GDP growing out-of-date

GDP is becoming increasingly outdated as we do more and more online

It is hard for most of us to keep up with the blistering pace of changes in modern technology.  This is also true for economists and the discipline of economics.  Nowhere is this more glaringly obvious than when trying to assess how well the economy is doing.  Measures such as GDP (gross domestic product) hark from a time when our economy was mostly made up of physical goods which did not improve much over time (such as fridges or lawn mowers).  Advances in computing were already making life hard for economists, but greater use of online services may be the last straw.  How can we measure the economic output if we can get stuff online for free?

More is better?

GDP is an aggregate figure of the market value of all goods and services produced in an economy.  This way of measuring output focuses only on transactions where money changes hands and is based on the premise that more is better.  Things have become more complicated with rapid improvements in technology.  The problems started as exponential leaps in processing power made computers both faster and cheaper.  Progress is now so rapid that computers from just a few years ago are no longer available, making price comparisons over time near impossible (also causing issues with measuring inflation).

The impact is spreading as people find better ways of putting cheap computing to good use.  Replicating any content in digital form is virtually without cost.  Thus, the problems that initially confronted the music industry were soon felt by TV and movie studios as well as newspapers.  The effects are becoming more pervasive now that almost all of us have small computers in our pockets in the form of mobile phones.  Even mobile network providers, who would have been expected to benefit from greater use of mobile phones, are under pressure from cheaper alternative methods of communicating such as Skype or WhatsApp.

What really matters

Things we may have needed to pay for in the past are now considerably cheaper if not free, whether it be making international phone calls, reading the news, or posting job ads.  Computers are also able to do most of the grunt work of online services, making it easier to launch new products.  For instance, WhatsApp, which was recently purchased for US$19 billion, only has around 50 employees.  As a result, computers and the Internet can be used to provide more for less. 

It follows that a stationary GDP does not necessarily indicate a lack of progress.  This creates a dilemma for economists.  Economic data such as GDP is usually trimmed back to take account of inflation as higher prices by themselves do not mean that the economy is any larger.  Yet, better computers and cheap services provided online suggest that normal GDP figures need to be increased to account for the wealth of benefits that are available without having to pay more money.

All of this tweaking of GDP is making the actual data less and less significant.  The weak recovery in places such as the UK may be due to a shift towards doing things online as people try to tighten their belts.  It may be the case that similar or even greater amounts of goods and services are being consumed but online and at a lower cost.  How can we account for this?

Rather than trying to add up everything in the economy, we could look at median earnings and how people spend their cash (including online freebies).  This is likely to be a better gauge at a time when wages are stagnating for most people.  Finding out whether the average person is better off has more real world relevance than focusing solely on levels of production.

Quantitative Easing – Get to the chopper!

What do you do when the economy needs a fiscal stimulus but there is no money for it?

Central banks have an ever expanding range in their toolkit to choose from to fix their individual economies but none of them seem to have worked so far.  This may be because they lack the right tool for the job.  In this case, the right tool is likely to be a large hammer in the form of a substantial fiscal stimulus but this is the preserve of governments who, at this point in time, are saddled with too much debt.  Yet, there is a way in which central banks could use monetary policy to act like a fiscal stimulus and generate the boost to demand that the global economy desperately needs.

Even new monetary policies are falling short

Economists thought we had it figured out.  Simply control the money supply by setting interest rates and it will be possible to ride out any booms and busts.  However, the weak recovery following the global financial crisis has shattered this belief.  Even manipulating the money supply using newly contrived measures such as quantitative easing has been less fruitful than hoped as well as creating unexpected problems. 

Quantitative easing has relied on a convoluted process where central banks create cash in order to buy bonds which frees up money for use elsewhere.  The problem has been that there is little demand for money in the actual economy as businesses are not keen to borrow as a result of the weak underlying economy.  Instead, what is needed is an instrument for inserting money straight into the economy.  This is because, rather than just cheap credit, companies need greater revenues from stronger sales in order to encourage investment and jump-start the economy again.

A fiscal stimulus fits the bill and has been tried already but only in small doses.  The key spanner in the works in this case has been high levels of government debt.  Before the crisis, politicians everywhere were almost as amped up as bankers and government finances were managed as if the boom time would continue forever.  The results have left us short of workable options to bolster the sluggish global economy.

