I studied Economics in my first year of university and never quite got it (that might have had something to do with the lecturer’s English being almost impossible to understand and a lecture hall full of muppets that caused the lecturer to actually walk out during one lecture). However, over the last year and a half I’ve managed to pick up and understand a lot more about Economics. So, I thought I would decide to post a blog entry about the economy. This entry will be grossly over-simplified (some of the things I mention in here have whole textbooks written on them alone).
We’re all acutely aware that the economy is not good. It all started with the crashing of the Subprime Mortgage market over in the USA. Subprime loans are ones which are given to people who do not meet the prime underwriting guidelines. These borrowers have a higher perceived risk of default on the loan repayment. It was this crash that is seen to have sparked off the “credit crunch” in 2007.
In the UK we have seen, like America, our banking system collapse. Many of our banks are now all or part state owned. Northern Rock was the first major problem in UK. The run on the bank (when large volumes of people withdraw their money) did not help matters as people continued to panic (and inaction from the Government) it meant that people continued to loose confidence in the bank and made more people with investments in the bank to withdraw them. This loss of confidence caused the share price of the bank to plummet and in the end nearly caused the bank to collapse (the media have just as many difficult questions to answer as the top bankers do, in my opinion). We’re now at a situation where banks are too frightened to lend, which is causing liquidity problems for the economy. As the availability of credit fell, fewer and fewer people were able to spend money, which is what keeps the economy going. At the same time there was a rise in inflation, which has caused the Central Bank (The Bank of England ,or BOE) to reduce interest rates to a point where they are approaching zero. What happens when they hit zero?
Several things can happen and a number are being talked about in the media. There is another interest rate to the one we are familiar with. We are familiar with the nominal interest rate, but not with the real interest rate. Let me explain the difference. There are three risk factors which have to be considered:
- The debtor will default or will be unable, for whatever reason, to repay the loan on the originally agreed upon terms or that collateral backing of the loan will prove to be less valuable than estimated
- Taxation or changes to the law which would prevent the creditor from collecting the repayments or having to pay more tax than originally thought
- The repaid money might not have as much buying power than the money lent (to do with inflation and the value of currency)
The nominal rate of interest includes these three risk factors, plus the time value of the money itself. The real interest rate is essentially the nominal rate minus inflation and currency adjustments. What is the point of explaining this? Well, this real interest rate can be played about with (and reduced) even when the nominal rate hits zero. This is one way the BOE is considering getting round the problem of zero interest rates. When negative interest rates are spoken about it usually refers to real interest rates and not nominal interest rates.
The other option that I’ve heard discussed a bit recently could prove to be quite dangerous if it was used. It is called Quantitative easing (QE). For those of you who do not know what QE is, the grossly over-simplified explanation is that it is when the central bank (in the UK that is the BOE) prints more money. It then uses this money to buy Government bonds or the CB will lend this money it has created to deposit-taking institutions or they may even use this money to buy assets from banks. The theory is that this money is then lent out to the wider economy, which increases the flow of money. Now, this all sounds brilliant. However, there is one major problem with printing money…it’s desired effect is that it creates inflation. However, it can cause hyperinflation. Furthermore, as you continue to print money the value of your currency falls and as such it can make it more difficult to compete on the international market. A prime example of where QE has gone wrong is Zimbabwe.
In my opinion, it may be necessary to use QE in order to help try and recover the economy. However, if it is used it must be used as part of a wider package of economic recovery, should be a last resort and in order to avoide a situation such as that in Zimbabwe must be kept under the microscope to ensure it does not cause further damage to our economy.