Lesson 2 was last week, and things aren’t really much clearer. Nonetheless, here’s a summary of what he told us, and this time I’ve tried to inject a bit more of my own brain into it (not too much, mind) rather than copy out my notes. If anyone would like to share an insight into economic growth please do. Sahil told me something the other night (about interest rates, and machinery depreciation), but I drank some beer and forgot it.
So my man in the lecture theatre claims the long term objective of economics is stability, where total demand equals the total supply. He then gave them all sorts of names, which I’ve summarised below.
Total or Aggregate Demand (AD) is the same as the total money spent. This splits up into spending by people (C, consumption expenditure), government (G, government expenditure), investment (I, investment expenditure), and the difference between exports and imports (X-M).
Meanwhile, total or aggregate supply (AS) is the same as the national income – ie it’s the stuff we’re making, which in monetary terms is the amount we get for it.
Now imagine a circle, where you have consumers and producers. Obviously the stuff produced is sold to the consumers. But, less obviously, all the stuff needed for producing comes from the consumers, completing the circle. It’s the consumers who also work in the offices, it’s consumers who also own land, or lend the money for a new business. So, ideally, the amount earned in various forms should be the same as amount spent, and all is well. However, you get leakages in this system.
When consumers save money instead of spending it, there’s a leakage. Sometimes this should be matched by investment (because people usually save money in something that gives them a return, hence it’s investment). However sometimes, for example in recessions, people are saving but there’s no investment. Then there’s a problem.
Another leakage is tax. But this should be matched by government spending. Sometimes, in recessions, government spends more than it gets in tax to plug the hole left by all the money that people aren’t spending. Then it gets itself into debt.
Some of this is fairly obvious, but to spell it out…
To begin with, a handy list. In 2009:
- The world economy shrank by 1.7%
- The UK economy shrank by 5.9%
- EU economy shrank by 4.7%
- US shrank by 6.3%
- China’s grew by 10%
- India grew by 8%
Comparing that to previous recessions, in 2002 our economy shrank by 2.9%, and in 81-82 it shrank by 6.1%.
The UK economy shrank so dramatically because it was skewed towards the financial sector: 23% of our GDP came from there. However, in December 2009, inflation increased from 1.9% to 2.9%, and unemployment fell for the first time since 2008 – both very good signs. The question is, are we now back on the upward curve out of recession? If so, will it be a quick recovery (a V shaped recession) or a slow one (U shaped)? And is there a danger that actually we’re going to recover and then slump again, before finally sorting it out (W shaped).
It’s possible that the inflation rise wasn’t a sign of recovery, but rather a resultof three things: the imminent end of the VAT cut, meaning people bought lots of things before VAT went back up; the weakening pound, making imports more expensive; and food price inflation, which is running at a worryingly high 11%.
How to sort out the recession
Now, there are three important tensions in an economic recovery. The first is between taking us out of deflation, without doing it so violently that we end up with runaway inflation. The second is between ensuring banks have more reserves to bail themselves out next time vs ensuring they keep lending to people and business (which relates to Sahil’s post). And the third is between maintaining the fiscal stimulus (ie the extra government spending which is keeping us going and plugging the hole), vs reducing the national debt. At the moment we’re borrowing about 9.8% of GDP every year, and our total national debt is now worth around 80% of GDP, something which most people other than Sahil seem to consider a Bad Thing.
This leaves government with two options. Either carry on with the fiscal stimulus – ie borrowing money and spending it. Or carry on with ‘quantitative easing’ – essentially printing more money – and a low interest rate. [can someone explain why these are the two options? I don’t really understand, particularly the second one.]
Finally, his prediction. Unemployment will rise again sharply as the fiscal stimulus ends and the public sector suddenly has to make the cuts which the private sector made last year (the public sector has actually grown over the recession, although not as much as some people claim). Government will keep interest rates low, and maintain quantitative easing. If the Tories win, they’ll need to cut fast and hard because they’ll want to blame all the consequent pain on Labour, and if they leave it too long they won’t be able to do that.
What are your predictions people?