Using Monetary Policy like a Fiscal Stimulus 

It may sound like a strange solution, but if monetary policy is not working and higher government spending is not possible, central banks could use their money-printing capacities to engineer a fiscal stimulus.  Rather than using freshly printed cash to buy bonds, central banks could just give it away.  Or, to use an analogy that economists like to use, drop money from a helicopter. 

Central banks operate the valves which control the supply of money, which is already being expanded on a temporary basis using quantitative easing.  The helicopter idea is a much more direct approach than shovelling money at the bond market.  Recipients of the cash would be free to spend it as they please, thus injecting money into the actual economy and creating a bonus for firms.  

The cash would not actually be in in the form of notes or coins but could be paid as a cheque or straight into the bank accounts of tax payers.  It strikes at the core of the main problem in the economy, a shortage of demand, allowing for more rapid results and less distortion compared to having surplus cash in the financial system.

The main drawback of this seemingly too-good-to-be-true policy is worries about inflation.  This is also the biggest obstacle as inflation is the primary concern of the central banks that would need to print the cash to be distributed.  It is the belief of many economists that it is the discipline of central banks which has kept inflation down over the past few decades.  Any sign that central banks might allow for more inflation is thought to push prices into a perilous upward spiral.  Yet, inflation is no longer the threat it once was and would not become an issue until the economic recovery was well under way.

Just like any handyman, economists have their favourite tools and are sometimes loath to admit that there might be a better option.  Unfortunately, it may just be a step too far for central banks to overcome their fear of inflation and leave the safety of familiar ground despite the extra firepower on offer.

Dysfunctional Politics – Time for a Reboot?

The failings of democracy have become more obvious and need more than just a tweak

Some things get better over time but politics seems to be getting worse.  Like a clunky computer that takes ages to get anything done, our political system has outdated hardware and buggy software which means that programs often don’t proceed as planned.  In computing terms, our governments’ failure to deal with the aftermath of the global financial crash is the equivalent of a number of flashing warnings and error messages.  With the faults more obvious than ever, perhaps it is time to look into rebooting the system.

Viruses in the system

Politics needs a remake as it has moved away from the ideals of democracy.  Our leaders have gradually become more and more separated from the world of the voters.  Direct contact has been replaced with communication through the media.  Policies espoused by the different parties take the form of grandstanding statements that fit into a newspaper headline.  The message contained in anything more complicated is often lost on voters with short attention spans. 

The result of this is that politics has become just another form of marketing vying for our attention.  We, in return, now also struggle to relate to political parties.  The number of those among us who are affiliated with a political party has been falling for decades.  Politicians instead work with pollsters and media firms to guess at what voters might want and how to package their policies. 

At the same time, politicians can only offer voters less bang for their buck.  In an increasingly globalized world, many choices that had previously been available to governments have been taken out of their hands.  No country can make decisions in isolation and this limits what politicians can offer voters.  Not that they will ever admit as much.  Yet this unspoken reality further separates voters from politicians who offer too much and can seldom deliver on their policies. 

Some rewiring needed

A good place to start in terms of rebooting politics would be to re-establish links with voters.  As with all forms of communication, this needs to be two-way street.  Politicians need to not only listen to the concerns of voters before forming policy, but more importantly to explain their actions.  Too often politicians sound as if they are talking in code with formulaic messages devoid of content or meaning.  More direct contact with normal people might help politicians to rediscover the benefits of speaking frankly and honestly.

The best politics these days seem to be happening at the city level.  Mayors are closer to the people they govern, even in the larger cities of London and New York, and they are better at solving problems with regard to things that matter in peoples’ lives such as transport, schools, and crime.  From personal experience, the mayor of my city is having a positive effect on the world around me even though I did not vote for him.  I cannot say the same for my representative in parliament (who only turns up once every four years at election time) - let alone our Prime Minister in the UK. 

Politicians serve many roles in their jobs.  At a time when politicians are offering less in terms of leadership, the least they could do instead would be to spend more time among those who elected them.  Something needs to be done to fix the systems that will only become more of a problem (see here for one idea).  A malfunctioning computer is a hassle but a broken-down political system is far more dangerous.  

