Friday, 19 August 2011
Friday, 20 May 2011
The Poverty Trap and how to Overcome It
The poverty trap occurs when people have little or no incentive to get a better paid job or work longer hours. (not to be confused with unemployment trap where there is no incentive to get a job at all.)
In the UK, there are a wide range of benefits. It is estimate that 5 million people receive some kind of government benefits and these benefits may create a disincentive to get better paid jobs
The poverty trap occurs due to benefits such as income support, housing benefit, single parent allowance and family tax credit. If somebody got a better paid job they would lose benefits and pay more tax (income tax and NI. Therefore, their take home pay may be the same as before.
Policies to reduce poverty trap
1. Reduce benefits.
If benefits are reduced or abolished, such as income support there is a greater incentive to get a better paid job. However,
This may increase relative poverty as the low paid will get lower incomes compared to the rest of the population.
It may cause the unemployment trap. It will reduce the gap between unemployment benefits and low paid work.
2. Have a Graded system of Benefits.
This means that if your income increases you still get some benefits. There isn't an immediate cut off point, but, there is still an incentive to work longer hours and get a better paid job.
3. Increase the Income Tax Threshold.
This means that you increase the amount of income that you can earn before you start paying any tax. At the moment, it is around £5,000. Increasing this limit gives a greater incentive to work and earn more.
4. Increased Minimum Wages.
A higher minimum wage helps to make work more attractive. However, if it is too high it might cause a rise in unemployment. However, the increase in the UK minimum wages since '97 has not caused unemployment
5. Family Tax Credits - graded benefits for those in work. It leads to lower tax bills and is graded to avoid any disincentives of working harder.
6. Make it harder to get sickness and disability to benefits.
It is argued that many people who are on sickness and disability benefits would be able to do some types of jobs. In some cases, sickness benefit has been seen as an alternative to being on unemployment benefit. But, because it is attractive to remain on sickness benefit there is a disincentive to work.
It is a difficult situation, with a conflict between the need to give workers the proper incentives and the importance of avoiding unfair treatment of the low paid.
Since the credit crisis,UK government bond yields have stayed low, despite having similar levels of government borrowing to Spain, Portugal and Ireland.
Why have members of the Euro faced more difficulties in financing debt than the UK?
(It is a similar story for US and Japan where interest rates have stayed low despite high levels of borrowing.)
Essentially members of the Euro need to finance their budget deficit, but they don't control their own monetary policy.
Since the credit crisis, the value of sterling has fallen considerably. This helps boost exports and growth. This boost to economic growth helps reassure investors the government will have more ability to pay back debt. The devaluation in sterling also makes sterling assets appear more attractive and so may encourage foreign investors to buy.
2) Bank of England could buy government bonds as last resort.
If the UK has difficulty in financing the deficit, the Bank of England can act as lender of last resort and buy up government bonds. This mechanism gives investors more faith that the UK can remain solvent. There is no danger of a liquidity crisis.
If Spain or Ireland has difficult selling bonds to the private sector, investors will sell Spanish bonds, however, this won't cause a depreciation in the value of the Spanish currency (because there is only the Euro). Therefore unlike the UK, Spanish assets don't become more attractive. Also, Spain will face a stronger currency than is ideal for the state of their economy.
Spain also can't ask the Spanish Central Bank to buy Spanish bonds. In theory the ECB could, but they are reluctant to for various reasons.
The markets know that Spain is more vulnerable - they can't benefit from devaluation and they can't ask their Central Bank to buy bonds. This increases the risk that Spain faces a liquidity crisis (can't raise enough money) Therefore, investors will be quick to move out of Spanish bonds into something more secure. The fear of a liquidity crisis in Euro zone countries means they are much more vulnerable to worries over increase in debt.
Vicious CycleSpain struggle to finance its deficit, it may rely on a bailout from the EU. This provides liquidity but also the ECB impose conditions (punishment). The EU make Spain and Ireland pursue austerity (spending cuts) and accept higher interest rates on bonds. The higher interest rates and spending cuts will lead to lower growth, deflation and higher unemployment. But, this fall in economic growth also leads to lower tax revenues which increases debt and makes Spanish debt more unattractive.
The result is that in a recession, Euro members have become much more vulnerable to problems in the bond market. It also means that their response to a recession needs to focus on deflationary measures (strong exchange rate, higher interest rates and spending cuts). However, this is exactly the wrong response that you need in a recession.
Also, these countries still face an interest rate set by the ECB for the whole Euro zone. The ECB have already indicated that recovery in Germany and France will lead to higher interest rates. But, higher interest rates is not what Ireland needs given they currently have deflation.