Posts Tagged ‘interest rates’

file0001742232424The UK economy grew by 0.7 per cent in the second quarter of 2015, and by 2.6 per cent over the past year. The US economy grew at an annualised pace of 2.3 per cent. The media and markets greeted the figures with relief, but they were wrong.

To understand why, first consider what things were like in the first quarter of this year. The UK grew by 0.4 per cent, that’s quarter on quarter, and the US grew by 0.6 per cent– annualised. Actually, the data for Q2 had been revised upwards, so the markets had a kind of double celebration. They were chuffed by the okay figures for Q2, and even more chuffed by the upwards revision for Q1. Even so, bear in mind that in the latest quarter both the UK and US economies grew at a rate that was still way below average. As for Q1, the data may say that the US grew by 0.6 per cent annualised in Q1, but frankly that is a pretty awful performance. It’s just not as awful as the figures originally suggested. It is like coming last in a race, and then celebrating because the judges discovered they had made a mistake and in fact you only came second from last.

History tells us that economies tend to enjoy a period of above average growth when coming out of recession. History tells us that when an economy suffers a one off shock, which is supposed to have been what happened in Q1 of this year, then the following quarter should expand at a faster than normal pace to make up for the lost production of the previous quarter.

We are told that poor figures on the first quarter were down to a shockingly bad winter in the northeast corner of the US. This even affected US imports to the UK, knocking the UK economy. If that is so, however, shouldn’t the second quarter have seen unusually fast expansion, making up for lost ground?

In the US, the Federal Reserve is losing patience, it will be a big surprise if US interest rates don’t go up very soon, September most likely. Rates will be rising in the UK soon too, probably January.

Once again, consider the lesson of history. The Fed increased rates in 1994, after a period in which they had been at 3 per cent for 18 months or so. A year and a half later, US interest rates were at 6 per cent. Crisis soon followed, however. The global economy had got used to low US interest rates, when they rose capital left developing markets and headed west. We had the Asian crisis of 1997 and the Russian crisis of 1998. The global banking system tottered.

A similar story occurred all over again the following decade. This time though, US rates were cut to 1 per cent, stayed there for about a year, and then gradually began to rise. Within a year or two, come 2008, the global banking system did more than totter, it fell over. We all know how nasty that was.

This time US rates have been at near zero per cent for almost seven years. As they rise, the shockwaves across the world will be nasty.

The problem is compounded. Critics of the Fed say that by cutting interest rate to near zero, it has nothing left to give in the event things make a turn for the worse. The snag with that is that if the Fed hadn’t cut rates so low its economy may have suffered an even more nasty turnaround. It is like a runner in a race, holding back for a sprint finish. But if the race leader sets a fast pace, and our runner goes with the leader and has the sprint run out of him, or indeed her. You can’t criticise the runner for going too fast, there was no choice.

In short, rates are low because they had to be, now they are rising because they have to. Neither the US or UK economy are strong though, indeed they are more like a wheezy athlete, about to start a long uphill climb.

Did you know that Diego Maradona, most famous as for his prowess as a football player, was also a top economist?

Maybe we can go further than that and say he was an economist first, but used football merely to illustrate his theories.

Take the world cup match with England in 1986. First of all there was that goal; the one in which Maradona rose above the rest of the players on the pitch, his hand held aloft and deftly patted the ball into the net. That had the effect, as it were, of putting the fear of God up the England players.

Such was this fear that later in the match, Maradona was able to sort of dribble past five or so England players, and score one of the most memorable goals in the history of the World Cup. It is just that if you were to plot the trajectory of his run you will find that the Argentinean footballing legend actually ran pretty much in a straight line. The England players, in anticipation of Madonna’s magic, sort of fell away. If instead the English defence had not moved and stayed put, Maradona may not have got past his first marker.

It all boils down to expectations. If you are expected to act in a certain way,  others change their behaviour accordingly. The result is that by doing nothing, but creating the impression of doing something, you can affect behaviour.

So let’s apply the Maradona model to the markets. For the markets, expectation is crucial. So let’s say you are a central banker, and – for the sake of picking a name out of thin air – let’s say you are called Mario Draghi, and you are the President of the European Central Bank.

You want to see confidence return to the markets, you want investors to buy Italian and Spanish bonds, and you are worried about the strength of the euro. But you have a problem. Some of your colleagues within the ECB, some very powerful colleagues at that, are what you might call hawks. They don’t like quantitative easing, and like to see a strong currency. So what do you do?  Answer: absolutely nothing, other than talk. You say things such as: “I will do what it takes.”  And hope that simply saying you will do that is enough.

Somehow, the strategy appears to be working. Last week the ECB voted to do nothing again. There would be no change in monetary policy for another month, but the feeling that Mario is there, pulling strings, and orchestrating recovery was enough to get the markets buying bonds and selling euros.

