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Articles for the ‘Essentials of Economics 7e’ Category

Bubbling bitcoin

What do tulips, nickel mining in Australia, South Seas trading, Beanie Babies and cryptocurrencies have in common? The answer is that they have all been the subject of speculative bubbles. In the first four cases the bubble burst. A question currently being asked is whether it will happen to bitcoin.

Bitcoin
Bitcoin was created in 2009 by an unknown person, or people, using the alias Satoshi Nakamoto. It is a digital currency in the form of a line of computer code. Bitcoins are like ‘electronic cash’ which can be held or used for transactions, with holdings and transactions heavily encrypted for security – hence it is a form of ‘crytocurrency’. People can buy and sell bitcoins for normal currencies as well as using them for transactions. People’s holdings are held in electronic ‘wallets’ and can be accessed on their computers or phones via the Internet. Transfers of bitcoins from one person or organisation to another are recorded in a public electronic ledger in the form of a ‘blockchain‘.

The supply of bitcoins is not controlled by central banks; rather, it is determined by a process known as ‘mining’. This involves individuals or groups solving complex and time-consuming mathematical problems and being rewarded with a new block of bitcoins.

The supply of bitcoins is currently growing at around 150 per hour and the current supply is around ₿16.7 million. However, the number of new bitcoins in a block is halved for every 210,000 blocks. This means that the rate of increase in the supply of bitcoins is slowing – the number generated being halved roughly every four years. The supply will eventually reach a maximum of ₿21 million, probably sometime in the next century, but around 99% will have been mined by around 2032.

The bitcoin bubble
The price of bitcoins has soared in recent months and especially in the past two. On 4 October, the price of a bitcoin was $4226; by 7 December it was nearly four times higher, at $16,858 – a rise of 399% in just nine weeks. Many people have claimed that this is a bubble, which will soon burst. Already there have been severe fluctuations. By December 10, for example, the price had fallen at one point to $13,152 – a fall of nearly 22% in just two days – only to recover to over $15,500 within a few hours.

So what determines the price of bitcoin? The simple answer is very straightforward – it’s determined by demand and supply. But what has been happening to demand and supply and why? And what will happen in the near and more distant future?

As we have seen, the supply is limited by the process of mining, which allows a relatively stable, but declining, increase. The explanation of the recent price rise and what will happen in the future lies on the demand side. Increasing numbers of people have been buying bitcoin, not because they want to use it for transactions, whether legitimate or illegal over the dark web, but because they want to invest in bitcoin. In other words, they want to hold bitcoin as an asset which is increasing in value. These people are known as ‘hodlers’ – a deliberate misspelling of ‘holders’.

But this speculation is of the destabilising form. The more prices have risen, the more people have bought bitcoin, thus pushing the price up further. This is a classic bubble, whereby the price does not reflect an underlying value, but rather the exuberance of buyers.

The problem with bubbles is that they will burst, but just when is virtually impossible to predict with any accuracy. If the price of bitcoins falls, what will happen next depends on how the fall is interpreted. It could be interpreted as a temporary fall, caused by some people cashing in to take advantage of the higher prices. At the same time, other people, believing that it is only a temporary fall, will rush to buy, snapping up bitcoins at the temporary low price. This ‘stabilising speculation’ will move the price back up again.

However, the fall in price may be seen as the bubble bursting, with even bigger falls ahead. In this case, people will rush to sell before it falls further, thereby pushing the price even lower. This destabilising speculation will amplify the fall in prices.

But even if the bubble does burst, people may believe that another bubble will then occur and, once they think the bottom has been reached, will thus start buying again and there will be a second speculative rise in the price.

The crash could be very short-lived. This happened with the second biggest cryptocurrency, Ethereum. On 21 June this year, the price at the beginning of the day was $360. It then began to fall during the say. Once its price reached $315, it then collapsed by 96% to $13 with massive selling, much of it automatic with computers programmed to sell when the price falls by more than a certain amount. But then, on the same day, it rebounded. Within minutes it had bounced back and was trading at $337 at the end of the day. It is now trading at around $450 – up from around $300 four weeks ago.

