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Secrets behind interest rates

24 January 2007

Last week the Bank of England caught the City by surprise by raising the Interest Rate by a quarter of a point. Not long ago, before Christmas, it also surprised the City by not increasing the interest rate.

This behaviour might be rooted on the “Expectations Theory”. According to this theory, people have some expectations about what somebody else is going to do, and they would act as if those expectations were going to be true. So perhaps the Bank of England was playing with the expectations in order to make them behave as if there were an increase in rates.

What is this behaviour?

Changing the interest rate in order to affect the economy is an idea developed by Milton Friedman. He observed that periods of speculation or situations where there is too much money in circulation lead to increase in prices, what we call Inflation. If the situation gets out of hand, it all can end up in unreal prices. A mix between people not being able to consume anymore because of high prices and a sudden selling frenzy of assets which people think overpriced can trigger a crash, which is followed by a crisis.

In order to avoid it, the Central Bank increases the interest rate. This, on one hand, makes credit more expensive, and people less willing to get them and therefore, less money will be available to keep prices rising.

On the other hand, those who have money will find more attractive keeping it in the bank to get higher interest, with the result, as well, of less pressure on rising prices.

Let’s suppose you expect the Central Bank will increase the Interest rate. You will hold your hand before asking for a credit (above all if rates are variable), or will keep the money just in case you need it in future, because it is better to keep yours than to pay the higher interest in some months. As a result of your expectation, there is less money changing hands. Exactly what the Bank wants to achieve by raising the interest, but without doing it.

Now, the economic data is saying that inflation nearly reached 3% in december, that property prices keep on growing, and growth is expected to be 3%, very high for a developed economy. Facing this data, the Bank could not waste any time and decided to increase the interest to “cool down” the economy.

The other aspect that must be considered when talking about interest rates is the currency exchange, but all the analyses seem to point that it was not relevant in these two decisions.


Why David Beckham’s salary is not an exaggeration

15 January 2007

All those who like or just enjoy a bit football (or soccer for this matter) must have noticed that David Beckham has been signed for £128 million. Or in other words, $1 million a week. Excessive as it looks, this amount of money might actually make economic sense.

LA Galaxy, the club that is signing him, is a company. Hence it must have enough revenues to cover its costs. And these costs will rise considerably from April when Beckham starts playing. They must have a plan.

Although his right leg was still one of the best in Europe, Real Madrid, his present club was not signing him from Manchester United to become the new superstar. Beckham had to become a living advert. And he did. There were record sales of shirts, the team got exposure in the whole world. Everyone wanted to see Madrid playing to see Beckham.

LA Galaxy is signing him after a bad performance in the World Cup. He went to Real Madrid to win trophies, and to date, he has won nothing at all. But he is not being signed for being a quality player. He is being signed for being a celebrity-player.

He will boost the name of LA Galaxy around the world (very few people in Europe knew the name of this team until one week ago and now it is everywhere). Thousands of fans will be willing to see him playing, which will fill the stadium. In a moment where the fan base is still being built, this might attract some fidelities to Galaxy. The merchandise sales will soar. There will be a demand to watch the games all over the world, which will turn into TV rights sold. And in a advertising-driven-economy as the USA, advertisers will be pouring millions on the team. Not to mention, obviously, that with such player, LA Galaxy increases the chances to win the championship. And this will attract more fans, more attention, more advertising and more money.

What is hard to comprehend is the amount of money that he will generate now, and above all, in the future. This revenue will make the signing amount small. In that case, if Beckham is generating more money than what he costs, the signing amount is not exaggerated.

We could discuss if it is fair that a single person receives such an outrageous amount of money. That would put us in the realm of ethics, which are not strange to Economics. But leaving ethics aside, it is clear that Beckham is being paid in accordance with his contribution to the revenue of the company, and that is perfectly economics.

Confirmed: Immigration is good and necessary

18 December 2006

The Bank of England has published the Bulletin Q4 2006, and it contains a very interesting article that we should rejoice, and not complain, that immigrants are coming over.

The whole article is really enjoyable, written with caution to avoid misleading readers in the wrong direction. And the conclusion leaves many things open to interpretation.

I already wrote about Immigration justifying it from the point of view of pure economics. But I was ending with some questions. One of them was that there is not enough work for immigrants. The Bank of England states clearly:

Immigrants are employed”

Another of the findings is that there are more immigrants than average both in high qualified jobs and low qualified. An explanation of this might be that the City is atracting brilliant minds, and the economic buzz is also attracting people who is poor at home and go to Britain to find a better life.

“Immigrants also tend to be younger, better educated, and work longer hours than those born in the United Kingdom”

Economically, this is perfect: young people that have not been educated at the expenses of the British public school. It is like suddenly, we have an army of people in the best age to be productive coming from nowhere. And they are willing to work as many hours as necessary to prove that they are good. Wouldn’t you be delighted if you were their bosses? This has a repercussion in the Economy of the country as it has more quality production at the same price. Well, not at the same price.

