Free market and Command Economy

Edexcel link for Economic thinkers

http://qualifications.pearson.com/content/dam/pdf/A%20Level/economics-a/2015/teaching-materials/Economic-thinkers-Theme-1-updated.pdf

Oligopoly

Why tacit collusion?

Tacit collusion is silent non traceable associated with price leadership.Kinked demand curve theory can be used to explain this.

http://www.tutor2u.net/economics/reference/oligopoly-tacit-collusion

Tutor2u has a good summary, case study video and powerpoint worth carefully looking at for the following exam type questions on overt collusion.

Overt or Explicit collusion between firms that is traceable means they have formed a cartel. A  cartel occurs when 2 or more firms enter into agreements to restrict the supply or fix the price of a good in a particular industry.The most famous example being OPEC (Organisation of Petroleum Exporting Countries). In the 1970s, OPEC tripled the price of oil because they controlled over 70% of the world’s oil supply. In the UK cartels are an example of restrictive trade practices and are illegal. 
- types and why engage in collusion
- what makes it easier
- why it make break down

http://www.tutor2u.net/economics/reference/oligopoly-collusion

A2 Monopolistic Competition

Using Tutor2U's excellent resource try to create am 8/16 mark exam question:

http://www.tutor2u.net/economics/reference/monopolistic-competition

Price Elasticity of Demand (PED)

Remember to consider the impact of changes in price on revenue.

Useful PAJ video here:

https://www.youtube.com/watch?v=hJIaiItHrpY

Additional Tutor2u video link here:

http://www.tutor2u.net/economics/reference/price-elasticity-of-demand

Derived demand and joint demand

Often overlooked - you need to be aware of derived demand and joint demand as factors that influence demand. Paj has a good video on this:

https://www.youtube.com/watch?v=KlnVTlRx4xA

Surpluses and Shortages

Surpluses and shortages are not in your November mock but will help you better understand why the equilibrium price is when supply equals demand, see short video on this tpic here:

https://www.youtube.com/watch?v=A59mPHj1rZI

Monetary Policy on pause.

The Financial Times today has 7 pages devoted to Mark Carney's announcement that interest rates are unlikely to be used for a while and that other monetary measures are now needed.

The following fro Tutor2u is an excellent summary of why inflation is likely to remain low:

http://beta.tutor2u.net/economics/blog/waiting-for-a-rate-move-uk-macro-analysis

What is Quantitative Easing:

http://www.bankofengland.co.uk/monetarypolicy/pages/qe/default.aspx


Crowding out and the loanable funds theory

https://www.youtube.com/watch?v=hucfTz4sPfU

A2 - using Anderton

If you can speak it you can write it.
If you take the time to read it you can speak it.

Learning Economics is like learning a new language.

From your senior examiners across to the British Council helping students with English as an Additional Language - all agree that Anderton is they key textbook for A Level Economics.

Use the model study notes as a template to help you make effective use of Anderton and grow in confidence.

Edexcel chapters
6EC03 - Ch38-56 and 64-65
6EC04 - Ch76-103

A2: one view on how the economy works

Useful video here that will help provide some insights into monetarism and economic cycles:

"How does the economy really work?

This simple but not simplistic video by Ray Dalio, Founder of Bridgewater Associates, shows the basic driving forces behind the economy, and explains why economic cycles occur by breaking down concepts such as credit, interest rates, leveraging and deleveraging."

 http://www.economicprinciples.org/

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6EC03 - Perfect Competition

Ebay is cited as an example of a market close to perfect competition, but how close is it? Read this excellent article by Tejvan Pettinger to get you exam prepared and consider EBay's competitors.

http://www.economicshelp.org/blog/2379/economics/ebay-and-perfect-competition/

Paj as always has a lovely short video explaining Perfect Competition here:

https://www.youtube.com/watch?v=7lhX78vlHSY

Exam Tip - always try to show the two diagrams market (industry) and firm alongside each other.

AS/A2 students - register for RES Online Lecture: Does Starbucks Pay Enough Tax - 5pm 24 November 2015

Another brilliant on line lecture from Tutor2U partnered this time with the Royal Economic Society  which runs the annual essay competition:

http://beta.tutor2u.net/economics/blog/res-online-lecture-24-nov-does-starbucks-pay-enough-tax

AS/A2 Students Financial Markets - Weds 4th Nov 4pm

Make sure you register in advance for this excellent on-line resource from Tutor2u and the Bank of England:

http://beta.tutor2u.net/economics/blog/financial-markets-school-webinar-by-the-bank-of-england-and-tutor2u

PAJ on Price Elasticity of Supply

Key points to recall before you watch the following:

https://www.youtube.com/watch?v=20b_zVHmZG0

Why does supply slope upwards?
What causes supply to shift?
Then after the video consider how is PES different to the above two points?

new A Level - 4 November Bank of England webinar

Dear Sir/Madam

Please help the Bank of England map a positive future for financial markets

On 11 November, the Bank of England will be bringing together a wide range of stakeholders in financial markets at an Open Forum.  Ahead of the day, we are conducting a short poll across a range of different constituencies across the UK.