Whether the bubble in bitcoin has more to inflate, when it will burst, and when it will rebound and by how much, depends on people’s expectations. But what we are looking at here is people’s expectations of what other people are likely to do – in other words, of other people’s expectations, which in turn depend on their expectations of other people’s expectations. This situation is known as a Keynesian Beauty Contest (see the blog, A stock market beauty contest of the machines). Perhaps we need a crystal ball.

Articles
Is Bitcoin a bubble? Here’s what two bubble experts told us Trade Online, Timothy B. Lee (8/12/17)
Bitcoin and tulipmania have a lot more in common than you might think Business Insider, Seth Archer (8/12/17)
Bitcoin ends dramatic week with 20% slump followed by recovery The Guardian, Jill Treanor (8/12/17)
Putting a price on Bitcoin The Economist, Buttonwood’s notebook (8/12/17)
Is Bitcoin a Bubble Waiting to Pop? InvestorPlace, Matt McCall (8/12/17)
Bitcoin bubble follows classic pattern of investment mania Financial Times, John Authers (8/12/17)
The Bitcoin bubble – how we know it will burst The Conversation, Larisa Yarovaya and Brian Lucey (6/12/17)
Bitcoin isn’t a currency – and unless it becomes one it could be worthless The Conversation, Vili Lehdonvirta (6/12/17)
Op-ed: Bitcoin Is Not a Bubble; It’s in an S-Curve and It’s Just Getting Started Bitcoin Magazine, Brandon Green (8/12/17)
Bitcoin vs history’s biggest bubbles: They never end well CNN Money, Daniel Shane (8/12/17)
The 10 Most Ridiculous Price Bubbles In History Business Insider, Vincent Fernando and Anika Anand (11/10/10)
After bitcoin’s wild week, traders brace for futures launch Reuters, Saqib Iqbal Ahmed (10/12/17)

Bitcoin current market prices
Bitcoin live exchange prices and volumes ($) CryptoCompare

Questions

  1. To what extent does Bitcoin meet the functions of money?
  2. Why is bitcoin unsuitable for normal transactions?
  3. To what extent is bitcoin like gold as a means of holding wealth?
  4. How would you advise someone thinking of buying bitcoin today? Explain why.
  5. Does a rapid rise in the price of an asset always indicate a bubble? Explain
  6. To what extent is the current rise in the price of bitcoin similar to that of the tulip, Poseidon and Beanie Baby bubbles?
  7. If bitcoin is appreciating relative to the dollar and other currencies, does this mean that the price of goods and services valued in bitcoin are falling? Explain.
  8. Explain and comment on the following sentence from the first Conversation article: “Like any asset, Bitcoin has some fundamental value, even if only a hope value, or a value arising from scarcity.”
  9. How might the introduction of futures trading in bitcoin impact on its price and the volatility of price swings?
  10. Explain and assess the argument that the price trend of bitcoin is more likely to be an S curve rather than a roller coaster
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The geographical immobility of labour in England – a social problem

Where you live in Great Britain can have a profound effect on your earning potential. According to a report published by the Social Mobility Commission, there is a growing geographical divide, with more affluent areas getting relatively richer, while ‘many other parts of the country are being left behind economically and hollowed out socially’.

The Commission uses a Social Mobility Index to rank the 324 local authorities in England. The index is a measure of the social mobility prospects for people from disadvantaged backgrounds. It is ‘made up of 16 key performance indicators spanning each major life stage’.

The index shows that children from disadvantaged backgrounds have lower educational attainment, poorer initial jobs and poorer prospects for advancement in the labour market. Often they are stuck in low paid jobs with little chance of getting on the housing ladder and fewer chances of moving away from the area.

