Macro Revision: Putting Things in Context

I always ask of my students that they try to put policy issues and decisions into context. The effective use of context - either in a domestic or external setting or using recent history as a guide can greatly improve evaluation marks in exam essays. Our aim in a revision session today was to build some of that context with respect to some of the key issues facing the UK economy.

A starting point was the short and medium-term impact of the recession and how this is shaping the strength and pattern of recovery as we head through 2011 and into 2012. As befits an open economy heavily integrated into the European and global economic and financial system, many key recent developments on growth, jobs, inflation and trade are impacted by external demand and supply-side shocks and headwinds.

The Legacy of a Recession

The 2008-09 recession was deep and we started by looking at some of the consequences:

a) High unemployment - lower than the jobless peaks of previous downturns but still a major policy issue - with 8.5% of the labour force out of work, amounting to 2.5 million on official figures. Hidden unemployment understates the true scale of the problem, part-time unemployment is rising

b) Long term structural unemployment (people out of work for at least a year) - now over a third of the total, with a particular focus on youth unemployment and deep-rooted unemployment in certain regions and industries. Many older unemployed people have little chance of finding fresh work. The estimated NAIRU has risen to aroud 6% of the labour force. For some economists this modest rise in the natural rate is relatively welcome news - it has grown more steeply in previous recession.

c) The recession has dealt a blow to consumer confidence (falling wealth, rising unemployment, declining real incomes, the prospect and reality of higher taxes). That said business confidence has rebounded well, indeed corporate finances (outside of the financial system) look healthy, there are many cash rich businesses out there. However weak consumer sentiment will hit short term growth and subdued domestic demand will do little to generate enough extra spending to promote job creation.

d) The impact of the steep decline (more than 25%) in the real level of business capital investment - capital spending is recovering but has a long way to go to reach pre-recession levels - this will limit productivity growth in the years ahead.

e) The legacy of high government borrowing (UK budget deficit = £155bn 2010-11) and (by modern standards) dangerously high levels of government debt.

f) A fall in productivity growth and this - combined with weak investment and high unemployment - is contributing to a reduction in the estimated trend growth rate for the UK economy. A “new normal” growth rate might be closer to 2% rather than 3% and this has important implications for a government desperate to bring borrowing down and for an economy badly in need of hundreds and thousands of new jobs.

g) High inflation - the economy emerges out of recession with CPI inflation running well ahead of the 2% target (latest data: 4.5% on CPI) - indeed CPI inflation has been higher than 3% in each of the last sixteen months. Inflation remains much lower than we saw in the 1970s and 1980s but with prices rising at close to 5% per year and wages for many frozen or static, we are seeing a sharp drop in real disposable incomes and living standards.

h) Perhaps the biggest legacy of the recession …. namely a financial system that remains fragile both here in the UK and overseas (e.g. the European banking system) - the system is still under-capitalised and has become deeply risk-averse. It charges higher and higher interest rates to corporate and personal borrowers.

The financial crisis created a negative externality that affects the entire economy. Yes - some mortgage payers are enjoying lower interest rates on their loans. But millions of savers have seen their incomes slashed (and they didn’t create the crisis!) whilst thousands of businesses find it tougher and more expensive to get the loans and trade credit needed to sustain a recovery and build new enterprises

Recessions are painful and damaging - there is an ongoing debate about the extent to which the downturn has damaged our productive potential and export capacity (i.e. hysteresis effects). Here is a simple question - where will growth come from - invites a range of answers - some of which are explored here.

Monetary Policy

Our discussion then switched to monetary policy… there is little doubt that the handling of monetary policy has become much tougher in recent times, a stark contrast with the NICE decade in which setting base rates must have seemed like a busman’s holiday. Divisions within the MPC have been well reported. Some of the questions we raised were as follows:

i) When to tighten monetary policy - either in the form of gradual increases in base interest rates or a partial withdrawal of the policy of quantitative easing (QE) - replaced by quantitative tightening (QT)

ii) Is the inflation credibility of the Bank of England being eroded by a long period in which inflation is persistently above target? How much longer will the “temporary factors” driving inflation higher continue to hold?

iii) What are the dangers of rising inflation expectations? Why has there been (so far) a muted wage-price response to CPi and RPI inflation in excess of 4%?

(iv) Should we continue to use inflation targets”>continue to use inflation targets? If so is there a case for changing the target?

(v) Is the Bank of England / government right to continue using a free floating exchange rate?

(vi) How effective is conventional monetary policy? Has the UK (and the USA) experienced a liquidity trap? If so what are some of the consequences?

Fiscal Policy

There are many important fiscal policy decisions in the near future. Most students will be familiar with the debate about fiscal tightening (mentioned below) but there are other key developments in changing the architecture of the fiscal system to meet supply-side, environmental and distributional aims …

(i) Fiscal tightening - when to cut the deficit? How to cut borrowing? Over what time frame?

(ii) The scale of government spending - with Government spending now more than 50% of GDP have we reached a point where the state sector has grown beyond an optimal size for long term growth? Govt spending can be a powerful force for good but what ought to be the balance between public and private sector demand and resource claims?

(iii) Could the balance between direct and indirect taxes be changed to create stronger incentives to work, save, invest, innovate, employ?

(iv) Should governments be more brave in using fiscal policy instruments to meet tougher environmental targets? how strong are the arguments for a proper tax on carbon?

(v) How best can fiscal policy support supply-side improvements in competitiveness and trade?

Well … this is what we covered in a revision lesson on context. Macroeconomic policy making is not easy at the moment and the last few years has certainly tested the design of policy - from choice of exchange rate regime, to the independence of central banks, to the ability of sovereign governments to engage in an independent economic policy in a world of globalization and increasingly frequent macroeconomic and financial crises.

Check below to some links on recent macro policy blogs that I think are helpful as part of final revision

Preparing for the AS Macroeconomics Paper (Slideshare presentation)