With your help, we would like to extend this poll to schools and to invite you and your economics and business students to take part.  The results of the poll will be used as a starting point for the day, and in particular to feed in to the opening session, which will consider the role of financial markets within the economy.  We would appreciate it if you and your students filled out the form online at http://www.bankofengland.co.uk/markets/Pages/ofpoll.aspx.  Should that be difficult you can also fill out a hard copy (available from Mr Gray)and return it to the address below.  The poll will close on Friday 23 October 2015.

Free schools webinar on financial markets for A-level students

We are also inviting you and your students to take part in an interactive webinar on 4 November on Why Financial Markets Matter to be hosted jointly by the Bank of England and tutor2u.net who are the UK’s leading online educational publisher.   The webinar will cover the A-level syllabus on financial markets and will give students the opportunity to ask questions live.  You and your students can register for the webinar athttps://attendee.gotowebinar.com/register/8958372512139742210

Kind regards,

Chris Peacock

Head of Public Understanding and Content | Stakeholder Communications and Strategy Division | Communications Directorate (TS-M)

Bank of England | Threadneedle Street | London | EC2R 8AH |

Year 12 - understanding Supply

Useful Tutor2u presentation here on supply: http://beta.tutor2u.net/economics/reference/how-markets-work-supply-theory

Also remember the mnemonic PINTS WC

new A Level - help

Introducing you to the wonderful video tutorials by PAJ Holden: Demand - https://www.youtube.com/watch?v=nhEJ5T7s5sY

6Ec03 - Revenue

Useful numerical analysis on why a Monopoly may to keep on increasing prices and what price to charge if a firm wants to maximise revenue:

https://mbaecon.wikispaces.com/file/view/Demand_Elacticity.gif/30500791/Demand_Elacticity.gif

Austerity - is there an alternative?

In the Spring term of each year, any school students studying UK A level or International Baccalaureate (IB) courses are invited to write a unique essay of between 1,000 to 2,500 words, on a subject set by the President of the Royal Economic Society, calling on key elements of their studies, examples from the world around them and imaginative discussion. Last academic year many Cherwell students entered, widening their subject knowledge beyond the constraints of the A level course and sharpening their essay skills. The following was among the best baaed on the students Extended Project and is very useful for thinking through the 'great austerity debate'.

Lok Hin Wong

Given that the UK’s national debt is said to be “dangerously high,” is a budget deficit still a viable policy for the government?[1]

                                                                                             

I. Setting the Scene

The debate over budget deficit and government debt has been particularly fervent in the aftermath of the financial crisis of 2007/08. In the UK, the Chancellor George Osborne told the Conservative Party conference in September 2014, "We here resolve that we will finish the job that we have started," saying Britain's national debt of £1,435bn (79.2% of GDP) was still "dangerously high."[2] The Tories want a surplus on all government spending, including investment, by 2018/19, though the repeated failures of meeting deficit-reduction targets now mean that Britain is less than half way to closing its  structural deficit,[3] despite the Chancellor’s initial plan in 2010 for the job to be all but done by now. In contrast, the Shadow Chancellor Ed Balls seems to favour a more Keynesian response, repeatedly issuing warnings about the potential adverse effects of fiscal austerity. Labour aims to balance the current budget, excluding investment, by 2020. Or to put it another way, Labour would cut spending less and tax more, to reduce the deficit by less. The Economist (2015a) reports that if Labour wins this year’s election, the additional borrowing could amount to £170bn by 2030 or up to 2.3% of GDP pa till 2020.

So, who is right? Will a faster or slower fiscal consolidation be more beneficial to the UK economy? The answer depends on which economist we ask and the period in which we ask the question. During the period between the mid-nineteenth century and the birth of Keynesian economics, UK governments generally followed the principles of sound public finance. The fiscal orthodoxy was to balance budgets whatever the state of the economy. However, under the influence of John Maynard Keynes, deficit financing became respectable and part of the new Keynesian orthodoxy in the 1950s-70s. From the 1980s onward, until the recent financial crisis, monetarism and the free-market revival resulted in a return to the principles of sound finance and balanced budgets. Fiscal policy was still used, albeit in a supply-side way and for promoting macroeconomic stability. In 2008, we saw again a significant U-turn in the use of deficit financing, whereby government spending was dramatically increased and VAT was cut. However, such fiscal loosening was reversed by the change of government in 2010. Thus, judging by the frequent changes in the budgetary policy over the years, the debate about budget deficit and government debt has never been settled in the past and may become increasingly polarised as we approach the general election in May 2015. Jones (2014, p.491) has argued that most of the advanced countries of the world are facing “an explosion of deficits” and “a huge, unsustainable increase in government borrowing” and he calls it “the fiscal problem of the twenty-first century.” This project is therefore an attempt to analyse and evaluate such a crucial topic with a view to reaching some tentative conclusions.