Dysfunctional Politics Needs Economic Reforms

Politics typically operates like a badly run economy with unappetising choices between limited options

Current politics could be compared with the old Soviet economy – consumers frustrated due to few choices between ill-conceived products designed to fit what most people want but ultimately satisfying very few.  Replace “consumers” and “products” with “voters” and “parties” and this is an apt description of many Western democracies.  The analogy is even more appropriate in that the solution in both cases is the same – reforms to make participation easier for newcomers so as to create more competition.

How have things gone wrong?

Public perception of politicians seems worse than ever.  The aftermath of the global financial crisis has further exacerbated this.  Governments showed themselves to be inept in managing their finances before the crisis and misguided in their response to the ensuing economic slump.  Though elected to serve for the good of the country, governments often prove themselves unable or unwilling to do so.

A number of examples spring to mind.  The United States came to the brink of defaulting over its debt and almost triggered another global financial crisis due to a reluctance on the part of its politicians to compromise.  The nation states of Europe almost destroyed more than half a century of integration and spreading democracy across the continent by refusing to band together to help out the weaker EU members until the central bank stepped in.  The economic recoveries in many countries have also struggled to gain traction as government policies have been more of a hindrance than a help.

The argument could be made that this is not the Soviet Union and democracy gives us a choice of government.  But this choice is often an illusion and often times boils down to selecting the least worst option.  To take a more pessimistic view, the most common political strategy appears to be to make voters dislike the other party more than your own.  This only works when the electorate is faced with limited options as is typically the case in countries where two parties dominate.

Outflank the other party on a few key issues and the voters have no other choice but to tolerate your policies.  The UK Labour Party lost the public trust by overspending in the lead-up to the global financial crisis, thus giving the current Tory-led government a freer rein on its economic policy.  As a result, the British have been lumped with austerity despite the need for measures to boost aggregate demand.  In the US, the Tea Party has infiltrated the Republican Party making it unpalatable for most voters resulting in a second term for an Obama administration which has been slow to act and disappointing in delivering on its promises of change.  The results of the European elections in May 2014 are yet another example of how mainstream parties are failing voters.

Change is possible

An economy with such poor products on offer would collapse but our political system continues to stumble on with voters choosing to tune out instead.  Reforms more typical in economics provide an option for changing this – more competition.

One key area would be changes to the voting system.  Elections using the first-past-the-post format hamper change by ensuring a large number of safe seats for each party while preventing smaller parties from getting into power.  New political parties would shake up politics by bringing in ideas in contrast to the stale left and right divide that still dominates politics.  Coalition governments do not always work (such as in Italy), but are not a recipe for sclerosis in politics as the experiences of the UK government have shown over the past few years.

Such changes may not bring about anything as profound as the fall of the Berlin Wall, but any change from the status quo is likely to be an improvement.

Global liquidity: have we created a monster?

Money in the financial system overwhelms all it encounters making it a growing threat that needs to be dealt with

We are being overrun – by money.  There may be worse things to have battering down one's door but a surplus of cash in the financial system can have scary consequences.  The financial system was set up to facilitate the movement of cash to parts of the economy where it is needed but has instead become a behemoth exerting a dominating influence over the creation of goods and services in the actual economy.

Quantitative easing feeds the beast by flooding the banking system with even more cash in the hope that a few crumbs will drop down into the actual economy.  However, not only is the financing no longer having the desired effect, but the extra money is becoming increasingly erratic and hard to control.  Policies are needed to yank banking back into line.

Money getting out of hand

Spare cash in the form of savings is the basis for economic growth.  Surplus from current production is invested to enable higher output later on.  Banks were first created to shift extra money elsewhere so that production could be expanded.  Yet, banks have gone beyond the basic operation of allocating money and moved into the business of making money from money.  This is a waste of resources considering our best and brightest could be put to better use.  But more than that, the colossal size of the financial sector is in itself a problem – it is like a giant trampling everything in its path.

Money is free to move around the globe on a whim.  Too much free-flowing cash turns into a menace in terms of stability.  The danger always seems close at hand – banks and others creating more cash out of thin air by increasing leverage when times are good while central banks unleash a mass of new money to shore up the economy when things turn bad.  Yet, money is not always forthcoming - the impact of the global financial crisis was exacerbated by a flood of cash fading to a trickle.

