The UK economy is in a dark place… a risk of double dip… deep depression… slow recovery.

The newspapers and television are full of a variety of predictions and warnings about the health of our economy. Who should we believe and is the Government taking the right action to “boost” the economy?

Here is a summary of my weekend economics lecture which, whilst a simplified model (professional economists will have to forgive me), has helped me to understand the situation better.

Let’s start with some mathematical looking formulas:

Y = AD

Where, Y = the real aggregate output of the economy (GDP); AD = Aggregate demand. So the economy overtime balances itself out by producing what is demanded. Y therefore becomes the full capacity of the economy.

Y = C+I+G+NX

Where, Y = the real aggregate output of the economy (GDP); C = Consumption Spending; I = Investment Expediture; G = Government spending on products and services; and NX = Net Export Revenue.

What on earth does this mean? (And I hope I haven’t lost too many readers already!)

Essentially this: The output of our Economy is made up of four main components:

1. Consumption Spending: The amount we all spend. We receive some sort of income (salary, investment revenue, etc), part of which goes to the taxman and a proportion of which we may decide to save. The rest we spend on a variety of things.The more we want to spend, the higher the demand and so output rises to keep pace.
2. Investment Expediture: This isn’t stocks and shares. This is real investment in buildings, equipment, factories, infrastructure, etc… There is an inverse relationship between Investment Expediture and interest rates. If interest rates go up, borrowing goes down and investment goes down.
3. Government Spending: This is the amount that the Government spends on products and services, such as the provision of central services (police, armed forces, govt dept) , buying in equipment, etc. The excludes any welfare payments. A more mathematical look at this model shows us that when government spending goes up by say £100, the economy rises by an amount greater than £100. Odd but true.
4. Net Export Revenue: The difference between what we export and what we import. This balance of trade is influenced by the exchange rate. If the pound is weaker, exports rise.

Still with me?

Have you heard of Quantitative Easing (QE). This is a way for the Bank of England to increase the amount of cash circulating in the economy. Our banking systems relies on the movement of cash. As cash flows it creates additional bank deposits which in turn creates lending, some of which is deposited and redistributed as loans. And the cycle goes on.

Adding additional cash into the economy (by buying back Government Bonds) allows, in theory, for more cash to be lent. And lending cash creates an increase in deposits. Essentially the flow of money, makes money. A strange concept I know but it works. (Search for “Fractional Reserve Banking”)

Buying back Government Bonds, has the effect of reducing interest rates throughout a range of markets, and is a way for the Bank of England to signal to commercial banks that they should increase lending (using the additional cash in the system). The reverse is also true, in that when bonds are sold the interest rate increases and, combined with less cash in the system, lending should reduce.

So let’s look at one more concept before we put this all together.

There are three basic sources of income to the economy:

Y = C + S + T

Where, Y = the real aggregate output of the economy (GDP) which we know balanaces with demand and therefore is also the aggregate income; C = Consumption spending; S = Savings and T = Taxes.

Putting this together with our first model and doing some rearranging (we will assume Net Exports are zero):

S + T = I + G

This formula tells us there there are two sources of money for Investment and Goverment spending: Savings and Taxes. Clearly Taxes are not used for private investment, so Investment Expenditure can only rely on borrowing from savings in the economy.

Government Spending however can rely on both. Where Government spend is equal to the Tax Revenue there is no need for the Government to borrow any money from the economy. However where there is a deficit in the budget, Government needs to rely on borrowing. If Government needs to borrow, there is less funding available for everyone else. If demand for loans goes up, the real interest rate increases; making borrowing more expensive and therefore less attractive. In turn, investment goes down. So, low Government borrowing, creates a lower real interest rate and encourages commercial borrowing for investment.

What does this all mean?

We can see from the models above that everything is related.

So when the real supply of money rises (through QE), it stimulates spending via three channels:

• Increasing the money supply through buying back bonds, causes the interest rate to decrease. Low interest rates increases borrowing, which in turn increases Investment Expenditure. (The Interest Rate Effect)
• Decreasing the interest rate, reduces the currency exchange rate and increases net export. (The Exchange Rate Effect)
• The third channel is The Wealth Effect. As cash increases and borrowing rises with falling interest rates, people “feel” more wealthy and spend more. Therefore consumption goes up.

Lastly, if Government borrowing goes down, the real interest rate reduces, and the above effects are therefore stimulated in the same way.

So…

Alot of this sounds great, but does it work in real life. Well yes… but…

The banking system, investment in the future and personal consumption spend all rely on one key factor: CONFIDENCE.

In order for cash to flow in the banking system, depositors must have confidence that their deposits are safe – otherwise we see runs on banks as happened with Northern Rock.

In order for companies to increase capital investment, they must have confidence that they will be able to recoup their investment by selling more product/service in the furture.

In order to spend more in shops people must have confidence that they will be secure in the future and that they can reduce the amount they save.

So the two important factors here are: Interest Rates & Confidence.

Some however will argue that all this will simply increase prices causing inflation. But, as we mentioned at the beginning the production capacity of the economy ends up balancing with demand. Inflation will only occur if production capacity is at its maximum.

During a recession, the economy is no longer producing its maximum output, therefore rather than increase prices, all this stimulus increases output until the equalibrium is achieved once more.

There is a risk here that economic stimulation measures over run beyond the equalibrium state leading to inflation. The key here is to increase the maximum capacity of the economy. This is achieved in three ways:

• Increase the availability of labour;
• Increase the use of technology; and
• Increase the capital investment.

Assessing Government Policy

Overall the Governments policies seem to be right:

• Reduce Government deficit, which in turn reduces interest rates on borrowing, and in turn increases commercial borrowing for investment.
• Increase the amount of cash in the system to encourage lending.
• Encourage companies to invest and grow.
• Discourage people to save, by keeping interest rates low, and encouraging them to spend.
• Make it easier for companies to increase their labour and technology in order to increase the maximum capacity of the economy.

This all relies on people having confidence in the future. And this is something which is difficult to control. But many people can have an impact on people’s confidence: Newspapers/Media and statements by the Opposition Party in particular.

However, policy and its effects have a time delay. In the short term, a Government austerity programme, companies making efficiency savings and people becoming more cautious with their spending has a painful effect.

The saying: “Short term pain, long term gain” is never truer than in our current situation.

Past performance is is no guarantee of future performance. Something which those who invest in the stock market will have heard many times before. Comfort can perhaps be taken in the fact that since 1930 despite a number of economic downturns GDP has continued to grow.

So perhaps the key to recovery lies with all of us being more CONFIDENT that things will get better.

The Prime Minister’s happiness measure was perhaps not such a bad concept!