                                             

II. UK’s Budget Balance & National Debt

When the UK government spends more than it collects in taxes, it runs a budget deficit, which it finances by borrowing from the private sector or foreign governments, for example issuing 10-year government bonds. Hence, public sector borrowing is the other side of the coin to the budget deficit – whenever there is a budget deficit, there is a positive borrowing requirement. In the UK, the public sector borrowing in a fiscal year is officially called the Public Sector Net Cash Requirement.  The accumulation of past borrowing is the government debt, also known as national debt or public debt. Conversely, a budget surplus allows the government to pay off part of its accumulated debt.

When Osborne delivered the Autumn Statement last December, he announced yet another missed deficit-reduction target. The budget deficit was expected to fall by only £6.3bn to £91.3bn in 2014-15, around half the decline he forecast in March 2014. To be sure, the deficit at 5% of GDP is uncomfortably large – higher, for example, than the deficits of France and Italy, which are widely seen as in worse economic and fiscal shape than Britain. The problem is no longer economic growth, which is likely to be around 3% in 2014-15. Nor is it the spending cut, which has largely gone according to plan. Rather, the economy is generating £7.8bn less taxes than predicted in March 2014, especially income tax. This is mainly because many higher-paying jobs have been replaced with lower-paying ones, and tax cuts for low earners have therefore left the Treasury short. What is striking is that the Office for Budget Responsibility (OBR) seems to consider this shift to lower wages and taxes as reflecting a change in the structure of the economy rather than a passing phenomenon. This surely does not bode well for long-term public finances. On the positive front, the UK’s public finances benefit from two useful windfalls. The continued drop in interest rates means that the government is making less interest payments than previously expected, whilst the fall in inflation results in lower cash increases in welfare and public-sector pension payments.

Going forward, Osborne argues that lower government spending should put him back on track by 2016-17 (see the graph above). The forecast for borrowing next year has been raised from £68.7bn to £75.9bn, but the predictions for the years after that have improved, with a significant surplus of £23bn projected for 2019-20. However, all this assumes further stringent spending cuts. Since a ring-fence protecting health, schools and foreign aid shields around a third of government spending from cuts, this implies a looming brutal slashing of the unprotected budgets for welfare, local government, justice, the police and defence. According to the OBR’s forecast, by 2020 these departments will have seen their budgets cut by a staggering 41% in a decade, with over half yet to be achieved. One area that, at least from a purely economic viewpoint, still offers material scope for cuts is pensions, as suggested by The Economist (2014) and Mulheirn (2012, pp.24-25). Yet, as a politician rather than an econometrician, Osborne would not base his decisions solely on the multiplier effects of various sources of spending and taxation, but more importantly he would consider the likely response and expectation of the voters, if he ever contemplates returning to office after May to finish the unfinished business.

With budget deficits escalating rapidly since the 2008 financial crisis, national debt, relative to the size of the economy, more than doubled from the pre-crisis level of 36% to 80% currently. The UK’s deteriorated public finances prompted Moody’s to cut its credit rating on government debt to one notch below the top AAA grade in February 2013. This suggested increased perceived risks, resulting in higher interest costs for subsequent issuances of government bonds. The only comfort factor was the downgrade by Moody’s was not followed by other ratings agencies. Standard & Poor’s, which had downgraded US debt in 2011, reaffirmed the UK’s AAA rating in April 2013, though it did place the UK under “negative watch” in a warning about possible downgrading if economic growth faltered or deficit reduction failed. Presumably, this has given Osborne renewed mileage to stick to his spending cut programme.

III. Economic Impact of A Budget Deficit

To undertake a more exhaustive evaluation of the economic impact of a budget deficit, I will divide my analysis into the short run, the long run and the international dimension.

(a) The Short Run

A budget deficit arising from higher government spending leads to an increase in aggregate demand, i.e. a rightward shift in the AD curve to AD2. Working through the multiplier effect, the resultant expansion in aggregate demand is likely to be greater than the initial rise in government spending. In the UK economy, where leakages from savings, taxes and imports account for a significant proportion of national income, the size of the fiscal multiplier is normally not substantial. However, today when interest rates are near zero, the multiplier is likely to be much higher, since people have a greater incentive than usual to spend than save. In the short run, when prices are relatively sticky, the increase in aggregate demand leads to higher output and lower unemployment, but only a modest rise in prices from P1 to P2.

P1

Price Level

Real Output

AD2

AD1

Q2

Q1

P2

SRAS

0

(b) The Long Run

In assessing budget deficits, their long-term effect should also inform our judgment. At a simplistic level, Anderton (2008, p.234) states a truism in that expansionary fiscal policy is unlikely to affect the long-term growth of an economy, since economic growth is caused by supply-side factors, such as investment and education. Indeed, classical economists would argue that fiscal policy cannot change real output in the long run, as the long-run aggregate supply curve is vertical – shifting AD has no effect on output!

