Ten years ago, the financial crisis deepened and stock markets around the world plummeted. The trigger was the collapse of Lehman Brothers, the fourth-largest US investment bank. It filed for bankruptcy on September 15, 2008. This was not the first bank failure around that time. In 2007, Northern Rock in the UK (Aug/Sept 2007) had collapsed and so too had Bear Stearns in the USA (Mar 2008).

Initially there was some hope that the US government would bail out Lehmans. But when Congress rejected the Bank Bailout Bill on September 29, the US stock market fell sharply, with the Dow Jones falling by 7% the same day. This was mirrored in other countries: the FTSE 100 fell by 15%.

At the core of the problem was excessive lending by banks with too little capital. What is more, much of the capital was of poor quality. Many of the banks held securitised assets containing ‘sub-prime mortgage debt’. The assets, known as collateralised debt obligations (CDOs), were bundles of other assets, including mortgages. US homeowners had been lent money based on the assumption that their houses would increase in value. When house prices fell, homeowners were left in a position of negative equity – owing more than the value of their house. With many people forced to sell their houses, prices fell further. Mortgage debt held by banks could not be redeemed: it was ‘sub-prime’ or ‘toxic debt’.

Response to the crisis

The outcome of the financial crash was a series of bailouts of banks around the world. Banks cut back on lending and the world headed for a major recession.

Initially, the response of governments and central banks was to stimulate their economies through fiscal and monetary policies. Government spending was increased; taxes were cut; interest rates were cut to near zero. By 2010, the global economy seemed to be pulling out of recession.

However, the expansionary fiscal policy, plus the bailing out of banks, had led to large public-sector deficits and growing public-sector debt. Although a return of economic growth would help to increase revenues, many governments felt that the size of the public-sector deficits was too large to rely on economic growth.

As a result, many governments embarked on a period of austerity – tight fiscal policy, involving cutting government expenditure and raising taxes. Although this might slowly bring the deficit down, it slowed down growth and caused major hardships for people who relied on benefits and who saw their benefits cut. It also led to a cut in public services.

Expanding the economy was left to central banks, which kept monetary policy very loose. Rock-bottom interest rates were then accompanied by quantitative easing. This was the expansion of the money supply by central-bank purchases of assets, largely government bonds. A massive amount of extra liquidity was pumped into economies. But with confidence still low, much of this ended up in other asset purchases, such as stocks and shares, rather than being spent on goods and services. The effect was a limited stimulation of the economy, but a surge in stock market prices.

With wages rising slowly, or even falling in real terms, and with credit easy to obtain at record low interest rates, so consumer debt increased.

Lessons

So have the lessons of the financial crash been learned? Would we ever have a repeat of 2007–9?

On the positive side, financial regulators are more aware of the dangers of under capitalisation. Banks’ capital requirements have increased, overseen by the Bank for International Settlements. Under its Basel II and then Basel III regulations (see link below), banks are required to hold much more capital (‘capital buffers’). Some countries’ regulators (normally the central bank), depending on their specific conditions, exceed these the Basel requirements.

But substantial risks remain and many of the lessons have not been learnt from the financial crisis and its aftermath.

There has been a large expansion of household debt, fuelled by low interest rates. This constrains central banks’ ability to raise interest rates without causing financial distress to people with large debts. It also makes it more likely that there will be a Minsky moment, when a trigger, such as a trade war (e.g. between the USA and China), causes banks to curb lending and consumers to rein in debt. This can then lead to a fall in aggregate demand and a recession.

Total debt of the private and public sectors now amounts to $164 trillion, or 225% of world GDP – 12 percentage points higher than in 2009.

China poses a considerable risk, as well as being a driver of global growth. China has very high levels of consumer debt and many of its banks are undercapitalised. It has already experienced one stock market crash. From mid-June 2015, there was a three-week fall in share prices, knocking about 30% off their value. Previously the Chinese stock market had soared, with many people borrowing to buy shares. But this was a classic bubble, with share prices reflecting exuberance, not economic fundamentals.

Although Chinese government purchases of shares and tighter regulation helped to stabilise the market, it is possible that there may be another crash, especially if the trade war with the USA escalates even further. The Chinese stock market has already lost 20% of its value this year.

Then there is the problem with shadow banking. This is the provision of loans by non-bank financial institutions, such as insurance companies or hedge funds. As the International Business Times article linked below states:

A mind-boggling study from the US last year, for example, found that the market share of shadow banking in residential mortgages had rocketed from 15% in 2007 to 38% in 2015. This also represents a staggering 75% of all loans to low-income borrowers and risky borrowers. China’s shadow banking is another major concern, amounting to US$15 trillion, or about 130% of GDP. Meanwhile, fears are mounting that many shadow banks around the world are relaxing their underwriting standards.

