European governments bail out more lenders - International Herald Tribune

As the US financial system holds its breath to see if the US government’s injection of $700 billion of liquidity actually results in new lending and restored business and consumer confidence, Europe is beginning to see its own government takeovers of European banks.

Regulators in Britain, Belgium and Iceland swooped in Monday to engineer emergency rescues of three banks with heavy exposure to soured mortgages, echoing moves underway in the United States.

In the latest sign of trouble to hit Europe from the global credit crisis, the Belgian, Dutch and Luxembourg governments announced a partial nationalization of the troubled Belgian-Dutch financial conglomerate Fortis, involving a combined injection of €11.2 billion from the three governments, which take a 49 percent stake…

Meanwhile, the British Treasury on Monday confirmed that it had seized the lender Bradford & Bingley - the third British bank to tumble this year - after no private buyers emerged.

Much as in the United States, several European banks have gotten into trouble as their assets tied to real estate have lost value due to the weak European and American real estate markets. As more and more borrowers are unable to pay their mortgages, banks’ assets decline in value and the banks’ willingness and ability to make new loans decreases. This limits the amount of credit available to households and firms, and with it their ability to make investments in consumer goods and capital. Tighter credit markets mean weaker aggregate demand (less consumption and investment), leading to slower or negative economic growth and rising unemployment.

In the past, when one bank got into trouble with bad assets like those tied to the real estate market, other private banks would come along and bail the troubled bank out, swapping cash for the assets, allowing the troubled bank to continue making loans. But when all banks find themselves in the midst of the same financial crisis, the likelihood of finding a private buyer for a struggling bank is low. This is where the government steps in:

The bailout of Fortis (Belgium’s largest commercial bank) orchestrated by the three neighboring countries (Belgium, Luxembourg and the Netherlands) and the ECB (European Central Bank)… was meant to restore confidence in the bank before the reopening of markets on Monday after a tumultuous week of imploding share values at Fortis. The shares gained 4.8 percent to €5.45 Monday.

In Britain, regulators were unable to find buyers to keep Bradford & Bingley afloat. The lender’s shares are down 90 percent from the peak, touching new depths Friday as an already skittish market punished the company, prompting the talks.

When the private sector is unable or unwilling to purchase the assets of a bank that has experienced a write down of its asset value, the government must intervene to make sure such banks have the liquidity (meaning the hard cash) they need to make loans to borrowers, whose spending is needed to keep the economy going.

In the US, the government has agreed to trade $700 billion in hard, loanable and spendable cash, in exchange for financial assets tied to bad mortgages worth something less than $700 billion. If the swap has the effect the government hopes it will, then lending institutions will feel more confidence and be willing to loan cash to each other and to borrowers (households and firms), spending in the economy will increase (consumption and investment) and aggregate demand will rise, meaning more total output, more employment and higher incomes. In addition, more lending will also lead to an increase in the capital stock, effectively pushing the American and European aggregate supply curves outwards, leading to a more stable rate of inflation (a major worry for both economies as oil prices hit record levels this year).

In spite of the recent round of bailouts in both the US and Europe, confidence among European firms and households is low:

Euro-zone economic confidence plunged to its lowest level in seven years in September, the EU said Monday.

A regular survey of European companies and consumers showed the index of confidence in the economy falling to 87.7, close to a 2001 trough, the European Commission said.

The EU executive warned that the survey carried out in the first two weeks of September may not fully reflect growing gloom in the last few weeks as worries over a U.S. and European recession widened on a financial market crisis.

Industry, services and construction were all more pessimistic than a month ago, it said, while consumer confidence was unchanged from a low level. Retailers were slightly more upbeat about their prospects.

It said industry managers’ employment expectations fell - meaning they believe they may have to cut jobs - although services companies were more hopeful.

Consumers thought that unemployment would increase in future months and expect prices to rise.

The 15 nations that share the euro are battling high inflation as oil prices remain high - although below recent record levels - and increasing fears that a financial crisis will freeze or sharply hike the cost of borrowing.

