Economics part II

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.

The recession

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?

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4 thoughts on “Economics part II

  1. Okay, some sketched thoughts (I’m brewing a longer post for the growth question), but…

    On interest rates (and quantitative easing) – Monetary Policy – is a favoured ‘control’ on the economy. The idea being that, as you said, we need people consuming not ‘leaking’ money away by saving. So if you have low interest rates there is little incentive for people to save and plenty of incentive for people to borrow money to spend. People spend = increase in aggregate demand = happiness. Printing money means banks have more to lend and the same thing happens.

    Increase fiscal stimulus – i.e. government spending – Fiscal Policy – is a direct way of increasing aggregate demand. Monetarists argue that the problem is people ‘expect that, in the long run, government will have to tax more, so with cut back on their current consumption to compensate’. Rendering the stimulus defunct. Keynes’s rather good retort was that “in the long run we’ll all be dead”.

    The political guff behind this is that Monetarists try to reduce the economy to a problem of managing the money supply, if the money supplied is correct, then ‘the market’ will work efficiently, not be distorted unnaturally by the big clunking fist of government. So Thatcher and Regan tried kick out government spending (and, ramp up the interest rate to prevent ‘distorted’ cheap borrowing) in their first few of years in charge. It worsened a massive recession, hence the 5.9% in the early 80s Will mentioned. Regan soon thought better of it and went on a massive spending binge, funding the military industry – military kenyesianism.

    As for what happens now, I think we’ll emerge out of recession with the power of finance strengthened. ‘Growth’ will come through another asset price bubble (dotcom, housing, whatnext?). It’s interesting to think of this. Significant inflation, as I’m sure you’re tutor will tell you, is a real awful – rising prices mean consumers don’t want to buy and producers don’t know when to sell – inertia. Yet since the 1980s transition, most growth in developed economies has come through inflation in some asset, which then brings a crash and plenty of ‘never again’ hand-wringing before it happens again, in a different way. Maybe our economy relies less on production and more on managing inflationary spikes?

    This is why I think it’s so important that non-elites have to find a new way of embedding into high finance. They will be drawn in, but how is what matters and at the moment there is no power.

    The deficit is no great shakes historically or comparatively, so I don’t know why everyone has become so obsessed by it. Financial elites, like rating agencies, are getting very excited declaring that the ‘quality’ of a UK bond (borrowing) will fall, making borrowing more expensive (ie heightening their profits). This is bad but we should see that as a political crisis, where an unelected elite group of private financiers can take more from taxpayers through downgrading the AAA credit rating, rather than an economic one. There is a decent, if lengthy New Statesman summary of the whole deficit myth.

  2. I’m economically illiterate so these Lessons and your comments Sahil – are seriously helpful. Keep them coming for the sake of my confusion. Ta

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