Into the (money) sink

Sinking more and more money into houses may be bad for the economy

A sink is not only something that we wash dishes in but also something that can absorb substances from the surroundings as a carbon sink does. While containing many of the first type of sinks, houses may also end up being like the second type in terms of soaking up money from the economy. Rising prices for property mean that many people must put aside more and more funds to buy a home. Without the need for such savings, the money would typically have been spent and flowed through the economy. More funds going into bricks and mortar maybe thus damaging the economy outside the walls of our homes.

Owning our own home is a desire for many people who thus must save up money for a deposit and then spend years paying off the mortgage. Property has also become a form of investment for many who buy houses to let and thus earn an income. But the demand for places to live (or rent out) has not kept up with availability in many locations (typically large cities), resulting in rising house prices (and the cost of renting). In economic theory, higher prices are supposed to spur an increase in supply but rising housing valuations have had the opposite result – more buyers rather than more availability of housing.

On top of the many problems caused by the booming property market, higher house prices could potentially weaken the economy through excessive amounts of money being tied up in residential property. The removal of such funds from the economy could be seen as a form of forced savings above the level that would be optimal. The issue with excess saving already appears elsewhere in economic theory, Keynes arguing that people would prefer to hold onto money during times of economic hardship. Such hoarding of cash would thus have an adverse effect on the economy as less funds would be spent, and higher prices for real estate could be having the same effect.

In both cases, the effect feeds off itself. Saving and not spending during a recession means taking money out of the economy, thus further exacerbating the problem. In a similar manner, a boom in house prices will prompt even more money to be drawn into property due to expectations of further gains. Yet, when seen as an investment, buying housing compares poorly in many ways to other forms of putting money away. Financial assets such as stocks and bonds have similar returns but also the benefit of much greater flexibility in terms of how much to invest as well as easy access to getting your money back when needed. Money invested in financial assets can thus be put away as savings mount up and can easily conform to the needs of the investor.

As well as money away being stashed away, a large lump sum investment in a home also tends to lock people down to a specific location which may limit their work options. Studies have shown that people tend to move less in search of work compared to in the past and the growing investment required to own property is seen as one possible explanation for this. Changing homes is also difficult due to the high transaction costs of both buying and selling property in terms of taxes and fees for real estate agents. The result is often that people can be stuck with property that does not suit their situation, either as a residence or as an investment.

Money flows out of the property market with the sale of houses but any gains for the seller often prove elusive due to the need to secure a new residence amid inflated house prices. Even if the benefits from a higher sale price are not sunk back into property, a rising housing market tends to shift money from people more likely to spend to those who tend to stockpile. This trend is due to the more well-off being the ones who own property and thus benefiting from rising house prices but who are more likely to put any cash windfall into other investments rather than spending the funds.

While those on low incomes suffer as rent rise in line with higher house prices, the middle class could possibly be seen as the main victims. Those with moderate earnings have the financial capacity to invest in buying their own home but tend to have little money left over. Being in such a position involves sacrificing spending to fund the house purchase but also greater risk if something goes wrong. The middle class is already on the backfoot, struggling most in the job market amid changes wrought by automation and globalization. The plight of the middle class matters beyond their own circumstances due to their role as an economic and political stabilizing force in most capitalist democracies.

Property prices are not likely to fall away anytime soon but the broader impact should be recognized in order to better manage the economy. In particular, monetary policy has been relied on for the past few decades to keep the economy ticking over but the end result of this has been prolonged periods of historically low interest rates. Such cheap credit has helped to buoy the property market as well as lift asset prices across the board, hence exacerbating the trends mentioned above. If more money going into housing is actually taking funds away from consumer spending, this would explain the need for more and more proactive monetary policy to keep the economy growing.