That would slow growth as companies found it harder to get credit and people faced high costs to buy homes. The U.S. government is trying to stave off tighter credit conditions by buying up hundreds of billions of dollars of bad debt from major lenders

As can be seen, falling confidence and tighter credit markets are evil twins. If the Euro zone economy is to avoid recession, the European Central Bank and the governments of the 15 Euro nations should follow closely events in the US over the next few weeks. The $700 billion injection of liquidity, if successful, will act as lubrication in the engine of the US economy.

Think of it this way: lately, the US economic engine has slowed down. Friction in the financial markets has slowed the flow of cash from households to banks to firms and back to households. In IB and AP Economics terms, the circular flow of money and income has slowed to a halt. To get the engine moving again, cash is needed. Banks with liquid cash are more willing to lend to one another and to households and firms. A healthy economy depends on a well lubricated economic engine, which in today’s world means a functioning financial market.

The government bailouts in the US and Europe are intended to do one thing: lubricate that engine and get the economy moving forward once more.

Discussion question:

1. Why does the government need to intervene in financial markets? Shouldn’t those who took risks by making bad loans pay for their mistakes and be allowed to go under?
2. What will it take to turn consumer and investor confidence around in Europe?
3. How might the crisis in the financial markets affect you and me in the real world?

I wonder how many people in countries like the United States, Switzerland, Brazil, Canada, Russia, and China would be surprised to learn that prices of products and services in their countries have become much less expensive over the years.

Say what? You must be crazy, you say! Prices are rising too fast!

Yes, most citizens see their purchases as becoming more expensive when, in actuality, things are becoming less expensive. Of course, the paradox is that although nominal prices (the actual price tag) are, in fact, increasing, nominal income (the average wage) has been growing faster. This is a topic that in economics is called “real income” or a measurement that compares a nation’s income growth relative to the growth in prices that the same income buys.

Let’s take some specific facts:

In the United States real median household income grew from $41,318 to $50,811 from 1970 through 2006 for a total percentage gain of 23% (source: Pew Research Center). Both of the aforementioned median household incomes are stated in 2008 or current dollars which makes the comparison valid. Median household income is an attempt to quantify the progress that the “middle American” family or typical family has made. So, in short, the median household in America can buy 23% more with their income today than they could in 1970. In other words, relative prices are lower to income.

If we look at the same United States income data over the same period for real average household income, there is real income growth of nearly 60%. The higher growth rate (60%) in real incomes for the average household versus the median (middle) growth rate (23%) is explained by the fact that much of the growth in United States’ real incomes has accrued disproportionately to the college educated & entrepreneurs driving up real income growth rates much faster for the “average” than the median or middle household. (Hint: continue your education!)

Now let’s get back to the main premise of the title of this blog and the opening assertion that prices are lower than ever. What we are really saying is that you have to benchmark price increases to income increases to really understand whether things are becoming more expensive. The vast majority of products & services are cheaper today in all nations than they have ever been before, which helps explain why more citizens than ever before can afford to own their own houses, drive more and better cars, have cable and computers. The reason we are led to believe differently is because we are victims of our own human nature which tend to focus on the problem areas (higher relative prices) and not the benefits (lower relative prices). Most all citizens expand out to the last dollar of our incomes and quickly notice about those products that are rising faster than normal like gasoline prices! Hey, even gasoline prices are barely at an all relative price high. If gasoline prices are restated for inflation they are $3.50 today vs. $3.17 in 1981 and $3.50 in 1918!

Now, you may say to yourself that statistics can lie or mislead and you are sure in your gut that things are getting more expensive relatively. You can try to validate that incorrect “gut feeling” by examining whether your country’s middle class is enjoying less or more products and services. “Real income” really is just a measurement of the quantity and quality of products and services that you have. The median and average American continually has more actual products & services in the aggregate as U.S. income gains have averaged 3.5% per year outpacing higher price increases averaging 3.0% per year leading to a real gain in products and services. True, there are many individual products and services that have risen in price faster than incomes (and big ones like education, energy, and health care!) but we must look at the whole picture of all prices to understand how our citizens, on average, are becoming economically better off.