Another issue is whether emerging markets can sustain their continued growth, or whether troubles in the more vulnerable emerging-market economies could trigger contagion across the more exposed parts of the developing world and possibly across the whole global economy. The recent crises in Turkey and Argentina may be a portent of this.

Then there is a risk of a cyber-attack by a rogue government or criminals on key financial insitutions, such as central banks or major international banks. Despite investing large amounts of money in cyber-security, financial institutions worry about their vulnerability to an attack.

Any of these triggers could cause a crisis of confidence, which, in turn, could lead to a fall in stock markets, a fall in aggregate demand and a recession.

Finally there is the question of the deep and prolonged crisis in capitalism itself – a crisis that manifests itself, not in a sudden recession, but in a long-term stagnation of the living standards of the poor and ‘just about managing’. Average real weekly earnings in many countries today are still below those in 2008, before the crash. In Great Britain, real weekly earnings in July 2018 were still some 6% lower than in early 2008.

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Questions

  1. Explain the major causes of the financial market crash in 2008.
  2. Would it have been a good idea to have continued with expansionary fiscal policy beyond 2009?
  3. Summarise the Basel III banking regulations.
  4. How could quantitative easing have been differently designed so as to have injected more money into the real sector of the economy?
  5. What are the main threats to the global economy at the current time? Are any of these a ‘hangover’ from the 2007–8 financial crisis?
  6. What is meant by ‘shadow banking’ and how might this be a threat to the future stability of the global economy?
  7. Find data on household debt in two developed countries from 2000 to the present day. Chart the figures. Explain the pattern that emerges and discuss whether there are any dangers for the two economies from the levels of debt.

I admit it, the title of my blog today is a little bit misleading – but at the same time very appropriate for today’s topic. Nancy Sinatra certainly wasn’t thinking about emigration when she was singing this song – it had nothing to do with it, after all. It is, however, very relevant to economists: Indeed, there are many economics papers discussing the effects of skilled immigration on host and source economies and regions.

Economists often use the term ‘brain drain’ to describe the migration of highly skilled workers from poor/developing to rich/developed economies. Such flows are anything but unusual. As The Economist points out in a recent article, ‘[I]n the decade to 2010–11 the number of university-educated migrants in the G20, a group of large economies that hosts two-thirds of the world’s migrants, grew by 60% to 32m according to the OECD, a club of mostly rich countries.’.

The effects of international migration are found to be overwhelmingly positive for both skilled migrant workers and their hosts. This is particularly true for highly skilled workers (such as academics, physicians and other professionals), who, through emigration, get the opportunity to earn a significantly higher return on their skills that what they might have had in their home country. Very often their home country is saturated and oversupplied with skilled workers competing for a very limited number of jobs. Also, they get the opportunity to practise their profession – which they might not have had otherwise.

But what about their home countries? Are they worse off for such emigration?

There are different views when it comes to answering this question. One argument is that the prospect of international migration incentivises people in developing countries to accumulate skills (brain gain) – which they might not choose to do otherwise, if the expected return to skills was not high enough to warrant the effort and opportunity cost that comes with it. Beine et al (2011) find that:

Our empirical analysis predicts conditional convergence of human capital indicators. Our findings also reveal that skilled migration prospects foster human capital accumulation in low-income countries. In these countries, a net brain gain can be obtained if the skilled emigration rate is not too large (i.e. it does not exceed 20–30% depending on other country characteristics). In contrast, we find no evidence of a significant incentive mechanism in middle-income, and not surprisingly, high-income countries.

Other researchers find that emigration can have a significant negative effect on source economies (countries or regions) – especially if it affects a large share of the local workforce within a short time period. Ha et al (2016), analyse the effect of emigration on human capital formation and economic growth of Chinese provinces:

First, we find that permanent emigration is conducive to the improvement of both middle and high school enrollment. In contrast, while temporary emigration has a significantly positive effect on middle school enrollment it does not affect high school enrollment. Moreover, the different educational attainments of temporary emigrants have different effects on school enrollment. Specifically, the proportion of temporary emigrants with high school education positively affects middle school enrollment, while the proportion of temporary emigrants with middle school education negatively affects high school enrollment. Finally, we find that both permanent and temporary emigration has a detrimental effect on the economic growth of source regions.

So yes or no? Good or bad? As everything else in economics, the answer quite often is ‘it depends’.