The problem is not simply one of a North-South divide or one of inner cities versus the suburbs. Many inner-city areas have been regenerated, with high incomes and high social and geographical mobility. Other inner-city areas remain deprived.

The worst performing areas are remote rural or coastal areas and former industrial areas, where industries have closed. As the author of the report states in the Guardian article linked below:

These areas have fewer specialist teachers, fewer good schools, fewer good jobs and worse transport links. … Many of these areas have suffered from a lack of regeneration: few high-paying industries are located there, and they often exhibit relatively limited job opportunities and clusters of low pay.

The problem often exists within areas, with some streets exhibiting growing affluence, where the residents have high levels of social mobility, while other streets have poor housing and considerable levels of poverty and deprivation. Average incomes for such areas thus mask this type of growing divide within areas. Indeed, some of the richest areas have worse outcomes for disadvantaged children than generally poorer areas.

There are various regional and local multiplier effects that worsen the situation. Where people from disadvantaged backgrounds are successful, they tend to move away from the deprived areas to more affluent ones, thereby boosting the local economy in such areas and providing no stimulus to the deprived areas. And so the divide grows.

Policies, according to the report, need to focus public investment, and incentives for private investment, in deprived areas. They should not focus simply on whole regions. You can read the specific policy recommendations in the articles below.

Articles
Social mobility is a stark postcode lottery. Too many in Britain are being left behind The Guardian, Alan Milburn (28/11/17)
State of the Nation – Sector Response FE News (28/11/17)
Social mobility: the worst places to grow up poor BBC News, Judith Burns and Adina Campbell (28/11/17)
How Britain’s richest regions offer worst prospects for poor young people Independent, May Bulman (28/11/17)
Small Towns Worst Places In Britain For Social Mobility, New ‘State Of The Nation’ Report Reveals Huffington Post, Paul Waugh (28/11/17)

Report
Social mobility in Great Britain: fifth state of the nation report Social Mobility Commission, News (28/11/17)
Fifth State of the Nation Report Social Mobility Commission, News (28/11/17)

Questions

  1. Explain how local multipliers operate.
  2. What is the relationship between social immobility as identified in the report and the elasticity of supply of labour in specific jobs?
  3. What is the link between geographical, occupational and social mobility?
  4. Explain why, apart from London, English cities are ‘punching below their weight on social mobility outcomes’.
  5. Go through each of the key policy recommendations of the report and consider the feasibility of introducing them.
  6. What policies could be adopted to retain good teachers in schools in deprived areas?
  7. To what extent might an increased provision of training ease the problem of social mobility?
  8. Investigate policies adopted in other European countries to tackle local deprivation. Are there lessons that can be learned by the UK government, devolved governments, local authorities or other agencies?
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A Budget warning on productivity and growth

In delivering his Budget on 22 November, Philip Hammond reported that the independent Office for Budget Responsibility had revised down its forecasts of growth in productivity and real GDP, and hence of earnings growth.

Today, median earnings are £23,000 per annum. This is £1500 less than the £24,500 that the median worker earned in 2008 in today’s prices. The OBR forecasts a growth in real household disposable income of just 0.35% per annum for the next four years.

With lower growth in earnings would come a lower growth in tax revenues. With his desire to cut the budget deficit and start eventually reducing government debt, this would give the government less scope for spending on infrastructure, training and other public-sector investment; less scope to support public services, such as health and education; less scope for increasing benefits and public-sector wages.

The normal measure of productivity, and the one used by the OBR, is the value of output produced per hour worked. This has hardly increased at all since the financial crisis of 2008. It now takes an average worker in the UK approximately five days to produce the same amount as it takes an average worker in Germany four days. Although other countries’ productivity growth has also slowed since the financial crisis, it has slowed more in the UK and from a lower base – and is now forecast to rebound less quickly.

