Monthly Archives: January 2014

Britain’s inflationary outlook

I’ve recently written for Save Our Savers attempting to square the massive expansion of Britain’s monetary base since March 2009 with the fact that inflation has now been within the Bank of England’s target range of 2% (+/- 1%) since June 2012. Here I’d like to expand a little.

Since March 2009 Britain’s monetary base, also known as narrow money or M0, has increased by 321%. We can see that the majority of this is in the form of increased bank reserves, up 642% since March 2009

https://i2.wp.com/www.cobdencentre.org/wp-content/uploads/2014/01/Untitled.png

Source:The Bank of England, series Notes in circulation – RPWB55A, and Reserve Balances – RPWB56A

This is just what we’d expect to see following the Bank of England’s Quantitative Easing, where the Bank creates new money and uses it to purchase bonds from banks – that new money becomes bank reserves. Those banks have sat on that money (not using it as a basis for new credit creation and feeding into M4) which is why, while narrow (M0) money has exploded, broad (M4) money has barely budged, increasing by just 7.4% since March 2009.

https://i0.wp.com/www.cobdencentre.org/wp-content/uploads/2014/01/Untitled2.png

Source:The Bank of England, series Notes in circulation (RPWB55A) and Reserve Balances (RPWB56A) (M0), and Monthly amounts outstanding of M4 (monetary financial institutions’ sterling M4 liabilities to private sector) (in sterling millions) seasonally adjusted  (LPMAUYN) (M4)

This relative restraint in M4 growth explains the relative restraint in inflation. There is no great mystery as to why banks which have just seen their assets tank and ravage their balance sheets should want to hold more reserves. The key question is what happens next.

https://i1.wp.com/www.cobdencentre.org/wp-content/uploads/2014/01/Untitled3.png

The chart above shows the ratio of M0 to M4 since May 2006; how many pounds of broad money each pound of narrow money is supporting. From 25:1 between May 2006 and March 2009, it slumped via successive bouts of Quantitative Easing to about 6:1 since September 2012.

Now, on the one hand banks might stick to this new, lower ratio. Chastened by their experiences with mortgage backed assets they might desire a permanently lower reserve to asset ratio and all QE will have been is a vast recapitalisation of banks.

On the other hand, as ‘recovery’ kicks in they might start to increase their reserve to asset ratio. They might not scale the giddy heights of 25:1 again, but they will be multiplying out from a monetary base which has tripled in size. Britain’s monetary base is now £362 billion and M4 is about six times that, £2.2 trillion. But if renewed confidence in the banking sector saw banks return to higher ratios, the resulting M4 figures would be as follows:

https://i0.wp.com/www.cobdencentre.org/wp-content/uploads/2014/01/Untitled4.png

Here, we are told, the Bank of England will be able to ‘drain’ this liquidity from the system. It would do this by reversing QE; selling bonds to banks and effectively destroying the base money it receives in return. But a massive increase in the supply of bonds relative to the demand for them will lower their price. This is the same as raising their yield and this is the same as raising a key interest rate.

It is worth pondering for a moment the scale of bond sales and consequent rise in interest rates which might be necessary to drain this base money from the financial system. We must hope either that the economy can stand it or that banks keep holding these reserves.

This article originally appeared at The Cobden Centre

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The economics of the minimum wage

Minimum wages are a popular topic. Barack Obama proposes a nearly 40% increase from $7.25 per hour to $10.10 and David Cameron has faced calls from some of his own backbenchers to raise Britain’s minimum wage of £6.31 per hour for over 21s. What are the economics?

A wage is the price of labour. At a given price/wage (W1) a certain amount of labour will be purchased (L1). We can show that with the following chart

https://i2.wp.com/www.cobdencentre.org/wp-content/uploads/2014/01/w1.png

Many argue that we can make people better off by either setting minimum wages or raising those that there already are. But what are the effects of this? Put another way, what is the effect of raising the price of labour? We can show that with the following chart

https://i2.wp.com/www.cobdencentre.org/wp-content/uploads/2014/01/w21.png

As with anything, if you raise its price the quantity of it demanded falls (caveats discussed below); there is less employment, in other words. As economists Paul Krugman and Robin Wells put it, “when the minimum wage is above the equilibrium wage rate, some people who are willing to work  that is, sell labor  cannot find buyers – that is, employers willing to give them jobs.” (Krugman and Wells 2008) Indeed, most supporters of higher minimum wages tacitly accept this. When you ask them “If raising minimum wages makes people better off, why not raise them to £/$50 per hour?” they generally reply “Don’t be so silly”. Well, indeed. A minimum wage that high would be unaffordable for many employers and unemployment would increase.