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Questions

  1. ‘The brain drain makes a bad situation worse, by stripping developing economies of their most valuable assets: skilled workers’. Discuss.
  2. Using Google, find data on the inflows and outflows of skilled labour for a developing country of your choice. Explain your results.
  3. ‘Brain drain’ or ‘brain gain’? What is your personal view on this debate? Explain your opinion by using anecdotal evidence, personal experience and examples.
  4. Referring to the previous question, write a critique of your answer.

So here we are, summer is over (or almost over if you’re an optimist) and we are sitting in front of our screens reminiscing about hot sunny days (at least I do)! There is no doubt, however: a lot happened in the world of politics and economics in the past three months. The escalation of the US-China trade war, the run on the Turkish lira, the (successful?) conclusion of the Greek bailout – these are all examples of major economic developments that took place during the summer months, and which we will be sure to discuss in some detail in future blogs. Today, however, I will introduce a topic that I am very interested in as a researcher: the liberalisation of energy markets in developing countries and, in particular, Mexico.

Why Mexico? Well, because it is a great example of a large developing economy that has been attempting to liberalise its energy market and reverse price setting and monopolistic practices that go back several decades. Until very recently, the price of petrol in Mexico was set and controlled by Pemex, a state monopolist. This put Pemex under pressure since, as a sole operator, it was responsible for balancing growing demand and costs, even to the detriment of its own finances.

The petrol (or ‘gasoline’) price liberalisation started in May 2017 and took place in stages – starting in the North part of Mexico and ending in November of the same year in the central and southern regions of the country. The main objective was to address the notable decrease in domestic oil production that put at risk the ability of the country to meet demand; as well as Mexico’s increasing dependency on foreign markets affected by the surge of the international oil price. The government has spent the past five years trying to create a stronger regulatory framework, while easing the financial burden on the state and halting the decline in oil reserves and production. Unsurprisingly, opening up a monopolistic market turns out to be a complex and bumpy process.

Source: Author’s calculations using data from the Energy Information Bank, Ministry of Energy, Mexico

Despite all the reforms, retail petrol prices have kept rising. Although part of this price rise is demand-driven, an increasing number of researchers highlight the significance of the distribution of oil-related infrastructure in determining price outcomes at the federal and regional (state) level. Saturation and scarcity of both distribution and storage infrastructure are probably the two most significant impediments to opening the sector up to competition (Mexico Institute, 2018). You see, the original design of these networks and the deployment of the infrastructure was not aimed at maximising efficiency of distribution – the price was set by the monopolist and, in a way that was compliant with government policy (Mexico Institute, 2018). Economic efficiency was not always part of this equation. As a result, consumers located in better-deployed areas were subsidising the inherent logistics costs of less ‘well endowed’ regions by facing an artificially higher price than they would have in a competitive market.

But what about now? Do such differences in the allocation of infrastructure between regions lead to location-related differences in the price of petrol? If so, by how much? And, what policies should the government pursue to address such imbalances? These are all questions that I explore in one of my recent working papers titled ‘Widening the Gap: Lessons from the aftermath of the energy market reform in Mexico’ (with Hugo Vallarta) and I will be sharing some of the answers with you in a future blog.

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Questions

  1. Are state-owned monopolies effective in delivering successful market outcomes? Why yes, why no?
  2. In the case of Mexico, are you surprised about the complexities that were involved with opening up markets to competition? Explain why.
  3. Use Google to identify countries in which energy markets are controlled by state-owned monopolies.

Donald Trump has threatened to pull out of the World Trade Organization. ‘If they don’t shape up, I would withdraw from the WTO,’ he said. He argues that the USA is being treated very badly by the WTO and that the organisation needs to ‘change its ways’.

Historically, the USA has done relatively well compared with other countries in trade disputes brought to the WTO. However, President Trump does not like being bound by an international organisation which prohibits the unilateral imposition of tariffs that are not in direct retaliation against a trade violation by other countries. Such tariffs have been imposed by the Trump administration on steel and aluminium imports. This has led to retaliatory tariffs on US imports by the EU, China and Canada – something that is permitted under WTO rules.

Whether or not the USA does withdraw from the WTO, Trump’s threats bring into question the power of the WTO and other countries’ compliance with WTO rules. With the rise in protectionist sentiments around the world, the power of the WTO would seem to be on the wane.

