Central Banks have often used the term ‘the neutral rate’ which refers to a rate of interest that neither stimulates the economy nor restrains economic growth. This rate is often defined as the rate which is consistent with full employment, trend growth, and stable prices – an economy where neither expansionary nor contractionary measures need to be implemented.
In most economies post GFC the neutral rate of interest fell as they have required lower rates to try and encourage growth. See table below of current rates of Central Banks and approximate neutral rates.
What indicators shoud you look at as to whether neutral interest rates might have changed? Here are 4 that are identified by John McDermott, Assistant Governor of the Reserve Bank of New Zealand:
1. World Conditions
Gowth of the major trading partners of any country can put pressure on aggregate demand which consequently causes inflationary conditions. With this and inflatinary expectations there could be pressure on a central bank to increase interest rates
2. Domestic productivity growth
A continued decrease in productivity growth will lower returns to investment, whcih means that investment is less attractive. If the desire to invest falls and the desire to save remains unchanged, a lower neutral interest rate will be required reconcile savings and investment plans.
3. Population growth
Lower population growth decreases the number of people in the labour force, meaning less investment is needed to provide the necessary capital stock to employ the average labour force. As investment falls, a lower neutral interest rate – the one that equalises the supply of and demand for funds – will be required.
4. Preferences for savings and investment
If people decide to save more and consume less a lower interest rate would be required to boost the pace of activity and inflation and reconcile saving and investment plans.
An implication of a lower neutral interest rate is that households and businesses will face lower interest rates ‘on average’, but this should not be read as a promise of lower interest rates all the time. Interest rates will need to be adjusted in response to the state of the economy. For times when demand in the economy is expanding more rapidly than the economy’s ability to meet that demand interest rates will need to be above neutral. Moreover, there is no reason to suppose how far interest rates move from trough to peak will be any different in the next business cycle than they moved in previous cycles. John McDermott, Assistant Governor of the Reserve Bank of New Zealand
Just published on their website, the Reserve Bank of New Zealand has prepared a short video explaining inflation. The video, featuring the Bank’s Head of Economics, John McDermott, explains how inflation is measured and how it manifests itself in everyday life. It also explains the importance of maintaining price stability. Well worth a look.
Nouriel Roubini wrote a piece on the Project Syndicate site focusing on the costs of QE. After three rounds of QE one wonders about its effectiveness. Roubini came up with 10 potential costs.
1. QE policies just postpones the necessary private and public sector deleveraging and if this is left too long it can create a zombie economy – institutions, firms, governments etc lose their ability to function.
2. Economic activity in the circular flow may become clogged with bond yields being so low and banks hoarding liquidity. Therefore the velocity of money circulation grinds to a halt.
3. With more money in the economy this implies a weakening of the currency but this is ineffective if other economies use QE at the same time. QE becomes a zero-sum game as not all currencies can fall simultaneously. QE = Currency Wars
4. QE leads to excessive capital to emerging markets. This can lead to a lot of extra liquidity and feed into domestic inflation creating asset bubbles. Furthermore an appreciation of the domestic currency in emerging markets makes their exports less competitive.
5. QE can lead to asset bubbles in an economy where it is implemented. It is especially prevalent when you’ve had an aggressive expansionary monetary policy (1% in USA after 9/11) already present in the economy for many years prior.
6. QE encourages Moral Hazard – governments put off major economic reforms and resort to a band aid policy. May delay fiscal austerity and ill discipline in the market.
7. Exiting QE is important – too slow an exit could mean higher inflation and assets and credit bubbles are created.
8. Long periods of negative real interest rates implies a redistribution of income and wealth – creditors and savers to debtors and borrowers. QE damages pensioners and pension funds.
9. With QE excessive inflation accompanied by slow credit growth, banks are faced with very low net interest-rate margins. Therefore, they might put money into riskier investments – remember the sub-prime crisis, oil prices up $147/barrel
10. QE might mean the end of conventional monetary policy. Some countries have discarded inflationary targets and there is no cornerstone for price expectations.
