tutor2u-logo

Astonishingly low interest rates on UK government debt: causes and effects

Friday, January 30, 2015
by Tom White

We all know that the UK government has run up a colossal national debt - £1475bn as I type this sentence. And it’s rising fast, since the UK government also has a fiscal deficit to finance this year, which will add even more to the total stock of debt.

Yet the cost of borrowing all this money is falling to new record lows. Why? And should this influence the government’s economic policy in any way?

The key to borrowing from the bond market at low rates of interest is to sell bonds at a high price (this forces down the yield, which I explain here). I’ve just been writing about Russian government debt, with the news that Russia’s government bonds are rated as ‘junk’. This pushes down the price of their bonds down, which forces up the cost of borrowing (the yield).

The UK government is in the opposite corner. According to Robert Peston from the BBC, there are two big immediate causes of the rising price of UK government bonds, meaning that it is cheaper than it has ever been for the Treasury to borrow for maturities of ten years and thirty years.

So bond prices are mainly driven up by the slow pace of economic activity, and the limited opportunities for good returns on money elsewhere in the economy. A further underlying cause of the record high price of the official debt of mature western economies is widespread pessimism that economic growth will be subdued for years and maybe decades - since that encourages investors to make low-risk investment in supposedly high quality sovereign debt.

Peston goes on to say that at times like these there are plenty of economists who argue that the government should take advantage of these record low rates to borrow even more, to finance big infrastructure and investment projects. In the Keynesian tradition, if a British or German government borrowed more to build new high speed train lines, roads and schools then the underlying growth rate of the European economy would pick up.

But those with a supply side perspective might say that with UK government debt so high and still rising, it is more sensible to reduce the deficit as fast as possible - just in case interest rates don't remain at these record low levels. Reducing government spending to pay for tax cuts is the best route to restore long run growth and competitiveness.

Economists like Jeff Sachs take a third view, which would see government setting an investment agenda for both the public and private sectors, thinking carefully about the type and purpose of those investments.

Questioning the UK’s Economic Recovery - Exam Style

Thursday, January 29, 2015
by Virang Dal

A lot has been made of the recent set of growth figures recently published of the UK economy. Despite the seemingly positive 0.5% quarterly growth and 2.6% annual growth, the overall impression is of disappointment and despondence. I am part of this crowd, a believer that the UK economy is only partially on the road to recovery. Several obstacles remain on this path ahead and some are already slowing us down including:

1) Poor real wage inflation

2) Poor productivity

3) A ever bulging current account deficit

4) National debts at record levels despite 'austerity'. Austerity set to continue

5) Huge economic and political uncertainty in the Eurozone

6) Consumer and Business confidence no more than pre-crisis levels and increasing survey data showing how households' perception of their financial situation is far below pre-crisis levels

7) Long term and youth unemployment above pre-crisis levels

8) Private indebtedness at record levels manageable through record low interest rates

9) Banks remain unwilling to lend despite huge rounds of QE - Deflation risks putting banks off even more

10) National election uncertainty

11) Credit fuelled consumption the key avenue promoting growth. Manufacturing, construction and the trade sector are not contributing substantially to growth and in some senses are shrinking

12) A rise in interest rates which could cause our debt time bomb to explode

These points make for excellent evaluation for an exam style question on the UK recovery, particularly for OCR's Global Economy paper. But can students actually effectively get these points down answering the question in the detail and clarity required to score fully? The difference between grasping a concept, applying it and reading about it in this case and writing formally can be stark. Here is my attempt to get students to see the light when it comes to transferring these real evaluation points on paper referring specifically to extract 1 of the OCR stimulus material to an evaluation question of whether UK recovery can be sustained. 