“The increasing share of “new” immigrants in low paid jobs appears to have led the emergence of a striking wage gap between “new” immigrants and UK-born workers”

Immigrants who come from poor countries tend to be willing to work at any price. And employers take good note of it. Hence, British workers ask for more money to do the same low skilled job. Is this good or bad for the Economy?

The article gives two explanations. Suppose that they are paid less because they work worse. In Leyman’s terms, they are not worth as much as the British. Then we will have worse productivity, as to create the same amount of product, we will need more people doing it, although the cost will be the same because they earn less.

The second view says that they “may have displaced similar or less productive workers”. In this case, they work as well as the British, or even better, but they earn less. Excellent for the economy as more product will be done with less cost.

The article does not indicate whether one view is more real than the other. But it keeps on saying that since immigrants work for less and in any job, unemployment has fallen and more importantly, wages are kept stable. This fact incredibly agrees with theory.

Let’s go back to pure Supply and Demand. If supply is greater than demand, prices will fall, won’t them? If there is more supply of work than workers seeking for a job, potential workers will ask for more salary. But if the gap between Supply of jobs and Demand narrows, the position of job seekers is weaker. Also workers trying to discuss a wage increase will have less power because others will be willing to do their jobs for less money, so insiders will have to accept lower wages.

“Immigration may also have increased the supply potential of the economy by lowering the natural rate of unemployment, either by reducing skills gaps in a tight labour market or by tempering the wage demands of domestic workers, or both.”

The Bank of England suggests that the last wave of immigrants is young, well educated, willing to do the same job as a British do, but for a lower pay, willing to work more hours, and on the top of it, they might even do the job better, displacing nationals that do their job worse, or who are not willing to work for that money, which is not a problem for them because they can live thanks to the subsidies of the Government.

The article hints that immigrants are good for productivity, and are definitely good to keep Inflation down, which at the same time will keep interest rates untouched and ease the fears of a national bankruptcy if the level of credit keeps on hiking and the interest rates increase suddenly.

So what about my questions about immigration. Will they make salaries drop? No, just keep them at the same level. Will they take British jobs? Only those that nobody wants, and those where the British worker is not willing to make an effort to stay. Will they enjoy the services we pay with our taxes? They also pay taxes (unless the employer breaches the law), and they are young and willing to work. They are not a burden to the NHS.

And for the Economy? They are a fabulous present.


11 December 2006

Romania and Bulgaria are just about to become members of the European Union, which has triggered again the arguments about immigration. In fact, there is no such argument. When analysed from the economics point of view, everything is very clear, even how surprising politicians are.

Let’s supose I have a company in London. I make nice fashionable clothes. The first thing I need is machinery, which I buy in England. Then I need cotton. There are no crops in London. Nor in England. But that is not going to stop me. I will bring cotton from India.

Now I have english machinery and indian cotton. I need people to work and turn the cotton into clothes I will sell in High Street shops. Suppose nobody wants to work for me because everyone is happy with their present situation. I know there are people out there willing to buy clothes. There is therefore demand. I am certain I would make money if I could produce clothes. I will import my workers. The same way I import cotton, I will import the worker.

Let’s now move a bit forward. My workers are already at work and the first supply of clothes is selling very well in the shops. The shops are now selling my products instead of importing stuff from overseas, which means that I am increasing the production of the country and hence, it’s wealth.

So as you see, we need to import people in order to increase the wealth of a country when there are places that are not covered.

Hey, hold on! People are not cotton! And we are not asking them to come, they are coming “en masse” without any request. And they are using the services that we are paying with our taxes.

True that they are not cotton, but it is not that true that we have not asked them to come. They have heard that there is a lot of work here. Check it  youself in any restaurant. And in the fields. There is a demand of people, but we can not expect that companies just ask for 37 workers to be sent over. That’s why they have to come and find the vacancies themselves. After all, they are not cotton.

So immigrants are good for the economy. But, as many will say, they make our salaries drop, they take our jobs, they enjoy services that we pay with our taxes.

Hmmmm… I think this should be treated in another post.

Richard Branson, Rupert Murdoch and the logics of strategy

8 December 2006

I have said before that business strategy is like a war, and it is even fir to get hostages. Richard Branson, owner of Virgin, wanted to include ITV, the British Independent TV in his portfolio of Media, recently increased by the cable operator NTL. And then, out of the blue, monopoly concerns appear because the deal is not done. Who does understands this?

Not long ago NTL, soon to be renamed “Virgin Media” was bidding for ITV. And it seemed that everything was done. But then, all of a sudden, ITV rejects the bid saying that from ITV’s perspective there is little, if any, strategic logic for ITV to combine with NTL”.

The deal would be excellent for NTL, because it would include the capacity of producing contents of ITV, apart from the rights in UK for the Champions League. This detail might not look very important, but around the world, football is a major incentive for customers to subscribe to payment TV.