For the past few years the OBR has been forecasting that productivity growth would return to the trend rate of just over 2% that the UK achieved prior to 2008. For example, the forecasts it made in June 2010 are shown by the grey line in the chart, which were based on the pre-crash trend rate of growth in productivity (click on chart to enlarge). And the forecasts it made in November 2016 are shown by the pale green line. Yet each year productivity has hardly changed at all. Today output per hour is less than 1% above its level in 2008.

Now the OBR believes that poorer productivity growth will persist. It is still forecasting an increase (the blue line in the chart) – but by 0.7 of a percentage point less than it was forecasting a year ago (the pale green line): click here for a PowerPoint of the chart.

We have assumed that productivity growth will pick up a little, but remain significantly lower than its pre-crisis trend rate throughout the next five years. On average, we have revised trend productivity growth down by 0.7 percentage points a year. It now rises from 0.9 per cent this year to 1.2 per cent in 2022. This reduces potential output in 2021-22 by 3.0 per cent. The ONS estimates that output per hour is currently 21 per cent below an extrapolation of its pre-crisis trend. By the beginning of 2023 we expect this to have risen to 27 per cent.

Why has there been such weak productivity growth?
Weak productivity growth has been caused by a mixture of factors.

Perhaps the most important is that investment as a percentage of GDP has been lower than before the financial crisis and lower than in other countries. Partly this has been caused by a lack of funding for investment as banks have sought to rebuild their capital and have cut down on riskier loans. Partly it has been caused by a lack of demand for investment, given sluggish rates of economic growth and the belief that austerity will continue.

And it is not just private investment. Public-sector investment in transport infrastructure, housing and education and training has been lower than in other countries. Indeed, the poor training record and low skill levels in the UK are main contributors to low productivity.

The fall in the pound since the Brexit vote has raised business costs and further dampened demand as incomes have been squeezed.

Another reason for low productivity growth has been that employers have responded to weak demand, not by laying off workers and thereby raising unemployment, but by retaining low-productivity workers on low wages. Another has been the survival of ‘zombie’ firms, which, by paying low wages and facing ultra-low interest rates, are able to survive competition from firms that do invest.

Why is weak productivity growth forecast to continue?
Looking forward, the nature of the Brexit deal will impact on confidence, investment, wages and growth. If the deal is bad for the UK, the OBR’s forecasts are likely to be too optimistic. As it is, uncertainty over the nature of the post-Brexit world is weighing heavily on investment as some businesses choose to wait before committing to new investment.

On the other hand, exports may rise faster as firms respond to the depreciation of the pound and this may stimulate investment, thereby boosting productivity.

Another factor is the effect of continuing tight Budgets. There was some easing of austerity in this Budget, as the Chancellor accepted a slower reduction in the deficit, but government spending will remain tight and this is likely to weigh on growth and investment and hence productivity.

But this may all be too gloomy. It is very difficult to forecast productivity growth, especially as it is hard to measure output in much of the service sector. It may be that the productivity growth forecasts will be revised up before too long. For example, the benefits from new technologies, such as AI, may flow through more quickly than anticipated. But they may flow through more slowly and the productivity forecasts may have to be revised down even further!