There has been numerous mentions in the media about the need to reduce the strength of the NZ$. RBNZ Governor Graeme Wheeler outlined some of these in a recent speech. He identified the following policy responses:
1. Lowering Interest Rates
By lower interest rates you may reduce pressure on the exchange rate as long as the new rate is uncompetitive to those in other countries. However a one-off reduction in the interest rate which conflicts wtih the policy of the central bank’s inflation target could lead to expectations of a subsequent reversal. Examples of when it hasn’t work:
Australia – since the end of 2010 RBA cut its official cash rate by 1.75% – no significant impact on the AUS$.
Japan – on the other hand the Yen actually appreicated by over 30% between February 2007 and November 2012 when the interest rates was lowered to 0 – 0.1%.
Switzerland – The Swiss Franc appreciated by 20% between Jan 2010 – July 2011 despite interest rates being lowered between 0 – 0.75%
2. Intervening in the Foreign Exchange Market
The RBNZ have 4 criteria it uses to decide whether to intervene in the foreign exchange market.
1. Is the exchange rate at an exceptional level?
2. Is its value justified?
3. Is intervention justified with current monetary policy?
4. Are market conditions conducive to achieving the desired outcome?
Global exchange rate turnover is between US$4 -5 trillion per day and it is estimated that the NZ$ is the 10th most traded currency in the world. The RBNZ has indicated that it is prepared to intervene but can only attempt to smooth the peaks of the US$ – NZ$ exchange rate.
3. Quantitative Easing – printing money.
This has been adopted by the US central bank in response to teh global financial crisis. However New Zealand was not exposed to risky investments to the extent that other countries were. New Zealand’s challenges are different from those in the US, Euro zone etc. The printing of more money would put upward pressure on inflation, especially asset prices, and ultimately lead to higher interest rates.
4. Cap the exchange rate – the Swiss experience
The Swiss National Bank spent had some success in capping the Swiss franc to the Euro – SFr 1.2 – 1 euro. This woud be very risky for New Zealand – Swiss lost approximately
NZ$35bn in the process. New Zealand would need to intervene to the same extent and the interest rates would need to drop to 0% also. The capping would amount to quantitative easing which with 0% interest rates would be inflationary.
Graeme Wheeler finished up by saying:
The New Zealand economy currently faces an overvalued exchange rate and overheating house prices in parts of the country, especially Auckland. The Reserve Bank will be consulting with the financial sector next month on macro-prudential instruments. These instruments are designed to make the financial system more resilient and to reduce systemic risk by constraining excesses in the financial cycle. They can help to reduce volatile credit cycles and asset bubbles, including overheating housing markets, and support the stance of monetary policy, which could be helpful in alleviating pressure on the exchange rate at the margin.
I have being going over the theory behind the output gap and here is an explanation – written a few years ago. Probably not so applicable to the economic environment today
Just as Messrs Friedman and Phelps had predicted, the level of inflation associated with a given level of unemployment rose through the 1970s, and policymakers had to abandon the Phillips curve. Today there is a broad consensus that monetary policy should focus on holding down inflation. But this does not mean, as is often claimed, that central banks are “inflation nutters”, cruelly indifferent towards unemployment.
If there is no long-term trade-off, low inflation does not permanently choke growth. Moreover, by keeping inflation low and stable, a central bank, in effect, stabilises output and jobs. In the graph below the straight line represents the growth in output that the economy can sustain over the long run; the wavy line represents actual output. When the economy is producing below potential (ie, unemployment is above the NAIRU), at point A, inflation will fall until the “output gap” is eliminated. When output is above potential, at point B, inflation will rise for as long as demand is above capacity. If inflation is falling (point A), then a central bank will cut interest rates, helping to boost growth in output and jobs; when inflation is rising (point B), it will raise interest rates, dampening down growth. Thus if monetary policy focuses on keeping inflation low and stable, it will automatically help to stabilise employment and growth.