One possible remedy to this is a shift back toward more use of fiscal policy which is a trend that is already underway. Even more benefits could be gained if government money was to be used to build more houses which would provide both an increase in supply of residential properties (and hence temper price rises) but also provide incomes for people to buy homes (or spend as they wish). Another potential policy is to promote working from home as a means to lessen the need for people to buy housing in big and already overcrowded cities. More money for government could be raised from the people that have benefited from the housing market to help out with those that have been left behind. Without some drastic changes, we might continue to throw money into the proverbial sink.

Growing where

As the economy grows, much of the extra cash may not be spent

We all change as we grow, and this is also true of the economy. With incomes typically rising with economic growth, what we tend to buy changes as well, and this shift in spending also goes on to shape what is produced when we are at work. What we normally think of as the economy typically revolves around things to consume but increasingly money goes towards buying into investments. While this trend is given little attention within economic theory, it is perhaps having a bigger impact than is thought.

There has been a change to the things that we buy as economic growth has progressed. With more people earning bigger pay checks, spending is shifting from things that we need here and now to money put away for the future. Like most things in the economy, more demand for places to put away cash has resulted in an increasing range of options of what to invest in. A whole industry has been built up on providing investment products for those with money where ever they might live.

In the past, any money stashed away as savings in the bank didn’t really earn much. The financial deregulation that started in the 1980s changed this with an increasing emphasis on money being put to work. More choice about where your cash could go also meant that funds could better be directed to areas of the economy where it could be put to the best use. Along with the extra cash to be made by investors, those who played their part in moving money around also got paid well for their role.

Economic theory would suggest that any money put aside is beneficial as it frees up important capital to be used by businesses to expand profitable ventures. Yet, the reality seems to be that many of the large companies have a surplus of cash, much of which is used in share buybacks rather than investing in new business. And banks no longer rely on deposits to issue loans to smaller businesses as they might have done in the past. Rather than going towards supplying goods and services to sell, funds for investment often go into buying an asset that someone else owns and wants to sell. This asset could be a stock or a bond but could also be a property or something more exotic like an artwork or vintage bottle of wine.

It can be assumed that demand for such investments must be growing as the prices for things that people buy to invest in are increasing. Rising demand seems intuitive as greater levels of wealth mean that there is more money available to be invested. For prices to rise, it is not enough for demand to be high but also that supply must be unable to keep up. It seems to be the case that coming up with new ways of making money from money is not that easy. Excess demand is most notable for less riskier investments with some investors prizing safety so much that they are willing to tolerate negative returns on some government bonds.

This trend might be something that is inherent to capitalism and will continue to build up over time. But there are also factors that are not permanent which may mean that demand may ebb away in the future. For example, less money might go into investments due to selling brought on by the retirement of the baby boomer generation who have built up financial assets to provide them with income into their old age. Also, some countries, such as China, also generate surplus capital that is channelled into foreign financial markets but these flows may dry up once options for investing in their domestic markets increase.

Whatever the source of excess demand, the resulting rising prices for financial assets contrasts with the relatively weak demand for goods and services in the underlying economy and the low levels of consumer price inflation. It may be the case that funds diverted towards investment tends to take money away from spending on goods and services which may have contributed to subdued inflation. After all, higher earnings are not likely to translate into more and more consumption, while investments can continue to mount up as incomes rise.

The increasing amounts of money going into investment products has the potential to change the way money flows around the economy. Normal consumption involves buying things that would have been made elsewhere and transported to the location of sale where staff wait to provide assistance. Or it may involve a service whereby an output is provided by someone on request. Purchasing goods and services thus typically involved substantial amounts of labour enabling a wide range of people to earn a pay packet.

Investment products do involve some labour but the amount of input involved is usually relatively small especially considering the large sums that are typically involved. The workers involved are also concentrated, both in terms of geographical space (financial centres such as New York or London) but also with regard to the type of workers (educated and white-collar). Their spending could also be seen as being different to the average worker such as more money flowing to other places through, for example, the purchase of imports.