But by acknowledging that at a higher price a lower quantity of labour will be demanded they are acknowledging that the demand curve for labour slopes downwards as shown in the following chart

https://i1.wp.com/www.cobdencentre.org/wp-content/uploads/2014/01/w3.png

But if the labour demand curve slopes downwards between £/$50 per hour and the current minimum wage why would anyone assume that it doesn’t continue to slope downwards below the minimum wage? In other words, might we not see an increase in employment if we reduced the minimum wage (in real or nominal terms) or eliminated it? At that point the conversation often moves to whether people should be able to hire/work at those lower wages, a question outside the scope of economics.

Now for those caveats. I recently asked some friends whether they would continue to buy the same amount of something if its price went up 25%. One answered “Well, cigarettes pretty much have (over a comparatively short time), and I pretty much have continued to buy them. But I admit that my sickness at having to pay that much for my brand has now driven me to tobacco during the week and the odd cigar at the weekend now (rather than the fiver per day for a pack of Embassy)”

What my friend Miguel has identified here is the notion of elasticity, the change in the quantity of something demanded resulting from a change in its price. If the quantity of something demanded varies greatly with changes in price then demand is ‘elastic’, if the quantity demanded changes very little (or not at all) with changes in price it is, like Miguel’s cigarettes, ‘inelastic’. We can show an inelastic demand for labour with the following chart

https://i2.wp.com/www.cobdencentre.org/wp-content/uploads/2014/01/w4.png

Here, with the steep curve given by the inelastic demand for labour, a large rise in the wage from W1 to W2 gives a comparatively small drop in employment, from L1 to L2.

But is labour demand inelastic? One of the factors determining elasticity is the availability of substitutes. If nothing else can fulfil the role of the good which is rising in price you will have to pay more (up to a point) but if something else will do well enough you will switch to buying that instead. And there is a substitute for labour; capital, the price of which is falling thanks to technological innovations just as people campaign to raise the price of labour. In a supermarket lately you might have used a machine to scan your own shopping. Those machines are direct substitutes for the labour of checkout staff. Or, as a meme humorously put it recently,

https://i1.wp.com/www.cobdencentre.org/wp-content/uploads/2014/01/w5.png

Another friend replied “Depends on the price to start with, the income of the person and their lifestyle. If Nigella Lawson was on a fixed rate water bill and it went up 25% then I think we can be pretty certain she would buy and consume the same amount.”

Indeed, as Tom says, rises in prices are felt differently by different people – and companies. Raising the price of labour by 40% might not have much of an effect on a big business operating on wide profit margins but it would be crippling for a smaller business with its much thinner margins. It’s curious that many supporters of ‘Buy Local’ also support minimum wage policies which give big businesses a crushing competitive advantage over smaller businesses.

So much for the theory, what about the practice? An extensive review of studies into the effects of minimum wages carried out in 2006 by economists David Neumark and William Wascher (Neumark and Wascher 2006) found that

“the oft-stated assertion that recent research fails to support the traditional view that the minimum wage reduces the employment of low-wage workers is clearly incorrect. A sizable majority of the studies surveyed in this monograph give a relatively consistent (although not always statistically significant) indication of negative employment effects of minimum wages. In addition, among the papers we view as providing the most credible evidence, almost all point to negative employment effects, both for the United States as well as for many other countries. Two other important conclusions emerge from our review. First, we see very few – if any – studies that provide convincing evidence of positive employment effects of minimum wages, especially from those studies that focus on the broader groups (rather than a narrow industry) for which the competitive model predicts disemployment effects. Second, the studies that focus on the least-skilled groups provide relatively overwhelming evidence of stronger disemployment effects for these groups.”

Neumark and Wascher updated and expanded this study in their 2009 book Minimum Wages (Neumark and Wascher 2009), concluding that

“minimum wages do not achieve the main goals set forth by their supporters. They reduce employment opportunities for less-skilled workers and tend to reduce their earnings; they are not an effective means of reducing poverty; and they appear to have adverse longer-term effects on wages and earnings, in part by reducing the acquisition of human capital.”

A fitting conclusion here also.

References

This article originally appeared at The Cobden Centre