The BNZ Markets Outlook looked at reasons why Graeme Wheeler, the RBNZ Governor, might keep a ‘steady as she goes’ attitude to Thursday’s OCR review. Below are some thoughts as to why he could be swayed to increase or decrease the OCR rate.
With all that said it is expected that Graeme Wheeler will leave the OCR unchanged at 2.5%.
With near zero interest rates in the US and the promise of them to remain until 2015 those that are living off the interest on savings, mainly the retired, are finding their incomes squeezed. According to The Economist personal interest income has plummeted by 30% which equates to a $432bn annually and more than 4% of disposable income. Former IMF chief economist Raghuram Rajan describes the Fed’s policy as:
“expropriating responsible savers in favour of irresponsible banks”
How should lower interest rates work according to the textbook?
However today it seems that even with these really low interest rates businesses and consumers don’t want to borrow or cannot qualify due to the more stringent requirements required. Furthermore with less consumption in the circular flow you would think that there is less need to fuel anymore investment spending.
From the Australian Markets Weekly:
The Chinese indicators released on Sunday showed further signs of recovery, with better than expected outcomes for industrial production and retail sales. Industrial production rose 10.1%yoy in November (median 9.8%) from 9.6%, continuing to trend
higher after the 3-year low of 8.9% seen in August. Retail sales were up 14.9%yoy in November (median 14.6%) from 14.5%. Meanwhile inflation was subdued, up just 0.1% in November and 2.0%yoy (median 2.1%), meaning the PBoC has room to stimulate the economy further if growth unexpectedly slows again.
With current central bank interest rates at very low levels there is concern that these policies have been fueling credit and asset price booms in some emerging economies. However, potentially there could be significant fallout of the unwinding of these booms on developed nations.
How do Capital Flows impact on an economy?
When you have long periods of loose monetary policy (including low interest rates), like that in the US 0-0.25% – since September 11 2001 the US Federal Reserve has implemented a near zero rate policy which is now expected to last until 2014. According to Stanford University Professor John Taylor this results in the following:
1 Investors look elsewhere to gain higher returns and buy foreign securities and
2 Low interest rates encourage overseas firms to borrow in US dollars rather than in their domestic currency – US branch offices of foreign banks raised over $645 billion to make loans in overseas countries.
This flow of money means that the strength of the local currency starts to appreciate as foreign firms exchange their borrowed US$ and for the domestic currency. With this appreciation, the central bank becomes concerned with the affect the higher currency is having on the exchange rate and therefore export competitiveness.
The above is a brief extract from an article published in this month’s econoMAX – click below to subscribe to econoMAX the online magazine of Tutor2u. Each month there are 8 articles of around 600 words on current economic issues.
Figures out today show that the unemployment rate increased by 0.5% from the previous quarter to 7.3% – see ASB Bank graph.. This was a concern considering the market expectation was a reduction of 0.1% to 6.7%. The main fall was in Auckland where employment fell by 2% and this should mean that new Reserve Bank Governor Graeme Wheeler will hold off on any increase until late next year. A reduction in the OCR is unlikely unless there is further deterioration on overseas markets.
Remember the types of unemployment
Frictional – The unemployment that inevitably results from the process of job-seeking. It will exist under conditions of generally so-called full-employment conditions (see employment, full), but it is not precisely clear what proportion of total unemployment can be called frictional.
Structural - Unemployment arising from changes in demand or technology which lead to an oversupply of labour with particular skills or in particular locations. Structural unemployment does not result from an overall deficiency of demand and therefore cannot be cured by reflation, but only by retraining or relocation of the affected work-force, some of which may find work at low wages in unskilled occupations.
Cyclical – Demand-deficient unemployment occurs when there is not enough demand to employ all those who want to work. It is a type that Keynesian economists focus on particularly, as they believe it happens when there is a disequilibrium in the economy.
Seasonal - Some workers, such as construction workers or workers in the tourist industry, tend to work on a seasonal basis. Seasonal unemployment tends to rise in winter when some these workers will be laid off, whilst unemploymnet falls is summer when they are taken on again.