Articles
The OBR’s productivity “forecast” Financial Times, Kadhim Shubber
U.K. Faces Longest Fall in Living Standards on Record Bloomberg, Simon Kennedy and Thomas Penny (23/11/17)
Britain’s Productivity Pain Costs Hammond $120 Billion Bloomberg, Fergal O’Brien (22/11/17)
OBR slashes Britain’s growth forecast on sluggish productivity and miserly pay The Telegraph, Tim Wallace (22/11/17)
Budget 2017: Stagnant earnings forecast ‘astonishing’ BBC News (23/11/17)
Economists warn Budget measures to lift productivity fall short Financial Times, Gavin Jackson and Gill Plimmer (22/11/17)
Why the economic forecasts for Britain are so apocalyptic – and how much Brexit is to blame Independent, Ben Chu (24/11/17)
Growth holds steady as economists doubt OBR’s gloom The Telegraph, Tim Wallace (23/11/17)
Britain’s debt will not fall to 2008 levels until 2060s, IFS says in startling warning Independent, Lizzy Buchan (23/11/17)
Philip Hammond’s budget spots Britain’s problems but fails to fix them The Economist (22/11/17)
Debunking the UK’s productivity problem The Conversation, Paul Lewis (24/11/17)
Budget 2017: experts respond The Conversation (22/11/17)
Autumn Budget 2017 Forecasts Mean ‘Longest Ever Fall In Living Standards’, Says Resolution Foundation Huffington Post, Jack Sommers (23/11/17)
It May Just Sound Like A Statistic, But Productivity Growth Matters For All Of Us Huffington Post, Thomas Pope (24/11/17) (see also)
UK prospects for growth far weaker than first predicted, says OBR The Guardian, Angela Monaghan (22/11/17)
UK faces two decades of no earnings growth and more austerity, says IFS The Guardian, Phillip Inman (23/11/17)
Age of austerity isn’t over yet, says IFS budget analysis The Guardian, Larry Elliott (23/11/17)

Summary of Budget measures
Budget 2017: FT experts look at what it means for you Financial Times (24/11/17)

Official Documents
Autumn Budget 2017 HM Treasury (22/11/17)
Economic and fiscal outlook – November 2017 Office for Budget Responsibility (22/11/17)

IFS analysis
Autumn Budget 2017 Institute for Fiscal Studies (23/11/17)

Questions

  1. What measures of productivity are there other than output per hour? Why is output per hour normally the preferred measure of productivity?
  2. What factors determine output per hour?
  3. Why have forecasts of productivity growth rates been revised downwards?
  4. What are the implications of lower productivity growth for government finances?
  5. What could cause an increase in output per hour? Would there be any negative effects from these causes?
  6. What policies could the government pursue to increase productivity? How feasible are these policies? Explain.
  7. Would it matter if the government increased borrowing substantially to fund a large programme of public investment?
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What they want you to want

We are coming into the big spending season, with Black Friday, Cyber Monday, the run-up to Christmas and then the winter sales. So will we all be rational maximisers and weigh up the utility we expect to receive from items against the price we pay (plus any other cost, such as time spent searching/shopping)? Or will we use a set of heuristics which make life easier and that we have found to be useful in helping us choose – heuristics such as buying things we’ve liked before, or going for things on special offer?

The answer is that we do probably use a set of heuristics, at least for many items. And don’t the retailers and the marketing firms they employ know this!

They will use all sorts of tricks of the trade to persuade us to part with our money. These tricks are designed to nudge us (or push us), without us feeling manipulated or conned – at least until we’ve bought their product.

And the tricks are getting more sophisticated. They include special offers which are not as good as they seem, time-limited offers which stimulate us to buy quickly without carefully thinking about what we’re doing, cunning positioning of products in shops to encourage us to buy things we had not planned to buy, adverts which play to our idealised perceptions or the ‘good life’ or what we would like to achieve, and packaging or display which make the product seem better than it is.

Also we are increasingly faced with targeted advertising where our smart devices capture information about our spending habits and tastes through our previous online spending or our search behaviour. This is then fed to advertisers to tailor adverts specifically to us on our mobiles, tablets, laptops and even, soon, on our smart TVs.

We may have a general desire to maximise utility from our spending, but market failures, such as consumers having imperfect information about products and a present bias (see also) in decision making, make us easy targets for the advertising and marketing industry. They understand the heuristics we use and try to take maximum advantage of them.

Happy shopping!