Even if the USA does not withdraw from the WTO, it is succeeding in weakening the organisation. Appeals cases have to be heard by an ‘appellate body’, consisting of at least three judges drawn from a list of seven, each elected for four years. But the USA has the power to block new appointees – and has done so. As Larry Elliott states in the first article below:

The list of judges is already down to four and will be down to the minimum of three when the Mauritian member, Shree Baboo Chekitan Servansing, retires at the end of September. Two more members will go by the end of next year, at which point the appeals process will come to a halt.

This raises the question of the implication of a ‘no-deal’ Brexit – something that seems more likely as the UK struggles to reach a trade agreement with the EU. Leaving without a deal would mean ‘reverting to WTO rules’. But if these rules are being ignored by powerful countries such as the USA and possibly China, and if the appeals procedure has ground to a halt, this could leave the UK without the safety net of international trade rules. Outside the EU – the world’s most powerful trade bloc – the UK could find itself having to accept poor trade terms with the USA and other large countries.

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Questions

  1. Explain the WTO’s ‘Most-favoured-nation (MFN)’ clause. How would this affect trade deals between the UK and the EU?
  2. Would the trade deals that the EU has negotiated with other countries, such as Japan, be available to the UK after leaving the EU?
  3. Demonstrate how, according to the law of comparative advantage, all countries can gain from trade.
  4. In what ways is the USA likely to gain and lose from the imposition of tariffs on steel and aluminium?
  5. How could a country that supports free trade ever support the imposition of tariffs?
  6. Why are tariffs not the most serious restriction on trade?

The median pay of chief executives of the FTSE 100 companies rose 11% in 2017 to £3.93 million per year, according to figures released by the High Pay Centre. By contrast, the median pay of full-time workers rose by just 2%. Given two huge pay increases for the CEOs of Persimmon and Melrose Industries of £47.1 million and £42.8 million respectively, the mean CEO pay rose even more – by 23%, from £4.58 million in 2016 to £5.66 million in 2017. This brings the ratio of the mean pay of FTSE 100 CEOs to that of their employees to 145:1. In 2000, the ratio was around 45:1.

These huge pay increases are despite criticisms from shareholders and the government over excessive boardroom pay awards and the desire for more transparency. In fact, under new legislation, companies with more than 250 employees must publish the ratio of the CEO’s total remuneration to the full-time equivalent pay of their UK employees on the 25th, 50th (median) and 75th percentiles. The annual figures will be for pay starting from the financial year beginning in 2019, which for most companies would mean the year from April 2019 to April 2020. Such a system has been introduced in the USA this year.

So why has the gap in pay widened so much? One reason is that there is no formal mechanism whereby workers can apply downward pressure on such awards. Although Theresa May, in her campaign to become Prime Minister in 2016, promised to put workers on company boards, the government has since abandoned the idea.

Executive pay is awarded by remuneration committees. Membership of such committees consists of independent non-executive directors, but their degree of independence has frequently been called into question and there has been much criticism of such committees being influenced by their highest paying competitors or peers. This has had the effect of ratcheting up executive pay.

Then there is the question of the non-salary element in executive pay. The incentive and bonus payments are often linked to the short-term performance of the company, as reflected in, for example, the company’s share price. In a period when share prices in general rise rapidly – as we have seen over the past two years – executive pay tends to rise rapidly too. A frequent criticism of large UK businesses is that they have been too short-termist. What is more, bonuses are often paid despite poor performance.

There has been some move in recent years to make incentive pay linked more to long-term performance, but this has still led to many CEOs getting large pay increases despite lack-lustre long-term performance.

Then there is the question of shareholders and their influence on executive pay. Despite protests by many smaller shareholders, a large proportion of shares are owned by investment funds and their managers are often only too happy to vote through large executive pay increases at shareholder meetings.

So, while the pressures for containing the rise in executive pay remain small, the pay gap is likely to continue to widen. This raises the whole question of a society becoming increasingly divided between the few at the top and a large number of people ‘just getting by’ – or not even that. Will this make society even more fractured and ill at ease with itself?

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Questions

  1. How would you set about establishing whether CEOs’ pay is related to their marginal revenue product?
  2. To what extent is executive pay a reflection of oligopolistic/oligopsonistic behaviour?
  3. In what ways can game theory shed light on the process of setting the remuneration packages of CEOs? Is there a Nash equilibrium?
  4. What are the advantages and disadvantages of linking senior executives’ remuneration to (a) short-term company performance; (b) long-term company performance?
  5. What is/are the best indicator(s) of long-term company performance for determining the worth of senior executives?
  6. Consider the arguments for and against capping the ratio of CEOs’ remuneration to a particular ratio of either the mean or median pay of employees. What particular ratio might be worth considering for such a cap?