The New York Times recently reported that the Japanese authorities are once again trying to stimulate a rather moribund economy with injecting more money into the circular flow.
* A ¥11 trillion is to be added to an asset buying programme
* The Bank of Japan will supply banks with cheap long-term funds in the hope of stimulating borrowing.
* Base interest rate to stay at 0-0.1% – see graph below
* These measures will stay in place until inflation has reached at least 1% – Bank of Japan forecast of this figure is March 2014.
There has been some return to growth with the reconstruction after the 2011 earthquake and tsunami. However global demand has declines and the issue of territory with China hasn’t helped – Japanese goods are not being favoured by Chinese consumers. Japan’s deflationary decade hasn’t been helped with a contracting population and monetary policy needs to be accompanied by government fiscal policy as private sector companies don’t have the confidence to invest in major expansions. To this end the government have thrown money at the economy to the tune of ¥422.6 billion (in the form of government spending) but this is already twice the size of the Japanese economy. A strengthening yen hasn’t helped matters as exporters find their products uncompetitive.
It is important that you are aware of current issues to do with the New Zealand and the World Economy. Examiners always like students to relate current issues to the economic theory as it gives a good impression of being well read in the subject. Only use these indicators if it is applicable to the question.
Indicators that you might want to mention are as follows:
The New Zealand Economy
The New Zealand economy expanded by 0.6 percent in the June 2012 quarter, while economic growth in the March quarter was revised down slightly to one percent. Favourable weather conditions leading to an increase in milk production was a significant driver of economic growth over the June quarter. The current account deficit rose to $10,087 million in the year ended June 2012, equivalent to 4.9 percent of GDP. Higher profits by foreign-owned New Zealand-operated banks and higher international fuel prices were factors behind the increase in the deficit during the year. Unemployment is currently at 6.8% but is expected to fall below 6% with the predicted increase in GDP. Annual inflation is approaching its trough. It is of the opinion that it will head towards the top end of the Reserve Bank’s target band (3%) by late next year.
The Global Economy
After the Global Financial Crisis (GFC) the debt-burdened economies are still struggling to reduce household debt to pre-crisis levels and monetary and fiscal policies have failed to overcome “liquidity traps”. Rising budget deficits and government debt levels have become more unsustainable. The US have employed the third round of quantitative easing and are buying US$40bn of mortgage backed securities each month as well as indicating that interest rates will remain at near zero levels until 2015. Meanwhile in the eurozone governments have implemented policies of austerity and are taking money out of the circular flow. However in the emerging economies there has been increasing inflation arising from capacity constraints as well as excess credit creation. Overall the deleveraging process can take years as the excesses of the previous credit booms are unwound. The price to be paid is a period of sub-trend economic growth which in Japan’s case ends up in lost decades of growth and diminished productive potential. The main economies are essentially pursuing their own policies especially as the election cycle demands a more domestic focus for government policy – voter concerns are low incomes and rising unemployment. Next month see the US elections and the changing of the guard in China. In early 2013 there is elections in Germany. The International Monetary Fund released their World Economic Outlook in which they downgraded their formal growth outlook. They also described the risk of a global recession as “alarmingly high”.
The recent job summit called by Engineering, Printing and Manufacturing Union (EPMU) focused on the strength of the NZ dollar and the impact it is having on manufacturing jobs in the New Zealand economy. This has been area that the opposition parties have targeted especially the Greens. Although a weaker dollar would make exports more competitive there are concerns about the mechanism used to achieve. Certain procedures to reduce the value of a currency have been well documented. They are as follows:
1. Quantitive Easing – printing money.
You need to look no further than the US economy to to see what has been the impact of 3 rounds of QE. Although the US dollar fell after QE1 in late 2008 a lot of could be said to have been caused by the collapse of Lehman Brothers and others around that time. QE2 in November 2010 correlated with the fall in the US dollar but again some have indicated that this was a result of the US economy being energised by the Federal Reserve and therefore it was safe to buy risky investments (US dollar seen as safe). You don’t have to look for another example where QE has had a limited impact – Japan since 2001. Here the Japanese authorities have found that QE has seen the Yen strengthen.