Federal Reserve sees slow economy, higher prices - Sep. 3, 2008

Weak aggregate demand and rising costs due to still high energy and food prices put the US economy in a tricky situation, one in which the Federal Reserve is forced to make the tough decision between tackling the unemployment problem (jobless rates have risen to 5.7%) or the inflation problem (price levels have also risen 5.7% this year, the highest inflation in 17 years).

The nation struggled with slow economic growth and still-high prices that are weighing on consumers and businesses alike…

Fed Chairman Ben Bernanke and his colleagues are all but certain to leave a key interest rate alone at 2% when they meet next on Sept. 16 and probably through the rest of this year.

Given the fragile state of the economy, the Fed isn’t in a hurry to boost rates to fend off creeping inflation. A growing number of analysts believe the economy is likely to hit another dangerous rough patch later this year as consumers and businesses curtail their spending even more.

Heading into the fall, economic activity continued to be slow, the Fed said. Businesses described the climate as “weak” or “soft” or “subdued.”

Consumers, the lifeblood of the economy, showed caution. Shoppers “concentrated on necessary items and retrenchment in discretionary spending,” the Fed observed.

In the short-run, as year 2 IB students know, society faces a trade off between high inflation and high unemployment. Rising prices and rising joblessness are both harmful to the economy, but when energy and food prices drive up the price level, while week investment and consumer spending lead lead to falling overall demand in the economy, the conditions exist where joblessness and prices can rise simultaneously. This is America’s situation at present.

The Fed must chose which problem to address. Ben Bernake, America’s central bank chief, could chose to tackle rising inflation by raising interest rates, which would discourage new investment and reduce demand for resources by firms in the economy. Investment spending by firms and consumption by households would decline, putting downward pressure on prices across the economy.

In the short-run, however, the decline in investment and consumer spending that would result from higher interest rates would exacerbate the already weak level of aggregate demand in the economy, driving unemployment even higher.

By keeping rates low, Bernanke hopes to encourage investment and consumption, which will contribute to overall demand in the economy. By encouraging new spending and investment, however, the threat that inflation will rise even more remains present.

In the trade off between unemployment and inflation, the Republican White House and the Democratic Congress made it clear that unemployment was the most important problem to address when they announced the $160 billion expansionary fiscal stimulus package earlier this year. By keeping rates at a low 2%, America’s central bank is also indicating that increasing employment is of greater importance than lowering the price level.

Discussion questions:

1. Low interest rates are clearly a demand-side policy, since they should lead to higher investement and consumption. But how might lowering interest rates result in positive supply-side effects for the economy?
2. Why do you think increasing employment is of a higher priority to policy-makers than bringing down the inflation rate? Does the fact that it’s an election year matter?
3. “Workers’ wage gains - characterized as ‘modest’ - aren’t raising
   inflation worries. Wary employers have cut jobs every month so far this
   year and aren’t inclined to be overly generous in their compensation to
   workers amid ‘a general pullback in hiring,’ the Fed said. If wages continue to rise even as unemployment rises, is it likely that the US economy will ever “self-correct” from in times of an economic slowdown?
   

U.S. food stamp use up sharply, sign of hard times (Reuters) by Charles Abbott

FT.com / Columnists / Wolfgang Munchau - Inflation and the lessons of the 1970s

It seem that everyone’s speculating about the US economy today. Recession or no recession, that is the question. The economy has even surpassed the Iraq War as the number one issue in the US presidential race! John McCain, who has publicly admitted that economics is not his strong suit, may just find himself in trouble in a general election where the most important concern among voters is the economic situation.

So what IS that situation, anyway? Is the US in a recession? In other words, has real gross domestic, or total output in the US economy, actually declined over the last six months? Technically, the answer is no. My fellow blogger, Steve Latter, explains this clearly here. What is true, on the other hand, is that the current situation shares many similarities to the global economic slowdown that did occur in the 1970s.

In 1973 OPEC, the newly formed oil cartel consisting at the time of only Arab states, reduced its output of oil and cut off exports to the United States in response to US support of Israel in the Yom Kippur War, in which the Israelis officially occupied the Palestinian territories of the West Bank and Gaza and seized the Golan Heights from the sovereign nation of Syria. To punish the US for its position on this conflict, OPEC cut off supplies of oil to the west, driving gas and energy prices upwards by 70%, triggering a supply shock characterized by a decline in total output and an increase in both unemployment and inflation, a phenomenon known as stagflation: a macroeconomic policy maker’s worst nightmare.