Consider the effect of higher government spending on the market for loanable funds.[4] Since the increase in spending is not accompanied by an increase in taxes, the additional spending must be financed by borrowing, i.e. by reducing public saving. With private saving remaining unchanged, the combined national saving will fall, represented by a leftward shift of the saving schedule from S1 to S2 in the diagram below. The new equilibrium is the point at which the investment schedule crosses the new saving schedule. Hence, a reduction in saving from higher government spending lowers investment from Q1 to Q2 and raises the interest rate from r1 to r2.

Rate of Interest

Investment, Saving

S1

S2

I

Q1

Q2

r1

r2

0

Moreover, according to the Solow growth model[5], lower investment is likely to result in lower consumption, further reducing national output. In this model, the accumulation of capital is key to long-run economic growth, in that if a country has high investment levels, it will have a high steady-state capital stock[6] and a high output, and vice versa. This perhaps explains why GDP per capita in South Korea grew so much faster at just under 6% per annum to over US$26,000 during 1960 – 2010, compared with a growth rate of only 1.6% in the Philippines to US$3,200 over the same period, even though both countries started off with GDP per capita levels of around US$1,500 and a similar population size of about 25 million in 1960. Increases in investment and productivity that took place in Korea significantly raised the country’s steady-state output. In the UK, as argued by Mankiw and Taylor (2014, p.275), the capital stock in its economy is well below the Golden Rule level.[7] Hence, a drop in the capital stock will reduce output more than depreciation, causing consumption to fall. In other words, since UK’s capital stock is less than the Golden Rule level, a drop in the capital stock, for example caused by lower investment, from k1 to k2 in the diagram will reduce consumption as well as output. According to Solow, therefore, an increase in government spending is likely to lead to a drop in national output in the long term, due to lower investment and in turn lower consumption as well.

(c) The International Dimension

When higher government spending reduces national saving, this saving is likely to fall short of investment and people start financing their investment by borrowing overseas. This in turn would cause a trade deficit. To illustrate the analysis, consider the diagram below. The line NX representing the relationship between net exports (exports minus imports) and the real exchange rate slopes downward, as a low real exchange rate makes domestic goods relatively price-competitive. The line showing the excess of saving over investment, S – I, is vertical as neither saving nor investment is a function of the real exchange rate. More precisely, the line S – I shows the net capital outflow or net foreign investment and therefore the supply of British pounds to be exchanged into foreign currencies and invested abroad, whereas the line NX shows the net demand for British pounds from overseas importers who need our currency to buy our goods. Thus, if government spending increases, thereby reducing national saving, it would shift S – I leftward, lowering the supply of British pounds available for investment abroad. As a result, the equilibrium real exchange rate rises from E1 to E2. British goods therefore become more expensive compared to foreign goods, which causes exports to drop and imports to increase, worsening the UK trade balance. In other words, a budget deficit is likely to lead to a trade deficit, which in turn is financed by foreign debt. Moreover, the inflow of foreign capital to make up for lower domestic saving pushes the economy to become even more indebted to foreign countries. Of course, a short-run trade deficit does not pose any problem. It even enables a country’s consumers to enjoy living standards boosted by imports, standards that are higher than would be possible from the consumption of their own output alone. In the long run, however, the decline of the country’s industries in the face of international competition would lower living standards.

Using a little algebra, it is interesting to see from the national income accounts identity that the international flow of funds must equal the international flow of goods, which are two sides of the same coin.

National income (Y) = Consumption (C) + Investment (I) + Government Spending (G) + Net

                                        Exports (NX)

Subtracting C and G from both sides to obtain, Y – C – G = I + NX

Given National Saving (S) = Private Saving (Y – T – C) + Public Saving (T – G) where T represents taxes, then Y – C – G = I + NX  becomes S = I + NX

                          Or, S – I = NX

In other words, the net capital outflow or net foreign investment must equal the trade balance. Crucially, the above equations also elegantly sum up that National Saving S is dependent on the consumption function and fiscal policy.

On international trade and finance, my analysis will not be complete without the Mundell-Fleming model,[8] which shows how the exchange rate and income/output respond to changes in government policy. It has been described by Mankiw and Taylor (2014, p.428) as “probably still the most useful and important macroeconomic model that has been developed to date.” It is created out of the IS-LM model,[9] both of which allow the interaction between the goods market and the money market. However, whilst the IS-LM model is for a closed economy, the Mundell-Fleming model assumes an open economy. There are several variants of the latter model; the one that I pick assumes a small open economy with perfect capital mobility and floating exchange rates, a reasonable approximation to the UK’s economy. In other words, it assumes that the UK does not dominate the money market and is a price-taker, and it can borrow or lend as much as it wants at the world interest rate.