2. RBNZ enter the foreign exchange market and buy NZ dollars with currency reserves
This has been tried before with little success – equilibrium is restored at pre-intervention levels and the venture has proved very costly. Furthermore, there is the specter of inflation to contend with in years to come. The currency value has been more influenced by which stage of the business cycle the NZ economy is sitting at. In the 1990’s the Bank of Japan has spent billions of dollars trying to stop the appreciation of the Yen against the US dollar. The Swiss National Bank had to spend the equivalent to 70% of its GDP buying euros to cap the Swiss franc.
3. Drop the Reserve Bank’s Official Cash Rate (OCR)
When an economy’s interest rates are relatively high compared to other economies there is the incentive to park your currency where you get higher returns i.e. borrow from Japan at near 0% and investing in Australia at 5%. However lower interest rates doesn’t necessarily mean a lower exchange rate – the Reserve Bank of Australia has dropped rates from 4.75% to 3.25% over the last couple of years but the Aussie dollar hasn’t moved. This is most likely due to the mining boom.
4. Contractionary Fiscal Policy
As Don Brash (Former RBNZ Governor) stated in the NZ Herald, the best way of reducing the value of the NZ dollar would be for the government returning to a surplus by reducing government spending and increasing taxes. This would take money out of the circular flow and therefore reduce aggregate demand. With inflation nearing the bottom of the target range the RBNZ would be forced to reduce the OCR and ultimately the NZ dollar without the threat of inflation.
Getting the exchange rate down is a very complex task and it seems that the foreign exchange market doesn’t punish negative figures of economic indicators i.e. high inflation. I suppose a increase in the value of the NZ dollar is due to our desire to fund our spending from overseas borrowing.
Here is a cool graphic from the WSJ that looks at the impact of the US Fed’s monetary policy of dumping trillions of dollars into the economy in order to stimulate economic activity – it covers the period from September 2008 through to today. The graphic shows the impact on the following:
* 10 year treasury yields
* DJIA – Dow Jones Industrial Average
* WSJ US dollar index
Click WSJ Interactive Graphic to go to the page.
With continued global weakness the RBA is becoming increasingly worried about the prospects for the Australian economy. According to the National Bank of Australia there are 3 factors that the RBA are concerned with:
1. Although house prices are stabilising there are some sectors of the economy that remain in a depressed state – residential construction has a record low capacity utilisation (see graph).
2. A tightening of state and federal fiscal policy has meant that there is less aggregate demand in the economy.
3. The high value of the AUS$ affects the competitiveness of exports. However business now see the high AUS$ as permanent rather than cyclical. This is important as the RBA is not expecting lower rates to significantly lower the AUS$ but rather is trying to offset some of the economic damage to the economy.
It could be that a rate cut by the RBA is an insurance policy in an environment where inflation appears stable. The graph below looks at the RBA Cash Rate and the Taylor Rule.
The Taylor Rule
This is a specific policy rule for fixing interest rates proposed by the Stanford University economist John Taylor. Taylor argued that when:
Real Gross Domestic Product (GDP) = Potential Gross Domestic Product and
Inflation = its target rate of 2%,
then the Federal Funds Rate (FFR) should be 4% (that is a 2% real interest rate).
If the real GDP rises 1% above potential GDP, then the FFR should be raised by 0.5%.
If inflation rises 1% above its target rate of 2%, then the FFR should be raised by 0.5%.
This rule has been suggested as one that could be adopted by other central banks – ECB, Bank of England, etc for setting official cash rates. However, the rule does embody an arbitrary 2% inflation target rather than, say 3% or 4%, and it may need to be amended to embody alternative inflation targets at different times or by different central banks. The advantages of having such as explicit interest rate rule is that its very transparency can create better conditions for business decisions and can help shape business people’s and consumers’ expectations. Central banks prefer to maintain an air of intelligent discretion over the conduct of their policies than to follow rules, but to some extent they do unwittingly follow a Taylor rule. This makes the rule a useful benchmark against which actual policies can be judged.