While the production of investment goods is narrow in its scope, the benefits from the money put away are also mostly captured by those owning the assets rather than being spread out through the whole economy. Higher asset prices do not serve any economic purpose (an increase in the cost of buying property should increase the number of houses being built but often doesn’t) but instead just results in a shift of funds to the owners of the assets. This issue is likely to worsen as the gap between those who have and do not have money in investments expands as financial assets are becoming pricier while wages (which cannot grow much faster than consumer inflation) are relatively flat.

On top of this rise in inequality and its economic consequences, a bigger finance industry is also problematic in terms of being a source of instability in the economy as seen in the dotcom bubble and the global financial crisis. Growing disparities in earnings also create problems in terms of social cohesion and can impact negatively on the political system. Another potential issue is the effect on aggregate demand in the economy. Not only is potential spending diverted into investment but the extra income going to the wealthy is less likely to be spent. This is because those with high earnings are likely to spend less when provided with more cash to spend compared to people on lower incomes.

The obvious conclusion from this trend is that asset prices will continue to rise as more money gets drawn into investment products unless there is a dramatic shift in either demand or supply. Such a trend would impact on how the economy functions and thus on attempts by policymakers to manage economic booms and busts. For example, the abilities of central banks would also likely suffer as measures such as quantitative easing (designed in part to boost asset prices) would have a diminishing effect. As already mentioned, boosting the earnings of holders of investment has less impact on overall spending and so monetary policy often struggles to gain traction.

Such difficulties have resulted in a recent shift to give greater emphasis on fiscal policy which allows for money to go towards people more likely to spend it rather than add it to their stockpile. Further government action might be necessary to avoid an economy where wealth continues to grow faster than incomes. Such was also the case around a century ago and it took unprecedented social and political change for wage-earners to make up lost ground and broader economic growth to take hold. With the value of investments climbing higher while prices for other things remains relatively flat, it is not obvious what it might take to (yet again) rebalance the economy and where, left to its own devices, economic growth might be heading.

Watch and learn

Economists still have much to learn as the latest shift in policy shows

It is said that “a crisis should never be allowed to go to waste” as it provides a chance to do new things that could not have been done otherwise. Such seems to be the impetus behind the Biden administration which has gone all out in its spending plans to spur on the post-lockdown economy. With policymakers typically conservative in nature, such boldness is usually limited and as such there is much contention about what will be the impact on the economy. Yet, the outcome of the policies will most probably be inconclusive and politics rather than economics is likely to be the more dominant force over government’s actions in the future.

The background story behind the bolder policy response seems to revolve around two changes over the past decade. The first is the leftward shift of the Democratic Party in the United States with politicians such as Bernie Sanders and Elizabeth Warren gaining large amounts of support. The other change is the lessons learned from how the economic recovery played out following the global financial crisis. At the time, concerns about rising levels of government debt meant a more muted response to the economic downturn which is turn hampered the recovery.

After his experience with Obama as vice president at the tail-end of the global financial crisis, Biden was well placed to see both policy in the making as well as how it played out in practice. The stimulus package back then was relatively limited especially when considering the extent of economic downturn. Measures in regard to other priorities such as infrastructure and social welfare from the Obama administration were also muted by worries about spending too much. The contrast, 12 years later, is stark with Biden unleashing a massive stimulus package followed up by big spending plans for infrastructure.

The contrast is all the greater as Biden brushed aside both concerns about mounting government debt as well as the potential for inflation amid a post-lockdown buying spree by consumers. Just as in the past, how the economy responds will shape what measures policymakers might adopt in the face of future crisis. Whether this shift will mark a return to more Keynesian (emphasising fiscal over monetary) policies depends on whether the spending actually has the desired effect. You might think that how to deal with economic downturns is something that economists would have figured out by now but there has been heated debate over what is expected to happen.