Articles
How shops use tricks to get you spending The Conversation, Cathrine Jansson-Boyd (16/11/17)
ColourPop looks to Qubit for next-gen personalization guidance Retail Dive, Dan O’Shea (13/6/17)
Channel 4 to offer 100% ad targeting across All 4 platform, seeking partners for linear equivalent The Drum, Jessica Goodfellow (14/11/17)
How Google aims to bring TV advertising into the 21st century The Drum, Ronan Shields (19/10/17)
How to Use Heuristics to Your Marketing Advantage MarketingProfs, Cam Secore (12/11/15)

Questions

  1. Does the use of heuristics contradict the assumption that consumers behave rationally?
  2. Give some examples of heuristics that you yourself use.
  3. Other than those identified above and in the first article, what ‘tricks’ might companies play on you to persuade you to buy their products?
  4. Is advertising personally targeted to individual consumers desirable for them?
  5. Give some examples of present bias in people’s behaviour.
  6. What factors should a retailer take into account when deciding whether to make pre-Christmas discounts?
  7. Explain what is meant by ‘affect heuristic’ and how the advertising industry uses the concept in setting the background to or scenario of an advertisement.
  8. Have you ever been persuaded into buying something you didn’t want? Why were you persuaded?
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Scotland to introduce minimum price for alcohol

In 2012, the Scottish Parliament voted to introduce a minimum unit price for alcoholic drinks. The Scotch Whisky Association along with others appealed against the legislation, but on 15 November 2017 the UK Supreme Court ruled unanimously that the legislation does not breach European Union law. It is thus likely that, after consultation, a 50p minimum unit price will be introduced, making Scotland the first country in the world to introduce minimum pricing for alcohol.

As we saw in a previous blog, Alcohol minimum price, the aim is to prevent the sale of really cheap drinks in supermarkets and other outlets. For example, three-litre bottles of strong cider can be sold for as little as £3.59. Sometimes supermarkets offer multibuys which are heavily discounted. The idea of minimum pricing is to stop these practices without affecting ‘normal’ prices. For example, the legislation will not affect prices in pubs, which are already more than 50p per unit of alcohol.

The following table shows how much prices would rise for various types of drink when compared to current cheap supermarket prices. The biggest percentage effect is for cheap, strong cider and beer.

Strength Size Units of alcohol Current price New minimum price
Cheap strong cider 7.5% 3 litres 22.5 £3.50 £11.25
Cheap wine 13% 750ml 9.75 £3.99 £4.88
Cheap beer/lager (normal) 4% 4 × 440ml 7.04 £2.50 £3.52
Cheap beer/lager (strong) 8% 4 × 500ml 16 £3.50 £8.00
Cheap spirits 37.5% 70cl 26.25 £10.00 £13.13
Cheap strong spirits 50% 70cl 35 £12.00 £17.50

The hope is that by preventing the sale of really cheap drinks in supermarkets, people will no longer be encouraged to ‘pre-load’, so that when they go out for the evening they are already drunk. It would also help to reduce the number of alcoholics amongst the poor.

But this raises the question of equity. By targeting cheap drink, the policy is likely to hit the poor hardest. The question is whether this will simply lead to alcoholics on low incomes cutting down on other things, such as food and clothing for themselves and their children.

How successful, then, will such a policy be in cutting down drunkenness and the associated anti-social behaviour in many Scottish towns and cities, especially on Friday and Saturday nights? This will depend on the price elasticity of demand.

Videos and podcasts
Scotland first country to introduce minimum alcohol price Channel 4 News, Fatima Manji (15/11/17)
The story of how Scotland brought in minimum pricing on alcoh The Scotsman, Ross McCafferty (15/11/17)
Supreme Court rejects challenge against plans for minimum alcohol pricing in Scotland ITV News, Peter Smith (15/11/17)
Scotland getting the all-clear for minimum alcohol pricing as judges reject appeal Heart Scotland News, Connor Gillies (15/11/17)