There has been much talk in political circles about the increasing strength of the NZ$ is and its affect on New Zealand’s current account deficit. Labour, NZ First, and the Greens have all being calling for a change to the monetary policy framework – less of a focus on inflation and more on the exchange rate. Brian Fallow of the NZ Herald referred to it as a King Canute-like to imagine in such times that the New Zealand monetary policy settings, or the framework in which the central bank operates, make a difference to the NZ dollar. Cutting the Official Cash Rate (OCR) in a bid to lower the value of the NZ$, making exports cheaper and imports more expensive, would be something that markets would see through and expect to be reversed, and could prove counter productive. Those who say that the main focus of the RBNZ should still be inflation believe that policy be directed to variables that we have some control of i.e. supply-side policies geared to improving New Zealand’s productivity and competitiveness in global markets.
What does determine the value of the NZ$
The NZ$ is deteremined a whole range of variables at different times of the growth cycle in New Zealand and in overseas markets.
* Interest rate differentials – hot money – money which is borrowed at cheap rates overseas and then invested in a currency that has relatively higher interest rates.
* Commodity prices – primary products (priced in US$) – with higher prices this means more US$ have to be converted into NZ$ which increases the value of the NZ$
* Quantitative Easing by economies – US now has implemented QE3
* Risk mentality in financial markets – when the major markets are bouyant they regain their eagerness for more risk and invest in currencies like the NZ$
* International events – with the ease of moving money globally events such as wars, oil prices, exchange rates policies of larger nations lead to more unstability in foreign exchange
* NZ$ appreciates against the AUS$ to news that the Australian economy is stronger than previously anticipated and vice-versa.
However, as Brian Fallow pointed out, the exchange rate is not just about exports and imports but the gap between investment and saving. The more we rely on importing the savings of foreigners, the more demand there is for NZ$’s the stronger it becomes.
It is the US Fed’s intention to buy volumes of mortgage backed securities and keep borrowing rates at near zero (0-0.25%) until the job market and broader economy pick up. Basically they are going to print money until there is some improvement in unemployment figures. Unemployment is at 8.1% and the Fed estimate that it will fall no lower than 7.6% in 2013 and 6.7 in 2014. Inflation is forecast to remain at or below 2% until 2015.
How does it work?
The Fed will buy $40 billion a month in mortgages and will keep doing this until unemployment starts to fall. This will have a couple of effects:
1. It might lower mortgages rates by another 0.25% (already quite low). The 30-year mortgage rate is 3.5% and could go down to 3.25%
2. When mortgage rates go down, the price of houses tends to go up which is beneficial even if you are not refinancing a mortgage
3. Investors tend to move out of low interest earning investments and put their money into stocks. The DJIA closed up more than 200 points and was 625 points off its all-time high.
Impact on NZ$
With the flood of US$ into the market this has put downward pressure on the US$ which will make its export market more competitive and imports more expensive. However risk currencies like the NZ$ and AUS$ have rallied. Looking at the NZ$, this has appreciated considerably against the US$ and will make NZ exports more expensive and NZ imports cheaper. This will not only hurt the export industry as the price of goods become more expensive but the domestic sector have now got to compete with cheaper imports. The NZ$ reached US$0.84 yesterday.
Here is a really funny video by the students of Columbia Business School (CBS) – you may have seen it before but I find it very useful when you start teaching monetary policy and interest rates.
Back in 2006 Alan Greenspan vacated the role of chairman of the US Federal Reserve and the two main candidates for the job were Ben Bernanke and Glenn Hubbard. Glen Hubbard was (and still is) the Dean at Columbia Business School and was no doubt disappointed about losing out to Ben Bernanke. His students obviously felt a certain amount of sympathy for him and used the song “Every Breath You Take” by The Police to voice their opinion as to who should have got the job. They have altered the lyrics and the lead singer plays Glenn Hubbard.
Some significant economic words in it are: – interest rates, stagflate, inflate, bps, jobs, growth etc.