When government spending rises, planned expenditure increases, shifting the IS curve rightward to IS2. The £ then appreciates from e1 to e2, but income/output remains unchanged. This stands in marked contrast to the usual, closed-economy IS-LM model, which postulates an income growth to follow a fiscal expansion. The economic justification for the Mundell-Fleming model lies in the effects of the international flow of capital on the domestic economy. It assumes when a fiscal expansion increases national income, interest rates also rise, since higher income increases the demand for money, according to the theory of liquidity preference.[10] However, as British interest rates rise above the world interest rate, foreign capital will be attracted into the UK to take advantage of higher returns. This not only pushes British interest rates back to the world rate, but also raises the demand for the £, thus bidding up its value. Domestic goods become less price-competitive relative to foreign goods. For Mundell-Fleming, the drop in net exports, triggered by higher exchange rate, offsets the expansionary effects of an increase in government spending. The fiscal multiplier is zero! The model and the results would be different if the UK adopts a fixed exchange-rate regime or if its economy is large like the US economy whose interest rates are not dictated by world financial markets.[11] The merit of Mundell-Fleming lies in its ability to capture the implications of the international flow of capital across countries.

IV. Crowding Out: Major Determinant to Impact of Fiscal Policy

Crowding out was an idea that became popular in the 1970s-80s when free-market economists argued against the rising share of GDP being taken by the public sector. Now crowding out refers to a multiplicity of channels through which expansionary fiscal policy displaces private sector spending and output.

Consider again a rise in government spending. The immediate impact is greater demand for goods and services. Since total output is fixed by the factors of production, especially in the short to medium term, the increase in government spending must be met by a decrease in demand elsewhere. As disposable income Y-T is unchanged, consumption should remain unchanged, which therefore points to a corresponding decrease in private investment. This economic reasoning is predicated on two fundamental concepts: scarcity and opportunity cost. The opportunity cost of employing more scarce factors of production to meet government demand inevitably involves sacrificing the employment of the same resources for the private sector. Contrary to what Powell (2013b, p.315) writes: “The resource crowding out argument assumes full employment of all resources,” I argue that full employment is not an essential prerequisite; crowding out can happen as long as the required supply-side production capacity is not in place to respond to the fiscal stimulus. Rather, other dynamics are more important; for example, whether the increase in spending is permanent or transitory. Permanent changes, financed by a permanent increase in taxes, are much more likely to lead to a proportional decrease in private spending. Indeed, any fiscal policy change is not necessarily limited to a maximum of a one-for-one substitution effect for private spending. The fiscal multiplier could become negative! This may happen if scarce resources from the private sector that is deemed productive are transferred to the public sector that is regarded as inefficient, thereby causing the production possibility frontier to shift inward.

The resource crowding out is just the beginning of the story. In the traditional IS-LM model above, a fiscal expansion from IS1 to IS2 does not just result in growth in output or income from Y1 to Y2 but also an upward pressure on interest rates from r1 to r2, not from any full employment constraint, but from the increased demand for money from higher income. Interest rates also tend to rise to persuade investors to buy government debt to finance budget deficits. The fiscal multiplier is smaller the lower the elasticity of money demand to interest rates, or the greater the elasticity of private spending to interest rates. Fiscal expansion crowds out the interest rate-sensitive components of private spending. In particular, higher interest rates are assumed to reduce investment, resulting in a drop in capital accumulation and output. However, a new empirical MIT study reported by The Economist (2014a) concludes that at least in the US, interest rates have little impact on how much firms invest. The profitability of a firm and how well its shares have been performing are far more important. Indeed, they have found that investment often increases when interest rates rise.

There is another channel through which financial crowding out can take place. First, recall that the national income identity requires investment in an economy to be equal to total saving. We can derive this relation from the national income identity:

Y = C + I + G + (EX – IM)

Rearranging, Y – C – G + (IM – EX) = I

Add and subtract tax revenues T from the left side, (Y – T – C) + (T – G) + (IM – EX) = I

This means, private saving + public saving + foreign saving = investment

Thus, there are three ways investment can be financed: saving by the private sector, saving by the government and saving by foreigners. When the government runs a budget deficit, public saving becomes negative. Some of the savings by the private sector and foreigners must then be channelled to fund government borrowing. In other words, budget deficits soak up saving, thereby crowding out investment. However, what about the possibility that private or foreign saving rises in response to increased government demand for funds, therefore budget deficits need not crowd out investment? Here, we can appeal to Ricardian equivalence,[12] which claims that consumers are forward-looking. They see current budget deficits as future higher taxes, which for them are equivalent to higher taxes today. Thus, financing public spending by debt is equivalent to financing it by taxes. Consumers save the extra disposable income to pay the future tax liability that current budget deficit implies. This increase in private saving means that budget deficits need not crowd out investment. In practice, however, consumers may just follow not fully rational rules of thumb when deciding to save/spend. Moreover, to the extent that households are limited by borrowing constraints, Ricardian equivalence may not hold. The equivalence argument can also break down when budget deficits benefit people different from those paying future higher taxes. This might occur because of a progressive tax system or because those who pay and those who benefit belong to different generations.