The money is out there lurking and waiting.  The skulking leviathan surfaces only in a few places but creates distortions wherever it emerges.  A clear example is the property prices in London and other places in the UK which are booming at a time when the underlying economy is stuck in a faltering recovery.  Emerging markets have also fallen victim to the ebb and flow of global finances due to their less developed financial markets and limited domestic savings.

Making money work for us

If massive money movements are causing chaos, it is only sensible to conclude that greater controls should be put in place to rein in the rampaging.  The current direction of policy on finance has turned to re-regulation after decades of deregulation gave banks the freedoms which allowed the phantom cash to wreak havoc.  The finance sector has railed against any restrictions, but the monster now rearing its ugly head cannot be left uncaged.

It is argued that free movement of money is essential despite the risks, as credit is cheaper as a result.  But even the cheap cash from central banks has not been enough to convince banks to lend which suggests that easy money does not bring the benefits previously thought.  This means that we should not fear the utilization of policies as controls over the movement of money, the separation of retail banks (which take in savings and give out loans) from investment banks (which deal in financial wizardry), or the introduction of higher standards for banks in each individual country.  Money in itself is not evil – it just needs to be kept in its proper place.

Another New Policy - Negative Interest Rates

Another unconventional policy measure may be trialled in Europe as its central bank struggles to revive the moribund economy

The on-going economic troubles have been demanding in many ways – including having to learn the meanings of an ever-increasing range of new economic terms.  This is due to central banks implementing a range of practices to breathe life into an economy which seems impervious to their best efforts at resuscitation.  The list of unconventional policies started with quantitative easing, which was soon followed with forward guidance.  The next piece of headline-grabbing jargon may be negative interest rates.  This latest innovation is expected to come from the European Central Bank (ECB) even as other central banks look to wind down their operations.

The What, How, and Why of Negative Interest Rates

The policy of negative interest rates is just as simple as it sounds – paying someone to hold money instead of receiving interest on any deposits of cash.  Fortunately, the humble blogger on the street will not be required to pay negative interest rates by his or her retail bank; instead, the banks themselves will be charged for their holdings at the central bank.  Banks tend to park any surplus funds with the central bank so the idea of negative interest rates is to spur banks into making better use of their reserves.  In particular, the policy is intended to boost lending by banks which has remained sluggish despite record low interest rates.

The policy is all about creating the right incentives.  The actual payments themselves would be small.  For example, the ECB is said to be considering an interest rate of -0.1% in place of its current rate of 0.25%.  Central banks have been frustrated by the failure of low interest rates to generate the desired result – more lending.  Both forward guidance and negative interest rates are policies aimed at achieving this.  

Timing – why now?

Now we understand the basics of negative interest rates, the final question is one of timing – why now?  The ECB is driven by two key factors – the changes to monetary policy in the US and fears about deflation in Europe.

The effects of the Federal Reserve printing money to buy bonds (known as quantitative easing) have reached far beyond the US borders with some of the money also finding its way to Europe.  Less loot leaving the US will likely lead to less liquidity in the European banking system.  Low levels of inflation (0.7% in January) have led to fears about consumer prices starting to fall, something already happening in places like Greece.  There are concerns that such deflation could further undermine demand and result in debts increasing in size relative to the economy.

The potential adverse consequences of these developments have pushed the ECB to act and negative interest rates are one of the few options available.  This is because the actions of the ECB are restrained by divergent views among the member countries of the European Union.  In particular, Germany has been adamant in upholding rules that limit the ability of the ECB to purchase bonds. 

Negative interest rates would also bring their own complications.  European banks may struggle to deal with negative interest rates which are not the norm.  The extra costs may weaken banks by lowering their profits, making them more cautious lenders and exacerbating the problem.  Low lending rates have had only a muted effect so the benefits of going negative may be limited.  Even if the policy is seen to be effective, Germany would be loath to offer more help to struggling countries in the periphery of Europe as it may encourage them to put off crucial reforms.

It is too early to say whether negative interest rates will ever make it into our everyday lingo.  Either way, we can only hope that it does not take many more new policies until we can shake off the current economic stupor.