According to Business Week, as the US was embarking on a US$787bn stimulus package in 2009 Estonian authorities decided to march in the opposite direction and avoided running budget deficits and borrowing money to try and trigger higher growth levels. In order to maintain a balanced budget the government employed a contractionary fiscal policy and did the following:
- they froze state pensions
- lowered salaries by 10%
- raised the tax on goods and services by 2%
As a result of this:
- GDP in Estonia fell by 14% in 2009
- Unemployment in rose to 16%
GDP grew by 7.5% and unemployment down to 10.8% which is still worrying but not as bad as Spain or Greece. However, Estonia has shown that a contractionary monetary and fiscal stance by government does lead to economic hardship but does in the long run generate growth. The IMF praised the country’s export-led recovery and its sought after fiscal position. A lot of Estonia’s success has been its desire to become part of the west since it regained independence in 1991 after the collapse of the USSR and joined the European Union in 2004. The country employed free market policies and with an open, efficient, and wired infrastructure the World Bank ranks it 24th out of 183 countries in “The Ease of Doing Business Index” – see graph.
One area that Estonia is very different than its European counterparts is their ability to follow through on prudent measures. The average salary in Estonia is 10% below the minimum salary in Greece. Furthermore pensions are also much lower and civil servants retire 15 years later. Although the graph below shows the peak of the boom in 2007 Estonian economists believe that this was fueled by cheap household credit and not realistic growth. Whilst the growth from 2010 – 2011 came from mainly exports and therefore seen as genuine. Their belief is “no pain, no gain”.
Just completing the Unit 6 of the A2 course and updating my notes on the current issue of debt hangover from the Global Financial Crisis. The FT recently reported that there are worrying signs of private sector credit in emerging economies.
Turkey Brazil Russia - private sector credit in year to April 2012 up 20%.
China – private sector credit in year to April 2012 up 15%.
Poland – private sector credit to GDP 49%
This is seen as inevitable if an economy is going to grow but there needs to be investment in capital which will ultimately increase a country’s productive capacity and long-term development. However a lot of this borrowing has gone into consumer goods rather than capital infrastructure projects. This is especially worrying in Brazil as the transport system needs a major overhaul if it is going to cope with the demands of the Olympic Games in 2016. According to the FT misdirected credit can produce two damaging consequences:
1. When too much money is directed into the housing market bubbles can occur – subprime for instance and more recently China.
2. Poor credit allocation can harm economic growth, both in the short and in the long term.
Although China and Brazil has loosened monetary policy this needs to be accompanied by a process that ensures it is directed to where it is most needed. Jeffrey Sachs in his book “End of Poverty” talked about how a country needs six major kinds of capital:
1. Human capital: health, nutrition, and skills needed for each person to be economically productive
2. Business capital: the machinery, facilities, motorized transport used in agriculture, industry, and services
3. Infrastructure: roads, power, water and sanitation, airports and seaports, and telecommunications systems, that are critical in-puts into business productivity
4. Natural capital: arable land, healthy soils, biodiversity, and well-functioning ecosystems that provide the environmental services needed by human society
5. Public institutional capital: the commercial law, judicial systems, government services and policing that underpin the peaceful and prosperous division of labor
6. Knowledge capital: the scientific and technological know-how that raises productivity in business output and the promotion of physical and natural capital
Figure 1 shows the basic mechanics of saving, capital accumulation, and growth. We start on the left-hand side with a typical household. The household divides its income into consumption, taxation, and household savings. The government, in turn, divides its tax revenues into current spending and government investment. The economy’s capital stock is raised by both household savings and by government investment. A higher capital stock leads to economic growth, which in turn raises household income through the feedback arrow from growth to income. We show in the figure that population growth and depreciation also negatively affect the accumulation of capital. In a “normal” economy, things proceed smoothly toward rising incomes, as household savings and government investments are able to keep ahead of depreciation and population growth.
Source: The End of Poverty: How we can make it happen in our lifetime by Jeffrey Sachs (2005).