Part of the reason for this is that economic theory actually rests on only a limited number of real-life outcomes when the economy is acting up. Economists do not have the luxury of testing their ideas in a laboratory so rely more on theory than practice. It is difficult to gauge the impact of any policy considering that the economy is so complicated with individuals and businesses reacting to countless risks and rewards with many things happening at the same time. Neither is there much chance to learn from the past in terms of what policies might work best as each economic crisis is different. And with economic policies having profound impact on the lives of millions of people, too much experimentation with policy could be seen as reckless.

Economic policy is not just about finding the best response but is also about fitting in with the politics of the time. Feeble economic growth over the past decade even with relatively aggressive monetary policy suggested that there was an opening for a new approach. The measures taken by the Democratic president in the US are the most proactive amid a general shift towards a greater role for government spending in managing the economy. Even the Tory party in the UK that pushed ahead with austerity a decade ago seems to have thrown caution to the wind when it comes to government debt.

It is too soon to tell whether this change in approach will be a permanent major shift or just a minor tweak of policy. Much (but not all) will depend on what will be the characteristics of the post-lockdown economic recovery. Despite what proponents on either side of the political debate are predicting, the stimulus policies themselves will probably neither see a resurgence in economic growth nor the return of inflation and higher interest rates. The economy will recover as things return to normal but the extent to which government policy has any influence over this will be disputed.

The likely absence of any solid evidence either way will most likely result in politics continuing to hold sway. Either side of the argument over more or less government action will look for whatever might strengthen their point of view. Those hoping for more government spending to bolster the economy during downturns will take heart if inflation remains subdued. Yet, the ability of the government to shore up the economy is limited by the extent to which it can borrow, unless there is a major rethink about how to repay such debt.

It is then strange to think that a discipline such as economics that sees itself as a science is so heavily influenced by the political whims of the time. But part of the reason behind this is that, while our understanding of the economy is improving, there is still much in economic theory that is subjective. Economists also tend to be on the backfoot as their theories tend to rely more heavily on the experience of the past rather than looking more closely at current developments. Thus, in what direction will the economy (and economic theory) be heading is something that economists, like everyone else, will just have to wait and see.

Caged Economy

Money seems to be everywhere except where we need it most

Miscreants are often locked up to keep them out of trouble. The same seems to be true of money. Not only do we stash it away for safe keeping but also act to stop too much money getting out into the economy where an excess of funds could create havoc. As such, those able to print money have, over the centuries, found ways of tying their own hands to limit how much cash they could generate. Yet such measures can backfire if the amount of funds free to move around the economy is not enough. While there seems to be plenty of cash around these days, money doesn’t seem to be able to get where it is needed.

The optimal amount of money never required much thought until it was actually something that was printed (on paper) instead of being dug up (as with gold or silver). Initially, the premise for printing money was that the paper notes were in lieu of a precious metal that was safely under lock and key. Not only was it more secure but large transactions were easier without having to lug around a bag of coins. The issuers of notes had to prove themselves trustworthy and not likely to succumb to the temptation of creating more notes that was actually backed by precious metals in the vaults.

It was banks that first issued notes but printing money later became the concern of governments who managed their own currency back by gold under a system which was known as the gold standard. The gold bullion in the vaults acted as a limit to how much cash would circulate within an economy. Growing prosperity with a relatively fixed amount of gold meant that there was likely to be a point at which enough money could not be printed.

Increased wealth also meant more trade between countries and large amounts of gold would cross borders if there was an imbalance between trade coming in and going out. If imports were larger than exports for any country, gold would flow out, thus restricting the amount of money in countries with higher imports. With less money to go around, the economy would suffer, but as a result, imports would also fall so that gold would flow back again and balance would be restored.

The gold standard thus had its own way of reigning in an economy that was overheating. But this process could be quite painful with a steep plunge in economic activity required to achieve even a small fall in imports. And this economic turmoil came at a time when there was no social welfare to help out anyone that would fall into hardship. This was at a time when only a few people had the right to vote and so the widespread suffering that would ensue had little political ramifications.

