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Issue 3/11 February 2009

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Today’s Issue Includes:

1) Is the Paradox of Thrift coming into play? By Nigel Tree

On 2nd February 2009 the Bureau of Economic Analysis of the US Department of Commerce published some revealing figures on personal income and outlays. These showed that on a month-on-month basis, disposable personal income in current dollars was stable in October 2008, but fell 0.3 per cent in November and 0.2 per cent in December.

They also showed that personal saving – which is disposable personal income minus personal outlays – was $378.6bn in December compared with $299.1bn in November. This means that personal saving as a percentage of disposable income was 3.6 per cent in December, compared with 2.8% in November. So, even though disposable incomes were falling the percentage of disposable income saved was going up!

What’s good for the individual may not be good for the economy

On a household by household basis this makes sense. With asset prices falling in the housing market and stock market and unemployment increasing daily, it seems to make sense to be thrifty – and to put money away for a rainy day.

However, while this may be good for individuals it is not good for the economy as a whole. This paradox of thrift (or paradox of savings if you prefer) was put forward by John Maynard Keynes in the 1930s and states that if there is an increase in the marginal propensity to save this will, other things being equal, move the equilibrium level of national income and national output downwards. The resulting equilibrium point of total savings and total investment will also fall.

Therefore, if people save more during a recession effective demand will fall causing the economy to slow even further. As total income continues to fall the level of total savings will fall even though the rate of savings has gone up.

As Professor Paul Krugman put it, writing in the New York Times on 5th February 2009: “…we’re in serious paradox of thrift territory here. Or perhaps more accurately, we’re in a paradox of debt. Consumers are pulling back because they’ve realised that they’re too far in debt. The economy is shrinking in large part because consumers are pulling back. And the result, almost surely, is to leave household balance sheets worse than ever.”

Why more savings doesn’t mean more investment

One question to ask is why the increased volume of savings or “loanable funds” which one would expect to lower borrowing rates does not lead to an increase in investment. The reason is that if companies are faced with a fall in demand for their product they are not going to be inclined to invest. Also, if deflation creeps into the economy so that prices are actually falling, then consumers have a further incentive to put off spending now, as prices will be lower in the future. So what happens when we have consumers who are not willing to spend and companies which are not willing to invest?

What is the answer?

Keynes’ answer, and the one being pursued around the world at the moment is for governments to pump more cash into the economy. Thus on 10th February 2009 President Obama is putting as much pressure as he can on the US Congress to pass his $800bn (£541bn) fiscal stimulus plan. He has warned that to delay this bill would worsen a “full-blown crisis”.

The amounts of money being ploughed into economies around the world is “eye-popping” in terms of the number of noughts at the end of figures, but the question still remains – how much is enough?


2) Has sterling bottomed out and what drives exchange rate changes? Interview with Neil MacKinnon, Director and Chief Economist, the ECU group plc.

Nigel Tree asks the questions.

NT: We have just seen a slight rally in sterling in the past couple of days. Can you explain why and whether it is likely to be maintained?

NM: I think sterling has "bottomed". It has been in a bear market since the banking crisis in the UK first broke with the collapse of Northern Rock. Sterling is viewed as a "financials and housing" currency given the significant contribution and role made by both sectors to the UK economy. So, a decline in banks' share prices and a decline in UK house prices tracks the decline in the exchange rate quite well. In addition, some regard sterling as a proxy for global risk appetite. Why? The argument is that the UK banking sector is actually nothing more than a giant hedge fund which has borrowed short (in foreign currencies like the low yielding yen) to lend long. Like hedge funds, UK banks find themselves at the centre of the global financial crisis facing sharply declining asset prices and a demand from lenders for loans to be repaid. In this scenario when global risk appetite is poor i.e investors are nervous then sterling does badly and vice versa. Now, there are some tentative indications that global risk appetite is gradually improving (equities are off their lows, treasury bill yields are higher and the prices of some commodities like copper, platinum are up). As a result, sterling is making a recovery off its lows against the major currencies.

NT: What role do "economic fundamentals" play in foreign exchange markets and could you explain the link between equity markets, risk aversion and the dollar/sterling exchange rate?

NM: The role of economic fundamentals in driving exchange rates is controverial. Meese and Rogoff (1983) claimed that economic fundamentals such as the money supply and the trade balance are of little use in forecasting exchange rates. There have been a number of academic studies since then trying to overturn Meese and Rogoff's findings. A recent paper from the Federal Reserve that is worth reading in this regard is on their website (The Taylor Rule and Interval Forecast for Exchange Rates" January 2009 ( ). Of course, in the real world of the currency markets, people like myself whose job it is to forecast exchange rates on a short term basis (ie which means anything from the next day or the next week for trading purposes) or for longer term purposes (1-2 years for corporate budget purposes say), I will look at a whole range of factors from sentiment. positioning, liquidity flows as well as "correlations" with interest rate differentials, equity prices or commodity prices. Fundamentals do matter at the end of the day in my opinion but there is a change and complex range of factors which need to be looked at. Even then, forecasting success is not guaranteed !

NT: What is likely to happen in the eurozone especially as the European Central Bank appears to be "dragging its feet" at the moment?

NM: The eurozone. What is going on ? A wide range of economic indicators suggest that the eurozone economies face a serious risk of falling into a depression and deflation scenario. On the day (last week) that the European Central Bank (ECB) decided to keep interest rates unchanged at 2.00% (the highest level of short term interest rates amongst the major central banks), German factory orders slumped 6.9% in December following a 5.3% decline the previous month. The following day, German industrial production collapsed by 4.6% in the month and is 12.0% lower than the same period a year ago. The ECB's inaction on interest rates is puzzling given that the Federal Reserve, Bank of England, Bank of Japan have aggressively cut interest rates as the global economic situation worsens. World trade is collapsing and exports are dropping sharply everywhere (e.g South Korean exports down over 30% year-on-year). China is facing a "hard landing" with other Asian economies weakening. Germany as one of the world's leading exporters is getting hit by a "double whammy" of collapsing world trade and a restrictive monetary policy. Tough times ahead for the eurozone (and the euro I think).


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