This is why you should try and get a wage rise at least in line with inflation or you will be worse off than you were last year! 

In reality, people really don’t like having their wages cut. I think people would generally prefer a wage rise to prices falling, but this is possibly down to individuals not understanding economic phenomena. Economists call this "downward wage rigidity", or in other words, “what the hell is deflation - get your hands off my wages?!”

You may say that deflation is better for savers, as prices are falling the money in my bank account can buy more stuff. If I am borrowing money, however, it means I will have to pay relatively more back. But again, this all depends on what interest rate you are getting on your savings.

To really understand why the current situation of 0% inflation is bad, however, we must first describe what is behind these average changes in prices.

What causes inflation and deflation?

Inflation can be caused by either (or a combination of) too much demand in an economy or too little supply. Deflation occurs for the opposite reasons: too little demand in an economy or too much supply. This is probably best explained with an example of someone who makes and sells cakes for a living.

Let’s say you go to market to sell your cakes. You have a steady flow of customers but then people start getting really hungry and you have a massive queue for your cakes. You may think about charging as much as you can get away with and raise your price for your cakes to make more profit.

But what if the next day you go to the shop to buy ingredients for your cake but you find that the flour has doubled in price. As this raises your costs it reduces the amount of cakes you can make (hence supply decreases) and so you may have to increase your price. Now if this is happening to a lot of business throughout the economy we will see the average price rise and hence inflation. This analogy can be reversed to describe how deflation works.

One of the reasons why we are experiencing zero inflation at the moment is due to an increase in supply due to oil prices falling (think of flour becoming cheaper in the previous example). As a lot of products use oil (from oil comes petrol – think transport costs falling), this will mean companies can cut prices (they may not want to cut their price but if a competitor does in order to capture the market they will have to follow).

So what is the problem? Well, our cake seller is having a hard enough time setting their price to deal with their own changes in demand and supply so having to deal with average price changes - that are nothing to do with the quality of the cakes or the way the cakes are advertised - is really annoying! We really need someone to sort out all these average price changes in an economy so that cake makers throughout the land can predict these movements in average prices. Cue, the Bank of England...

What does the Bank of England do?

The Bank of England tries to control inflation by affecting interest rates. Their objective is to hit a certain target of inflation. Imagine the Bank of England is like air conditioning and the target rate of inflation is that sweet spot - not too hot and not too cold. If it is too hot (inflation is above target and prices are rising too fast) you turn the air condition on full blast to cool the economy. This would be equivalent to increasing interest rates – saving becomes increasingly more attractive to borrowing, so people spend less and prices fall. If, however, it starts becoming cooler (and inflation is looking like it is falling below target) we start turning down the air conditioning. This is equivalent to cutting interest rates and borrowing becomes more attractive. This tempts people to spend more and makes prices rise. Changing the interest rate in this way is what economists call monetary policy but for our purposes we can think of it as air conditioning.

Why is 2% the “perfect temperature” and why not 0% if inflation is so bad?

What really matters is that there is a target inflation rate and the Bank of England can consistently meet that “sweet spot” temperature. The perfect temperature can be subjective, but what we can all agree on is that it shouldn't change a lot and it is predictable - you don’t want to be having to put additional layers on and taking them off all the time! You want the temperature nice and constant. This is just like having an inflation target, we want a constant level of inflation so it becomes easy for us to predict what inflation will be (or what we are going to wear).

One of the main reasons why 2% is the target rate of inflation is that it becomes easier to keep the temperature nice and constant. If we set it at 0% (which is what Andrew Sentance would like) we may end up in the situation where we have switched the air conditioner off but it is still getting colder. In other words, interest rates are zero and they can’t get any lower. The worse case scenario is that we end up in a deflationary spiral. If prices start to decrease, wages decrease. This will then cause prices to decrease as people have less money to spend and the process starts over again spiraling down.

