Why officials in Labour government pushed ‘dash for ‘diesel’ – BBC News

In 2001, the then Labour government introduced Vehicle Excise Duty (VED) – a tax on car ownership. It was intended to disincentivise the purchase of cars that produced high levels of carbon emissions – the more CO2 your car emitted the higher the VED charge. An economist would argue that carbon emissions create negative externalities, costs to third parties for which no compensation is paid. These ‘externalities’ can come in many forms, in this instance the costs associated with global warming and climate change affect us all regardless of whether we buy or sell a car. This results in market failure as resources are over-allocated and, so, an indirect tax, which should lead to an increase in the market price, would deter consumption and reduce the over-allocation of resources. Unfortunately, as in this case, government intervention does not always work. One reason is the idea of ‘unintended consequences’, I.e. some adverse effects arise as a result of the intervention that was not initially considered. These consequences can actually make the allocation of resources worse post-intervention, clearly, this is inefficient. In this case, the ‘dash for diesel’ has led to a significant increase (approx. 300%) in the number of diesel cars on Britain’s roads. As a result, non-carbon emissions, often more damaging than carbon, have surged, reducing air quality, increasing lung disease, and leading to the premature deaths of thousands of people. Car manufacturers and firms with a large fleet of diesel vehicles, such as logistics firms, are likely to resist any ‘diesel tax’, but the health costs are clear and the previous government’s mistake in VED design needs to be addressed as a matter of urgency. Look out for some movement in this week’s budget. You can read the full article here.

 

 

Budget Day Approaches

The newspapers and current affairs programmes are full this weekend with thoughts on what will be in Wednesday’s budget. However there is general agreement that the Chancellor faces a number of tricky issues. The economic context is difficult. So far this month, interest rates have been increased, last week it was announced that employment had fallen by 14,000, the largest fall in two years, yet unemployment remained at 4.3% (1.42m people), the lowest for 42 years. Inflation has remained at 3% for the second month but there is view that the rise since the Brexit vote, caused largely by the fall in the value of sterling, is likely to drop out of the calculations in the next few months, supported by evidence which shows producer’s costs are rising  at their slowest rate  since last July. However recent rises in the price of oil might upset these calculations.

A key problem remains the UK’s low rate of productivity growth. Although it has just increased over the second and third quarters this year, this is down to the fall in employment, rather than underlying improvements in the UK economy. The poor productivity performance has meant that pay increases have been low and lower than the rate of inflation, causing a fall in living standards. Commentators are looking for measures which will improve our productivity such as money for infrastructure projects, such as the £7bn infrastructure spending on housing and transport proposed for the region between Oxford, Cambridge and Milton Keynes. Others want more money for the NHS and social care,  some believe that education should be a major recipient of increased spending, some want more spent on housing and  others want a relaxation of the public sector pay cap. For those in the north, there is a feeling that the south has gained at their expense in terms of spending (think Crossrail 2, HS2 not going far enough and HS3 being delayed).

In addition, the Chancellor still has the problem of managing the budget deficit, where the timeline for reducing the structural deficit (that element not directly related to the economy’s position in the economic cycle) has been gradually extended.

Finally, the budget must be delivered in the context of considerable uncertainty over the Brexit outcome. Anything too deflationary will reduce confidence among consumers and businesses while anything too expansionary might risk boosting inflation and the budget deficit.

Since writing this at the weekend, matters have moved on. On Monday  Visa reported that they were predicting the worst Xmas for retailers since 2012, based on the slow-down in spending compared to last year, while, on the political front,  Tuesday’s newspapers reported on tension within the Conservative Party over the forthcoming budget and a fear that it might be economically sound in terms of keeping a rein on spending but politically unacceptable.

The Financial Crisis – 10 Years On

August 9^th, 2007, is sometimes cited as the start of the financial crisis which has impacted on world economies for the last ten years. This was the day when BNP Paribas, a major French bank, stopped customers withdrawing money from three sub-prime mortgage investment funds, largely operating in the USA. This might not seem particularly significant, but what it suggested was that it was possible that money lent to a bank might not be repaid. Another key date for the UK was 14^th September 2007 –  the date when Northern Rock suffered a “bank run” – the first in the UK for 150 years – and the news was full of pictures of people queueing outside Northern Rock branches to get their money out. For those in the USA, 15^th September 2008 was significant since it was the date Lehman Brothers filed for bankruptcy protection, leading to the largest drop in the Dow Jones Index (similar to the UK FOOTSIE Index) since the September 11 attack in 2001.