Point (1)

There are concerns that even though unemployment in the UK is falling, the long term unemployed are accounting for an ever increasing share of the unemployment figure. Professor John van Reenen in the extract is concerned that 36% of the unemployed have been unemployed for more than one year. A major negative impact of this is hysteresis where unemployment can lead to permanent unemployment in the future due to the loss of skills and human capital as that person becomes detached from the working environment. As a consequence, labour supply may be permanently lower in the medium term as growth picks up in the economy harming future potential growth curbing aggregate supply (a waste of resources) and aggregate demand through reduced incomes and spending. The recovery therefore may not be sustained.

Point (2)

Although growth has increased, real wages in the economy have yet to increase at any pace, that is wage growth beyond the rate of inflation. This is because productivity levels in the economy remain low and firms are not yet fully confident in increasing their costs when the economic climate is uncertain. Consequently, incomes and therefore spending in the economy maybe more subdued in the future if growth begins to slow halting the recovery.

Point (3)

To deal with mounting national debt, the UK government has implemented a strict deficit reduction plan which may conflict with UK economic recovery. This plan has involved heavy reductions in government spending accompanied by increases in taxation such a rise in VAT from 17.5% to 20% in 2011. Further austerity measures may reduce aggregate demand in the economy and reduce the chances of sustained economic growth and therefore recovery.

Point (4)

There are also concerns that UK growth is unbalanced with credit fuelled consumption still dominating. Personal levels of indebtedness are very high, corporate and public sector debt is also at record highs with this debt needing servicing. The longer the UK continues to grow based on borrowing, the more difficult it will be to sustain as money becomes more difficult to service and pay back. No where is this more evident than by looking at the UK’s current account position. Net trade is negative and has been negative for a large period of time and this deficit is growing. To finance this, the UK is borrowing large sums abroad adding to indebtedness. It is argued that for the recovery to be sustained, growth should be pursued from more investment and trade, which requires an improvement in international competitiveness.

Evaluation

Whether the UK recovery can be sustained depends on the nature of growth. If the UK economy is reliant on debt fuelled consumption to buy UK goods and services or imports (increasing the current account deficit), there is a risk that as interest rates begin to rise debts become so hard to service and repay that spending in the economy may grind to a halt. However if the UK can diversify and stimulate the trade sector, exporting more and importing less coupled with sustainable approaches to increase growth like increasing investment and productivity in the economy, these concerns may be limited.

Judgement

Based on the evidence, the UK economic recovery may well be sustained in the future. Inward growth from consumption as a result of higher incomes and falling unemployment will keep growth increasing as consumption is the major driving factor of UK GDP accounting for approximately 66% of growth. However there are significant risks to this recovery such as unsustainable levels of indebtedness, unbalanced growth and of real wages not increasing quickly enough which could scupper recovery if the UK suffers an unexpected economic shock, perhaps emanating from economic troubles in the Eurozone.

Russia’s credit rating is ‘junk’

by Tom White

What does this mean? Stated simply, it means that ratings agencies – who try to judge how reliable a debtor is – have issued a warning about the Russian government. If traders in the bond market doubt Russia’s ability to pay back debts, it will make it much harder, or at least more expensive, for Russia’s government to borrow.

According to the BBC, the ratings agency Standard and Poor (S&P) gave Russia a rating of BB+, which puts it at the same level as Indonesia and Bulgaria. Why might it have made this statement? The factors that cause alarm bells to ring are typically:

In more colourful terms, “Russia’s monetary-policy flexibility has become more limited and its economic growth prospects have weakened,” S&P said in a statement. “We… see a heightened risk that external and fiscal buffers will deteriorate due to rising external pressures and increased government support to the economy,” it added.

Russia’s economy has been in free fall since the middle of last year, when plummeting oil prices cut the income for its oil industry and the unrest in Ukraine led to international sanctions. Oil prices have plunged over 50% since the middle of last year, to $45 a barrel, which has been particularly difficult for Russia, which expected prices to stay near $100 per barrel in 2015. Russia’s economy is expected to contract by 4% to 5% this year. The currency has depreciated over 40% against the dollar in the past year.

I've tried to explain how bond markets work here.

-------------------------------------------------------------------------------------------------
Copyright Tutor2u All Rights Reserved www.tutor2u.net