What makes this notion of a 0% inflation target an even worse idea is that interest rates are already near zero now and prices are falling. This is a bit of a problem because even with a 2% target our air conditioner is off and it is getting pretty cold. This situation is described by a rather abstract sounding economic term called the zero lower bound (ZLB). I think we need to rename it to something like “air conditioning when it is freezing (LOL)”.

Can we not just turn the central heating on?

As the air conditioning of the economy (interest rate changes) is ineffective when it is freezing outside, we may want to think about turning the central heating on. The central heating in this case is government spending. This can be in the form of tax cuts or building new hospitals and schools in an economy. This essentially creates more demand in the economy (if you get a tax cut you may start spending some of that money, building a new hospital creates jobs and new businesses will pop up in the area).

But are we not in massive debt? The government says that we cannot afford to spend any more as the debt is so high! This argument seems to have become the accepted view in the UK despite it being untrue - much to the dismay of myself and most other economists. Paul Krugman sums it up pretty well. Basically, the US is more informed than the UK...

Although this will take another blog to explain, the simple answer is that debt is a long term problem and this freezing temperature is short term. We should turn on the central heating (government spending) while it is cold and when we get back to normal temperatures we can start using air conditioning again (interest rates). Once temperatures are normal again we can start repaying the debt. Also, if prices do end up falling, this will make the debt harder to pay back anyway. If you can't wait for my next blog then you should read this and this.

Can we change the “sweet spot” temperature?

In the longer term it could be the case that changing the “sweet spot” temperature to a slightly higher temperature may be a better idea. This is so we can ensure air conditioning never becomes ineffective. This is what Tony Yates argues and advises that the inflation target should be increased to 4%. 

But wait, didn't we decide the “sweet spot" target is an inflation rate of 2%? Well, as I described earlier, the “sweet spot” temperature is one that doesn't change much and is predictable. If it is a little warmer I can just take a layer off but at least I know I won’t have to keep putting stuff on and off again! This doesn't mean that Tony loves inflation, I am pretty sure he would be just as annoyed if inflation was 2% under or 2% over the target rate. 

Jeremy Warner thought this was a ludicrous idea suggesting that raising the target will just raise inflation and as inflation is bad, raising the target would be a bad idea. However, this misses the point entirely, it would take a long time to implement this new target. It is not a short term solution to current freezing temperatures (unlike government spending).

One of the main reasons why the Bank of England controls air conditioning (interest rates) is that their sole purpose is to hit the “sweet spot” temperature by hitting the inflation target. 
Basically, if the Bank of England cannot guarantee that they will be able to hit that “sweet spot” temperature, we will stop believing them when they say that this particular inflation target is what they are trying to achieve. If this starts happening, and the Bank of England loses credibility, then our air conditioning unit will become faulty and it will take a long time to repair.

Is there any other way we warm the place up a bit?

We could warm up the place by creating demand with quantitative easing (I never like the phrase quantitative easing, it sounds like a laxative marketed towards accountants). It is fairly complicated to understand the inner workings of it, and not essential to this post, but it is basically creating money to increase demand within an economy.

I may have stretched my analogy a bit far but let us say that quantitative easing is like starting a fire in the house. Sure it may get you warm, and if controlled properly it unlikely to set the whole house on fire (despite some peoples worries). However, quantitative easing isn't a tried and tested method; it is very difficult to know how much the temperature will rise when starting a fire compared to central heating (government spending) or air conditioning (monetary policy). 

In a nutshell

If we think of the Bank of England controlling inflation like an air conditioner, then current conditions means that it is so cold out the air conditioning is switched off and it is getting colder. We need to increase the temperature by increasing demand. Personally, I think turning the central heating on by increasing government spending is the best option until we can get to a temperature where air conditioning can be used again. For a long term solution increasing the “sweet spot” temperature by increasing the target rate of inflation might be a good idea so we can always use air conditioning. This is because turning the central heating on always causes arguments... just like increasing government spending.