Almost every bank in Europe and the USA relied on borrowing from other banks. The borrowing was via the inter-bank market (loans from one bank to another) and Northern Rock, like other banks, lent money to customers for long periods (e.g.  a 20 or 25 year mortgage) using both its customers’ deposits and money borrowed from other banks on a short-term basis in the money market. The BNP action made banks less willing to lend in the inter-bank market and as a result interest rates rose and the duration of loans fell despite central banks trying to inject liquidity into the market. As the inter-bank market froze, more financial institutions such as TSB, Bradford and Bingley, Lloyds, Alliance & Leicester and HBOS in the UK,  found themselves in difficulties and confidence among banks fell further.

However, although the BNP Paribus action was significant, there were other factors which created the circumstances which made its action so important. Firstly, there had been an excessive expansion of the money supply, particularly in the USA, in the years leading up to the financial crisis caused by excessive lending and borrowing. This excessive money supply growth caused an increase in asset prices, especially housing.

Secondly, in the late 1990s there was a vast quantity of savings looking for a reasonable return, a large part of which came from Asian countries running large balance of payments surpluses seeking somewhere to invest their surpluses. This excess of savings resulted in low rates of interest and encouraged banks and other financial institutions to look for areas with a high rate of return. One of the most attractive areas was to take advantage of the property boom and lend to mortgage borrowers, particularly those classified as “sub-prime”, who were less financially reliable and paid a higher rate of interest than lenders could obtain elsewhere. In the climate of the early 2000s, this was a safe investment since housing markets were booming and if the borrower were to default, the lender would re-possess the property and sell it at a profit.

A third factor was the way in which financial organisations making these sub-prime loans combined them into packages to create a new financial asset consisting of a bundle of these individual loans, called CDOs, or collateralised debt obligations, which could then be sold on to other financial institutions. Further bundling then took place as financial institutions bundled CDOs together and sold off slices to other financial institutions. In theory, the CDO was safer than the individual loan since, the argument went, if one made one loan and it failed, one had lost all one’s money. However, if one invested in a CDO, where you might have a slice of 100 loans bundled together, one individual loan failing was relatively insignificant.

Unfortunately, as it transpired, when the sub-prime market as a whole collapsed, due to rising interest rates and falling house prices in parts of the USA, the CDOs were equally risky and quickly depreciated in value. They also suddenly became illiquid meaning that their holders were unable to sell them to realise even a part of their value.

A fourth factor to consider was the separation of responsibility for the regulation of the UK banking system from the operation of monetary policy, both of which were previously the responsibility of the Bank of England. However, in 1999, the Chancellor, Gordon Brown, created a three-way structure involving the Bank of England, the Treasury and the Financial Services Authority. The FSA was responsible for maintaining confidence in the financial system, preserving financial stability, protecting consumers and reducing financial crime. Following the crisis, the FSA was replaced by the Financial Conduct Authority in 2013 which is responsible for regulating 56,000 financial services firms to protect consumers, protect financial markets and promote competition). The move from a single body regulating the financial system to a tripartite arrangement possibly hindered a speedy response to the crisis.

In retrospect, a final factor must be the failure of the US authorities to arrange a bail-out for Lehman Brothers. It is difficult to speculate on what would have happened had Lehman Brothers not been allowed to collapse, but one can reasonably assume that there would not have been the same collapse in confidence which affected financial markets world-wide.

It is worth reflecting on the effects of the crisis by looking at what has happened to the UK economy in the decade since the crash. Since the third quarter of 2007 UK GDP has grown by approximately 11%. This was one third of the growth in the previous decade. As a result, economists talk of a  ”lost decade”.   The situation is even worse if we focus on the growth in GDP per head where we are only 3% up on where we were ten years ago. Focussing on real average weekly earnings shows an even worse picture. Although average weekly earnings are up 19% over the decade, the CPI has risen by  26%, showing that workers are 7% worse off in real terms. There has also been a shift in the distribution of income with the elderly gaining at the expense of workers through the triple lock (the commitment to link the increase in the value of pensions to inflation, the rise in average earnings or a minimum of 2.5% whichever is higher). As a result, the median income of retired households has gone up 13% compared to a fall of 1.2% for non-retired households.