And that is where Maradona comes into it. Back in 2005, Mervyn King came up with what he called ‘The Maradona theory of interest rates.’ He said that the markets are a little like those England players in the match with Argentina. He said: “Market interest rates react to what the central bank is expected to do.  In recent years the Bank of England and other central banks have experienced periods in which they have been able to influence the path of the economy without making large moves in official interest rates.  They headed in a straight line for their goals. How was that possible?  Because financial markets did not expect interest rates to remain constant.  They expected that rates would move either up or down.  Those expectations were sufficient – at times – to stabilise private spending while official interest rates in fact moved very little.”

What has that got to do with the here and now? Last week Jonathan Loynes at Capital Economics said: “The ECB president appears to have become the undisputed champion of the ’Maradona theory’ of monetary policy, in which market expectations of policy changes relieve the need for those changes to be implemented.”

So there you have it: Maradona economics.

But of course this begs the question: in today’s times do we need a new theory, perhaps a Lionel Messi theory of fiscal policy.

©2012 Investment and Business News.

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Look, you have to be patient. It takes time to repay debt, but once it is repaid, well…yippee. That is one argument.

Others go further, and say things such as: “If it isn’t hurting, it isn’t working.”

Those who support austerity don’t deny it will be painful – except that is for a few nutters in the US Tea Party that seem to think there is an automatic and immediate positive relationship between austerity and growth.  No, the sane austerians are simply saying that it is worth it in the long run: pain today, wealth tomorrow.

And, of course, for most individuals such an attitude is right. Some businesses may argue that the way to deal with debt is to expand, but on the whole, most agree that times of peril mean cuts.

The snag is that when we are talking about the whole economy, things can get very nasty if we all start behaving in the same way. If all those with debts make cutbacks, and as a result there is less demand, and those with savings see the fall in demand, so start saving even more, then the economy will start contracting faster. And supposing that as a result of these cuts, demand shrinks, our income falls, and as a result our debts actually increase. In such circumstances, the more we cut back, the worse our debts.

The National Institute of Economic and Social Research (NIESR) reckons this is precisely what’s happening.

In a report published this morning it said: “As a result of the fiscal consolidation plans currently in train, debt ratios will be higher in 2013 in the EU as a whole rather than lower.”

Its argument continued: “under normal circumstances a tightening in fiscal policy would also lead to a relaxation in monetary policy. However, with interest rates already at exceptionally low levels, this is unlikely or unfeasible.” To put it another way, when interest rates are near zero, the argument that you need to make cuts so that the central bank can then make interest rate cuts doesn’t hold up. Right now, we are in what’s called a liquidity trap. Rates can’t fall much further, but when the economy is struggling like it is, the normal solution is to cut interest rates. Quantitative easing is not proving very effective because people don’t want to borrow more. The Bank of England hopes, by the way, that QE will push up the price of government bonds, meaning other assets will look cheap in comparison and push their prices up, which will make us feel richer, so that we will spend more.

Returning to the NIESR report it stated: “During a downturn, when unemployment is high and job security low, a greater percentage of households and firms are likely to find themselves liquidity constrained.”

NIESR added – and this is the key bit – “With all countries consolidating simultaneously, output in each country is reduced not just by fiscal consolidation domestically, but by that in other countries, because of trade. In the EU, such spill-over effects are likely to be large.”

Now it is only right to point out at this stage that the NIESR director, Jonathon Portes, is very much a supporter of the idea of stimulus. He bats for the same side as Paul Krugman – an out an out supporter of Keynesianism. So given this, perhaps the conclusions of the NIESR report are not surprising.

But then again  austerity can work when applied by individual countries which can simultaneously grow via exports. But when austerity becomes a global thing, it becomes very dangerous.

On the other hand…

The big snag with fiscal stimulus is that sometimes economies need to adjust. There is a danger that a fiscal stimulus can take away the need for change.

Take Japan, as an example. In Japan failure is not popular. In fact, it is seen as something that needs to be avoided at all costs. But as a result, maybe Japan is too slow to change. This morning both Sharp and Panasonic warned of heavy losses in their current financial year.  Truth is, Japanese electronics companies are getting a drubbing.  Being thrashed by Apple, and Samsung and Google and Amazon is bad enough, but now even Microsoft with its Surface tablet is making the once seemingly invincible Japanese giants look like dinosaurs.

Maybe Keynesian is partly to blame. There’s not enough creative destruction in Japan.

So returning to the NIESR, it is right. Austerity is causing damage, and may even be making debt worse, but that does not mean we don’t need creative destruction.

The debate has become polarised. Either you are an Austerian or a Keynesian. Why can’t you be both?

Anyway to finish on a more cheerful note, here is piece by yours truly on some promising news out of China today.

©2012 Investment and Business News.

Investment and Business News is a succinct, sometimes amusing often thought provoking and always informative email newsletter. Our readers say they look forward to receiving it, and so will you. Sign-up here