Based on the above analysis, whether budget deficits crowd out investment is still the subject of much debate and research. Jones (2014, p.503) sums up: “The extent to which budget deficits crowd out investment is unclear, and there is no consensus on the answer in the economics literature.” The graph below shows the time series for investment and government borrowing in the UK. To measure their relation, I calculate the product-moment correlation coefficient, which is -0.91, indicating strong negative linear correlation. Thus, there appears a negative relationship between investment and government borrowing, though this does not definitively suggest that there is a relationship in reality. In particular, the appearance of a correlation does not imply a causal relationship. In other words, we cannot say budget deficits have crowded out investment, no matter how negative the correlation coefficient is. It is significant that excluding the years from the financial crisis in 2007/08, the value becomes only -0.76. I have considered running a significance test to determine if this changed value still indicates a correlation between the variables, backed by statistical theory. However, since my sample size is only 16, it would be inappropriate to assume that the two sets of investment and government borrowing data are jointly normally distributed with the population correlation coefficient.[13] Moreover, other important factors seem to be at work that contribute to the apparently strong negative correlation between investment and government borrowing. Especially since 2007/08, with unemployment high and private demand for loans low, the problem was excessive saving. There was very little likelihood that the government did crowd out private activity. What probably happened was in the wake of severe economic downturn, the Labour government pursued aggressive fiscal expansions, resulting in a surge in government debt, which coincided with a lack of confidence on the part of companies and banks, leading to a sluggish picture of investment and loans.

Source: ONS and World Bank

V. When Does National Debt Become Too Big?

It is a very hard question to answer, not least because debt is a highly useful tool, allowing borrowers to get much needed funds from creditors with an excess of them. Indeed, the broadening and deepening of international credit markets that preceded the financial crisis was considered a spur to growth, since it gave ever  more borrowers access to bigger loans at lower interest rates. However, whilst there is no magic threshold for the debt/GDP ratio, beyond which economic growth is slower and default is certain, the risks increase as the ratio grows.[14] Though net global debt is zero, it is far from a zero sum game. High debt levels do matter. With UK’s national debt reaching 80% of GDP, if the average maturity of debt is 10 years, then 8% of GDP or around £150bn must be refinanced every year. If creditors lose confidence in the UK’s economy, a debt crisis may occur. This can potentially lead to a trap that Irving Fisher called “debt deflation” which is already happening in the euro zone. True, economies as a whole differ from individuals in that they essentially have infinite lives, so there is no reason why they should ever pay off their debts entirely. Nevertheless, what is important is fiscal sustainability, and there are important principles that a government should follow in managing deficits and debt.

(a) Budget Constraint

The principle of the inter-temporal budget constraint is that the present value of tax revenues is enough to cover current and future spending plus paying off the initial debt. The government can borrow or lend in any given period. However, the budget must balance, not period by period, but in a present discounted value sense. I would argue whilst this principle enables us to understand the logic of why borrowing today implies future higher taxes, it is hard to estimate the present values of the future streams of revenue/spending with any precision.

(b) Debt/GDP Ratio and Economic Growth

Following the budget constraint principle, an economy’s ability to generate revenue partly depends on the size of its GDP, which roughly reflects the total tax base. This explains why we often divide government debt by GDP. For debt to be sustainable, the ratio of debt/GDP must not exceed some long-run constant value. In other words, government debt must not continue growing faster than GDP; otherwise, debt will become a larger and larger multiple of GDP, and there must come a point at which the government is no longer able to service its debt. Moreover, the long-run constant value must be prudently set to allow for short-term shocks. In the UK, under the Code for Fiscal Stability in 1998, the “golden rule” states that over an economic cycle the government will borrow only to invest. This means net government borrowing should be to fund new social capital such as schools and roads, but not to fund current spending, such as welfare benefits.[15] To stop the government undertaking excessive capital spending, the “sustainable investment rule” requires the debt/GDP ratio to be held over an economic cycle at a stable and prudent level, which is defined as “below 40% of GDP.” Together the two rules seem to be good.[16] The “golden rule” allows for the budget deficit (excluding investment) to vary over the business cycle, so that it can be used for macroeconomic stabilisation. It also aims to protect necessary investment in social capital when faced with the need to rein in public spending. Meanwhile, the “sustainable investment rule” ensures that investment and public debt do not become uncontrollable.

The frightening speed of the economic collapse in 2008 pushed many countries including the UK to roll out big packages of extra spending and tax cuts. In November, the Chancellor suspended the two fiscal rules. Compared to the pre-crisis level, the debt/GDP ratio doubled to 72% in 2011/12 before reaching 80% in June 2014. The key to lowering debt is rapid economic growth, which many countries struggle to achieve. Keynesians would suggest that this failure reflects an undue obsession with fiscal austerity, but I would add that demography is also a constraint, and an enduring one: workforces in many developed countries are stagnant or shrinking. In the Autumn Statement, the OBR raised its forecast for economic growth in 2014 from 2.7% to 3.0%, and from 2.3% to 2.4% in 2015. The recovery seems real, and still has momentum. Hence, I expect the debt/GDP ratio to peak at 80-81%. However, it gives pause for thought that growth is largely driven by consumer spending on the back of house-price growth, when we should be rebalancing, towards manufacturing and investment. To ensure sustained growth, the economy must overcome structural weaknesses.