Recently the world has seen a similar (albeit of a different cause) rise in the price of oil and energy prices. Today the rise in energy prices is driven primarily by rising demand, rather than reduced supply (since the 1970s the OPEC cartel has grown to include many non-Arab nations, making it harder to achieve collusion to restrict output and drive up oil prices). Global demand for oil has risen steadily, driven ever higher due to rapid growth in China and other developing nations, and exacerbated by the falling value of the dollar, the currency in which oil prices are denominated.

The supply shocks of today have combined with falling aggregate demand in the US due to weak consumer spending to slow real growth rates to nearlry 0%. So technically, the US has avoided a recession, but the effect on American workers and consumers may be just as painful as the real recession of the 1970s. In order to prevent the “r” word from becoming a reality today, central banks (including the US Fed) have eased money supplies, lowering interest rates, fueling even greater increases in the price level.

…the global weighted average inflation rate will be 5.4 per cent this year, while the global money market interest rate is currently only 4.3 per cent. This means that global short-term real interest rates are negative – at a time when inflation is rapidly accelerating. As monetary policy has been excessively accommodating for more than a decade, inflationary pressures have built up in the global economy.

Central bankers like Ben Bernanke have to make tough decisions sometimes, weighing the trade-off between unemployment and inflation, and determining their monetary policies based on whatever they deem to be the “lesser of two evils”. Rising energy prices have forced firms to cut either cut back their production and raise the price of their products, both actions that result in less overall spending and output in the economy. Falling house prices have led consumers to cut back their own spending, further reducing demand for firms’ output. These factors have all pushed the unemployment rate from around 4.8% a year ago to 5.1% today, which combined with an estimated additional 3-5% of American workers having dropped out of the workforce, (referred to by the Department of Labor as “discouraged workers”) paints a pretty ugly picture of the reality for the American worker today.

The harsh reality of the weak labor market has led Mr. Bernanke and the Fed to pursue an expansionary monetary policy aimed at avoiding further increases in the unemployment rate and decreases in the GDP growth rate. Expansionary monetary policy means lower interest rates, with the goal being increased consumption and investment, both factors that could worsen the inflation problem already experienced thanks to the global supply shock. Evidence indicates that the inflation problem, even in the US where slow growth usually leads to lower price levels, is not going away:

In the US, a survey-based measure of inflationary expectations recently showed an increase to more than 5 per cent. I would estimate there are now several hundred basis points of difference between the current Fed funds rate and an interest rate that would be consistent with price stability in the medium term.

…meaning the Fed, in its attempt to avoid recession and rising unemployment, has created a condition where real interest rates are actually negative, a highly inflationary condition. All this wouldn’t be so bad if wages in the US were rising along with the price level. This however, does not appear to be happening:

The main difference between the situation in the 1970s and now is today’s absence of wage inflation, which explains why absolute inflation rates are a little more moderate. I guess this is probably because of some combination of deregulated labour markets and globalisation. But the lack of wage-push inflation is not necessarily good news. Falling real wages mean falling disposable income and tighter credit conditions mean less borrowing for consumption.

Rising prices for energy, transportation and food have put American households in a tough situation. In the past, periods of inflation have often been characterized by rising wages, meaning the full brunt of nominal price level increases was not entirely born by the American worker. Today, on the other hand, a recession has thus far been avoided, but the combination of record numbers of “discouraged workers”, rising unemployment and inflation may make the pain of our current economic situation just as real as recessions of the past.

In the words of billionaire investor and economic sage Warren Buffett just today:

“I believe that we are already in a recession… Perhaps not in the sense as defined by economists. … But people are already feeling the effects of a recession.”

“It will be deeper and longer than what many think,” he added.

Discussion Questions:

1. What is the difference between nominal and real GDP? Which must decline in order for the economy to be in a recession?
2. What impact do rising energy prices have on the behavior of individual firms?
3. Why are low interest rates likely to make the inflation problem even worse?