Eventually, the lack of flexibility in the money supply proved too much, especially when the government needed to spend lots, typically when at war. As such, countries in Europe suspended the gold standard during the world wars and had trouble getting it back in place. A pseudo form of the gold standard was reestablished in the postwar era when the value of the US dollar was fixed against gold while other currencies were pegged to the US dollar. This too was abandoned in the 1970s after a prolonged period of heavy spending by the US government during the Vietnam war.

The new regime involved different currencies changing in value relative to each other depending on the economic circumstances in each country. The money supply fell under the control of central banks who used inflation as a gauge as to the health of the economy. To stamp out inflation in the early 1980s, central banks raised interest rates to punishingly high levels that in many ways was similar to the harsh measures adopted under the gold standard. Yet, inflation has been relatively subdued since then and the economic conditions relatively benign with the notable exception of the global financial crisis (where it was mostly banks who were at fault).

The new monetary regime saw the end of the fluctuations between rapid growth and sharp downturn that had plagued the economy in the past. Policymakers of old did not have the understanding or the data to know what was going on in the economy and thus had to rely on the crude mechanism of the gold standard to manage policy. Nowadays we know a lot more about what is going on and have also learnt lessons from the past, allowing a better response to recent crises as compared with the measures taken which led to the Great Depression.

Yet, it may be the case that we have swapped an economy that would run hot and cold for economic growth that is lukewarm. While the management of the economy is far superior to what we had in the past, it is as if having more scope to direct the economy has increased the fears of doing something wrong. The economy could grow faster except for central banks being wary of getting too close to circumstances whereby inflation might set in. Yet, without any substantial price rises being seen in richer countries for over three decades, it is not certain that inflation would be close at hand.

A sub-optimal economy would not be an issue if there were not concerns that require a response. Potential problems such as growing inequality and climate change would be best if dealt with sooner rather than later, but a lack of funds is often cited as an excuse for not acting. Other areas that deserve more attention such as health and education are left to languish despite the potential to improve the livelihoods of many people. There has been a shift in policy toward doing more to boost the lacklustre economy but the current range of options for policymakers don’t seem up to the job.

What seems to be the issue is not a lack of money but an inability to direct funds towards solving the problems at hand. The main means to deal with such issues in the past was through government, but this path has been hampered by a general aversion to taxation as well as the rise of global business. Rather than being able to invest in the long-term health of an economy, governments tend to rack up debt during economic downturns and then focus on paying back the money when the worst is over. While being able to deal with the immediate crises at hand, the more intransient and structural problems get neglected.

Signs of change are afoot as governments have been more willing to spend, but it still seems as if public debt will act as the bars of the cage that the economy seems to hit up against. Without more resources being directed through government towards dealing with long-term issues, a growing sense of injustice from unresolved problems could fuel a political backlash. One option that has attracted growing attention has been using cash from central banks to provide funds for government to spend or repay debt. The thinking behind such a proposal is that fiscal and monetary policy seems to have reached their limits, but a combination of the two could offer up more potency.

Putting money to work in this way is obviously controversial in terms of requiring a dramatic shift in the way we think about government debt. Abandoning the gold standard also demanded a change in thinking but it was necessary to escape from limits that are self-imposed and hamper further development of the economy. Otherwise, the economy will be stuck in a cycle between inevitable crises which prompt a sharp rise in government borrowing followed by years of growth hampered by debt repayments. And, as under the gold standard, the economy will remain trapped in a cage of our own making.

Debt looms over Covid recovery

After the Covid crisis comes the overwhelming mountain of government debt

With the worst of the Covid pandemic seemingly behind us, attention is shifting to the next threat looming over the economy – paying for the cost of lockdown. With public finances suffering with every new crisis, getting the government budget back into a healthy state is tricky when the underlying economy is already under pressure. Austerity measures have fallen out of favour and monetary policy does not seem to be able to do enough. If the economy continues to flag in years to come, more unconventional policies to help with the aftermath of economic downturns might be on the cards.