(c) Interest Rate, Default and Inflation

If government borrowing gets too high, it can meet its interest payments on existing debt only by borrowing more and more. Bondholders may start anticipating repudiation of government debt and demand a risk premium, further accelerating budget deficits and debt. Of course, the government can pay its debt by simply printing money. This is likely to cause inflation, which reduces the debt’s real value. However, this is not a long-term solution. If bondholders anticipate repudiation through inflation, they will require higher interest rates. Either way, there will be heightened uncertainty in financial markets, depressing output and employment. If investors perceive significant default risk or inflation getting out of control, the economy may then experience capital flight – an abrupt decline in the demand for a country’s assets in world financial markets. This in turn will cause a drop in the currency’s value and an escalation in interest rates. This is precisely what happened to Mexico in the early 1990s. Surely, the UK’s fiscal situation is not there yet, with its debt/GDP standing at 80% and interest payments totalling £49bn (3% of GDP). However, caution needs to be exercised. In 2001, the debt/GDP ratio in Argentina peaked at 65% just before its default crisis, though the danger level varies with each economy, based on historical experience, growth prospects, and the credibility of the government and central bank. Moreover, we must not overlook the opportunity cost involved (because interest payments of £49bn could have been used in productive ways) and the redistribution of income and wealth from taxpayers to bondholders.

As government debt rises, the increased demand for loans is often claimed to drive up interest rates, further raising the loan demand, which triggers a vicious spiral of escalating debt and interest rates. To test such an argument, I compute the product-moment correlation coefficient  between government borrowing/GDP and 5-year or 10-year bond yield over the period 1997-2014, and the results of -0.61 and -0.49 respectively suggest no meaningful correlation between government debt and government bond yield.[17] This is consistent with Blanchard’s finding that “empirical evidence, both across countries and from the last two centuries, shows surprisingly little relation between the two.” Indeed, in the UK the sharp rise in government debt during 2008-12 coincided with a fall in bond yields. This presumably reflects more the difficulty of identifying and controlling other factors than the absence of worsening effects of deficits and debt on interest rates. Other factors are: bond yields have been held down by low inflation worldwide, weak investment and the increased appetite for safe assets. Another significant factor is Bank of England’s massive “quantitative easing,” resulting in a buyback of government bonds worth hundreds of billions of pounds. That is why despite mounting debt, the UK has seen fairly stable interest payments as a percentage of GDP in recent years.

VI. Conclusion

As the UK has been struggling with its economic recovery, people are divided over whether our national debt is too high and in turn whether a budget deficit is a viable policy. My research shows that this two-pronged question should be rephrased, and we should instead ask ourselves whether we can afford to continue pursuing a budget deficit and whether we ought to do so in the interests of our economic well-being. As mentioned earlier, the UK can afford to see its debt rising only if its economy grows at least at the same pace. I have argued that the economy must restructure itself, reducing its dependence on the service industry and rebalancing towards manufacturing and investment. With investment trending down from 25% of GDP in the late-1980s to around 15% currently and standing at the bottom in the G20, British productivity has become highly uncompetitive – the French could reportedly take Friday off and still produce more than Britons do in a week! No doubt the Keynesians would argue that the deficit/debt problem is essentially a growth problem in disguise. When there is growth, revenue will increase to balance the budget and perhaps to pay down borrowing. Thus, on growth-enhancing investments, Britain faces the choice to decide or decline.

As for the “ought” question, during 2008-10 many countries ran budget deficits and issued debt to boost confidence and demand. The logic was quintessentially Keynesian: as the economy sank into recession, the government acted as the demander of last resort. However, section III shows that in an open economy like the UK, when national saving falls on the back of a budget deficit, people start financing investment by borrowing overseas, leading to increased foreign debt. The Mundell-Fleming model suggests that the appreciation of the exchange rate and the resultant drop in net exports reduce the short-run expansionary impact of budget deficits on output and employment. Thus, budget deficits are likely to cause trade deficits, pushing the economy to become even more indebted to foreigners. In the long run, the reduction in saving lowers investment and raises the interest rate, according to the loanable funds theory. The Solow growth model shows that lower investment eventually leads to lower steady-state capital stock and in turn lower consumption, further reducing output and economic well-being.

Hence, whilst the UK can afford to continue running budget deficits subject to its ability to deliver growth, the resulting benefits are uncertain at best in the short run and non-existent in the long run. The short-run uncertainty partly depends on how the Bank of England responds to the deficit – holding constant the money supply, the interest rate or national income? These three scenarios produce widely different outcomes. Our focus should thus be on the fiscal-monetary policy mix rather than just fiscal policy alone. We might hope that drawing on empirical evidence could help us settle the debate on the consequences of budget deficits and government debt. Yet when I run statistical tests on the relationship between investment and government borrowing, and between bond yield and government borrowing, the results are inconclusive. This reflects more the difficulty of identifying and controlling other factors than the actual absence of any relationship between the variables. Notwithstanding such ambiguities, policy makers have the unenviable task of facing two important normative questions: the size of the state and the intergenerational distribution of the fiscal burden. Is there an optimal size of the state that will incentivise both the public and private sectors, and that will provide a firm foundation for long-term wealth creation? Insofar as future generations are likely to be much richer than current generations, largely due to investments in capital, education and research made by current generations, how should policy makers allocate the fiscal burden across generations? We should realise that national debt is just a way to spread national burden and output across generations. Overall, therefore, when addressing the issues of deficits and debt, policy makers must ensure that they are not just sustainable but also optimal and equitable, to future as well as current generations.