Interest rates have fallen from 5.75% before the crisis to 0.25% today (31^st October 2017).  Therefore homeowners with mortgages have gained significantly. For example, mortgage payments on a £150,000 fixed rate mortgage would have been £1355 per month in 2007 compared to £871 today, and an additional benefit has been that average   house prices have risen by 10%, although there have been significant regional variations. This is a further benefit to the elderly although since many of them might be savers, they have lost out from the low interest rates.

The National Debt has soared as a result of the measures taken by the government to reduce the effects of the crisis. In August 2007, the national debt was £534bn; it is now approximately three times as large at £1.6tr. The value of sterling has fallen from £1 = $2.11 to $1.3 today (but the implications of this deserve a separate article) and, on the positive side, UK unemployment is at a 42 year low.

The end of the era of low interest rates?

On Thursday 2^nd November, the Bank of England increased interest rates. Although the increase was not large (from 0.25% to 0.5%), possibly it marks the end of an era. It was the first increase since 2007 and follows the cut in rates in 2009 from 4.5% to 0.5% after the collapse of Lehman Brothers. The rate was further cut in 2016 to 0.5% following the Brexit vote.

Traditionally the rate rise should benefit savers and make it more expensive for borrowers, particularly those with mortgages. However the UK economy has changed in the ten years since rates were last increased. Banks have been far slower to reward savers  than to punish borrowers when rates rise so savers should not get too excited by the rise in interest rates. More importantly, the number of homeowners with variable rate mortgages has fallen significantly, with The Times estimating that only 10% of households will be affected by the rate rise. This is partly because of the shift to fixed rate mortgages, which now account for 60% of mortgages, the increase in renting and the repayment of mortgages among older households.

Secondly, although in percentage terms the rise is large, in absolute terms it is relatively small and, for a family with a £250,000 variable rate mortgage, they will currently be paying approximately £1,125 per month and their payments will rise about 2.25% or £25 per month. This will reduce discretionary income and consequently consumption is likely to be slightly reduced. There are however two more significant effects. Those borrowing via  credit cards or taking out loans for large purchases such as cars or furniture, will see borrowing costs rise and this could deter future consumption. Another issue is that people currently with very high borrowing, particularly those on low incomes, might find it increasingly difficult to repay the interest on their existing borrowing, with an impact on bankruptcies. Most important is likely to be the psychological impact of the rate increase since a signal has been sent out that the era of ultra-low interest rates is coming to an end.

The rate increase is not unexpected, having been forecast in the press for some time. The recent rise in inflation to 3% made it more likely. However it is worth assessing the decision  in more detail. Normally interest rates increase as inflation rises in order to reduce inflationary pressures in the economy and keep inflation within the 1% – 3% band set for the Bank of England by the Government. According to the traditional Phillips Curve idea, rises in inflation are likely to occur simultaneously with falls in unemployment as increases in aggregate demand in an economy work simultaneously to increase prices and reduce unemployment as firms attempt to hire more workers to increase output, thereby putting an upward pressure on wages which then feeds into higher inflation. One could therefore easily argue that, at many times, an increase in interest rates is a sign of a strong economy experiencing rapid growth.

The current situation is slightly different. The increase in UK inflation can be partly explained by the fall in the value of sterling following the Brexit vote and this will drop out of the CPI index over the next few months. Secondly, although unemployment is at a record low at 4.3%, there has not been the rise in earnings which, in the past, we would have expected to accompany the strength of the labour market, thirdly there has been a slow-down in the UK’s rate of growth and finally there is still considerable uncertainty in the economy about the outcome of the Brexit negotiations which is affecting confidence among businesses. So why the rise in rates?

One explanation for the rise in interest rates comes from Ed Conway, the Economics Editor of Sky News who suggests that the UK’s ability to grow without inflation has fallen in recent years because of our poor productivity growth. Whereas in the past we might have been able to sustain growth of 2 – 2.5% without inflation, he thinks the maximum figure for non-inflationary growth might now be 1.5%. Therefore, without compensating action, inflation is likely to increase.