When something goes wrong with the economy, it tends to fall on the government to step in and provide support. This action by governments is like a type of insurance but one where the costs are borne afterward rather than funded in advance. So instead of building up a rainy-day fund (which seems to be something beyond most politicians), debt is used to get through any crises. Governments thus do what needs to be done to ride out any economic storm and then figure out later how to pay the bill.

This approach is becoming more difficult as even in good times the economy is already struggling to deal with the impact of globalization and automation. The economic difficulties are manifested through chronically low levels of inflation suggesting that demand for goods and services is relatively weak. The problem is worst in Japan where the central bank has been actively trying to push up prices in an attempt to end years of deflation. While not yet going this far, central banks in other developed economies have softened their stance towards rising prices and have been actively supporting the economy.

The likelihood of large debt repayments by governments in the years to come would go against these efforts. Austerity measures in the past have taken their toll on the economy and there seems to be an aversion to going down this road again. Yet, public debt that has piled up over the lockdown of the economy would have to be dealt with at some point. Central banks have already purchased large volumes of bonds from the government and are in no hurry to demand repayment. So, the debts could just be rolled over year after year (or more purchased if needs be) which would ease some pressure.

Rather than letting the overhanging debt stay in place, central banks could take a further step and right off some of the debt. The ability to print money means that it would be within the power of central banks to do so. Putting aside the rights and wrongs of such an action, the other major concern would be the impact on the money supply. The cash used to buy the government debt would remain in the economy and would have the potential to cause of spurt of inflation.

An increase in the money supply would normally stoke up demand as people rushed to the shops with the extra cash and supply would struggle to keep up. Along with the resulting higher prices, the value of the currency would also drop off, thus making imported goods more expensive and further exacerbating the problem. Countries such as Argentina and Turkey have often suffered such a fate, but countries with more sound economic management have increasingly gotten away with policies that could potentially spur on higher prices.

The use of unconventional policies, such as quantitative easing, has opened up a gap between what would be expected in the theory and what happens in practice. The economies in some of the richer countries seem to be able to absorb influxes of cash without inflation kicking in. The role of central banks and their firm stance against inflation is one aspect that has changed how the economy might respond to more money. Greater levels of wealth also mean that extra funds might go into financial assets rather than consumer spending. Other developments such as international supply chains also act to limit shortages brought on by a spurt of demand that would otherwise see prices rise.

While the economy might allow for such a measure by central bank, it is the politics that is likely to be the main sticking point. Overcoming the notion that debt could potentially be forgiven is likely to be a substantial hurdle. Not repaying back money that is owed seems wrong in an almost moral sense and only acceptable in terms of those for whom the debt burden is overwhelming. Yet, the cancelling of loans has a long history and has been used when the debts themselves are not sustainable.

A further complication would be the extent to which the role of the government would change. If debt was less of a limiting factor, money could be spent without having to worry too much about paying the bill afterwards. It would also take much of the meaning out of raising taxes and creates uncertainties over how the economy should be managed. But these are matters that could be dealt with as a new regime is implemented in small steps to gauge the impact. And it is central banks that would be in charge of how much relief should be offered up.

Any new measures such as this is typically not taken at a time when most optimal but when the needs arise. To override the aversion to debt forgiveness would take a prolonged slump where other options would have been exhausted. The time for implementation would come not during a crisis but in the years afterwards when attempts to repay the debts would weigh on the economy. Other demands on the government, such as the cost of pensions or healthcare, would add to the burden and potentially threaten to drag down the whole economy.

Monetary policy has been used to try and fill the gap but experience has taught us that central banks by themselves can only achieve so much. It is increasingly seen that a combination of monetary with fiscal policy is a more effective option. Using central bank cash to pay off government debt thus seems like the obvious progression in economic management. If the politics can be overcome, the hard-earned trust in central banks’ ability to manage inflation could then be put to use in cutting the mountain of government debt down to size.