And for ITV? Well, given their recent problems of revenues, being part of NTL would ease this concern. It would give them new platforms to broadcast their content, and also the power of the broadband, which seems to be the future of TV.

So if they were happy with the idea some time ago, and it seems that the merger makes sense, why such harsh statement?

While the decision was taken, Rupert Murdoch increased his ownership of ITV to 18%. Murdoch is the owner of BsSkyB, the satellite broadcaster, owner of the majority of rights to the English football league, and who has recently moved into broadband.

Take this with a grain of salt, because it is just speculation but, what if Murdoch is using the old business strategy of weakening the enemy? Branson and Murdoch are fighting for the hill. Although Murdoch seemed to have it very well controlled, Branson has lately started a battle with new strength. Branson is dealing with a neighbouring tribe that was being neutral until the moment. He want them to join forces. But then, Murdoch manages to have a decisive authority in that tribe and make sure that they remain neutral.

Why is Murdoch not buying ITV himself? That would spread serious concerns of monopoly. But because the deal NTL-ITV makes a lot of strategic sense, Murdoch is making sure that it will not happen. This reassures him that NTL will not grow while he makes further deals to lock his position at the top of the hill.

Milton Friedman

22 November 2006

Milton Friedman died last Thursday 16th November 2007. He was awarded Nobel Prize of Economics 1976 and was one of the most important economists of the XX century. I just want to talk here about one single thing of his long list of innovative theories, the management of the interest rate by central banks.

The Economy has cycles. Economists love to use graphics, and line graphs with peaks and troughs are their favourites. Those graphics mean that the economy has good times, when the curve goes up, and bad times, which are the crisis. The task of the economics authorities is trying to make the cycle as flat as possible, that is, to cool down the good times and try to make the bad times less severe.

One of the ways is with taxes and public investment. The trick is that when the Economy is in recession, an injection of money in the form of infrastructures or subsidies keeps the Economy going. This was the theory that worked to help recover from the 1929 crisis, the post-war recovery in Europe and Japan, and was developed by John Maynard Keynes.

The other way is playing with the amount of money available in the Economy. This was one of Milton Friedman’s contributions to the theory of Economics, the Monetarism, and it is normally managed by the central banks.

One of the tools used by Monetarism is the Interest Rate. When the Economy is growing, the movement of money increases, and Inflation becomes a real problem, because people having money in their hands tend to compete for the same goods, and those increase the price, which is the explanation of Inflation. Increasing the Interest Rate makes credits more expensive, and saving more beneficial, so the total amount of money in the economy decreases and so does the risk of Inflation.

On the other side, in periods of crisis, when people has no money or tend to save because bad times are coming, a reduction of the Interest Rate makes borrowing money cheaper and so companies can make investments, people can buy goods and the Economy starts working again.

Obviously this is an oversimplified explanation, but it works, and Milton Friedman was the first to come with the idea.

How Internet Explorer 7 proves that competition is good

19 October 2006

Internet Explorer 7 (IE7 or WIE) is being released today for those using Windows XP. But this was never supposed to happen. Back in 2003, Microsoft was planning destroying the market for browsers. So why now we have a new browser from Microsoft? Why did they change their master plan?

Just for reference, a browser is a program that allows us to browse all the information stored in the millions of computers that from the Internet. Without it there would be no way to see webpages, photos, news, etc.

In 1994, the first commercial browser, called Netscape appeared. In a proof of forward thinking, Microsoft thought that this thing of the Internet would never be interesting to users. In July 1995 they released their own browser. That was the beginning of the Browser Wars, which finished around 2002 when more than 95% of browsers were IE.

Then Microsoft took the decision of not releasing any other stand-alone version of IE. From 1995 to 2003, six versions of IE had been released, including some updates and minor improvements. Today is the marks of the first release since then. This means that there has not been any improvement in the browser for 3 years. And nobody can think there was no room for improvement.

Today, IE7 is released. Why is there need for a new one now?

The ashes of Netscape gave birth to a new non-for-profit organisation that released a new browser called Firefox, in September 2004. It was introducing many innovations such as tabbed browsing, pop-up block, search box, the extremely useful extensions, and a download manager. Its use started to grow to the extent that somebody in Microsoft started to get worried.

Then the original plan of not releasing any other IE, and totally integrating it in the next version of Windows, called Vista, was dropped. Today we see the results of that. A brand new IE that includes many of the innovations of Firefox, like tabbed browsing, and other interesting solutions.

If Firefox had never appeared, if the users hadn’t switched to look for the new features it was offering, IE7 with its innovations would have never happened. While Microsoft was enjoying a monopoly situation there was no point to improve, it was a one man race. When a new racer appeared at the end of the street IE had to start running. And it is indeed running! And this is much better for all of us. You can add some excitement by downloading Firefox 1.5 for free and the new IE7 and choosing your favourite. Oh, and just wait couple of months to see the much promising release of the new Firefox 2.0.