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Outline (50-150 words) the nature of your final product, its main content and your conclusion

My final product is an extended essay that is empirical as much as theoretical. I collect and analyse macroeconomic data, and run statistical tests on them. I argue whilst the UK can afford to continue running budget deficits subject to its ability to deliver growth, the resulting benefits are uncertain at best in the short run and non-existent in the long run. How the Bank of England responds to the deficit is important. Our focus should thus be on the fiscal-monetary policy mix rather than just fiscal policy alone. The crowding-out hypothesis is still the subject of much debate and research. I conclude that faced with the two normative questions about the optimal size of the state and the intergenerational distribution of the fiscal burden, policy makers must ensure that budget deficits and debt are not just sustainable but also optimal and equitable, to future as well as current generations.

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[1] This research was completed before the Budget announcement on March 18^th.

[2] National debt represents accumulated borrowings by the central government, local governments and other state bodies but excluding public sector banks. Some argue that Britain’s national debt is actually a lot higher, for it excludes pension liabilities.

[3] Structural deficit is budget deficit, adjusted to strip out the cyclical nature of the economy. One would expect, for example, the budget deficit to narrow when the economy grows after a sluggish period. The structural deficit attempts to exclude the effect of this recovery.

[4] The loanable funds theory explains how interest rates are determined in a simple economy where the main demand for money comes from investment and the main supply of money comes from savings. In the real world, however, money markets are far more complex. In an open economy like the UK, interest rates are also influenced by flows of money between countries; see the next section.

[5] The Solow growth model is named after Robert Solow and was developed in the 1950s-60s. In 1987, he won the Nobel Prize for his work on economic growth. His model was introduced in “A Contribution to the Theory of Economic Growth,” Quarterly Journal of Economics, 1956, pp. 65-94.

[6] A steady-state level of capital is the level at which investment equals depreciation, and where an economy tends to end up in the long run. Thus, the steady state represents the long-run equilibrium of the economy; it is a ‘state’ of the economy in which all the key endogenous variables, such as investment, are ‘steady’.

[7] The Golden Rule level of capital is the steady-state value of capital that maximises consumption. It has nothing to do with the “golden rule” under the Code for Fiscal Stability. The similarity in names is purely coincidental.

[8] The model was developed in the early 1960s. In 1999, Robert Mundell was awarded the Nobel Prize for his work in open-economy macroeconomics. His contributions are collected in International Economics, 1968, New York: Macmillan.

[9] The IS-LM model is really a short-run aggregate demand model, and was first introduced by the Nobel Prize-winning economist John Hicks in 1937 as the leading interpretation of Keynes’s theory. IS stands for investment and saving and shows the goods market equilibrium condition, whereas LM stands for liquidity and money and represents the money market equilibrium condition. The IS curve is drawn for a given fiscal policy: changes in fiscal policy that raise the demand for goods and services shift the IS curve to the right. The LM curve is drawn for a given supply of real money balances: decreases in the supply of real money balances shift the LM curve upward.

[10] The liquidity preference theory suggests when income is high, expenditure is high, so people engage in more transactions that require the use of money. Thus, greater income leads to greater money demand. The quantity of money demanded is positively related to income but negatively related to the interest rate.

[11] For example, a fiscal stimulus does raise income/output in a large open economy, unlike in a small open economy with floating exchange rates. The level of the impact, however, is smaller than in a closed economy. For a full exposition, see Mankiw and Taylor (2014, pp.431-434).

[12] The theory was first noted by the 19^th-century economist David Ricardo. His contribution was in his 1817’s work, Principles of Political Economy and Taxation.

[13] For a detailed explanation of how to construct the null hypothesis and the alternative hypothesis in carrying out the significance test, please refer to Crawshaw and Chambers (2001, pp.600-604).

[14] Carmen Reinhart and Kenneth Rogoff of Harvard University published a much-cited paper claiming that economic growth slows sharply when government debt tops 90% of GDP. Follow-on studies confirm a negative relationship between growth and debt, albeit not at the same threshold.

[15] In practice, to differentiate investment from current spending is not as straightforward as it seems. For example, should teachers’ salaries be treated as investment in human capital?

[16] Critics have argued that the government fudged the distinction between current and capital spending, and that it was free to define and date the economic cycle. However, keeping national debt within 40% of GDP did increase the confidence of financial markets in the government’s handling of public finance.

[17] To support the theoretical argument that higher debt leads to higher interest rates, the correlation coefficient has to be significantly positive.