Articles
Alcohol minimum unit pricing to go ahead Scottish Government: news (15/11/17)
Scottish alcohol price survey 2016 Alcohol Focus Scotland (2016)
Minimum pricing Alcohol Focus Scotland (2017)
Supreme Court backs Scottish minimum alcohol pricing BBC News (15/11/17)
Supreme Court backs Scottish minimum alcohol pricing plans Out-Law.com (15/11/17)
Go-ahead for minimum alcohol pricing British Medical Association (BMA), Jennifer Trueland (15/11/17)
Expert reaction to UK supreme court ruling that the Scottish government can set a minimum price for alcohol, rejecting a challenge by the Scotch Whisky Association Science Media Centre (15/11/17)
Scotland to become first country with minimum price for alcohol sales Independent, Alex Matthews-King (15/11/17)
Scotland leading the world over minimum alcohol price ITV News (15/11/17)
Campaigners urge minimum alcohol price in England after Scottish ruling The Guardian, Severin Carrell (15/11/17)
Scottish ‘booze cruises’ to England predicted as minimum pricing introduced The Telegraph, Olivia Rudgard (15/11/17)

Questions

  1. Draw a diagram to illustrate the effect of a minimum price per unit of alcohol on (a) cheap cider; (b) good quality wine.
  2. What would be the likely effects of a 50p per unit minimum price on the pub trade?
  3. How is the price elasticity of demand for alcoholic drinks relevant to determining the success of minimum pricing?
  4. What determines the price elasticity of demand for cheap alcoholic drinks?
  5. Compare the effects on alcohol consumption of imposing a minimum unit price of alcohol with raising the duty on alcoholic drinks. What are the revenue implications of the two policies for the government?
  6. What externalities are involved in the consumption of alcohol? How could a socially efficient price for alcohol be determined?
  7. Could alcohol consumption be described as a ‘de-merit good’? Explain.
  8. Other than high minimum prices and taxation, what other policies could be used to (a) tackle binge drinking; (b) tackle the problem of alcoholism?
  9. What will determine the number of people travelling from Scotland to England to buy cheaper alcoholic drinks?
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Bank Rate ‐ first rise for more than 10 years

On 2 November, the Bank of England raised Bank rate from 0.25% to 0.5% – the first rise since July 2007. But was now the right time to raise interest rates? Seven of the nine-person Monetary Policy Committee voted to do so; two voted to keep Bank Rate at 0.25%.

Raising the rate, on first sight, may seem a surprising decision as growth remains sluggish. Indeed, the two MPC members who voted against the rise argued that wage growth was too weak to justify the rise. Also, inflation is likely to fall as the effects of the Brexit-vote-induced depreciation of sterling on prices feeds through the economy. In other words, prices are likely to settle at the new higher levels but will not carry on rising – at least not at the same rate.

So why did the other seven members vote to raise Bank Rate. There are three main arguments:

Inflation, at 3%, is above the target of 2% and is likely to stay above the target if interest rates are not raised.
There is little spare capacity in the economy, with low unemployment. There is no shortage of aggregate demand relative to output.
With productivity growth being negligible and persistently below that before the financial crisis, aggregate demand, although growing slower than in the past, is growing excessively relative to the growth in aggregate supply.

As the Governor stated at the press conference:

In many respects, the decision today is straightforward: with inflation high, slack disappearing, and the economy growing at rates above its speed limit, inflation is unlikely to return to the 2% target without some increase in interest rates.

But, of course, the MPC’s forecasts may turn out to be incorrect. Many things are hard to predict. These include: the outcomes of the Brexit negotiations; consumer and business confidence and their effects on consumption and investment; levels of growth in other countries and their effects on UK exports; and the effects of the higher interest rates on saving and borrowing and hence on aggregate demand.

The Bank of England is well aware of these uncertainties. Although it plans two more rises in the coming months and then Bank Rate remaining at 1% for some time, this is based on its current assessment of the outlook for the economy. If circumstances change, the Bank will adjust the timing and total amount of future interest rate changes.

There are, however, dangers in the rise in interest rates. Household debt is at very high levels and, although the cost of servicing these debts is relatively low, even a rise in interest rates of just 0.25 percentage points can represent a large percentage increase. For example, a rise in a typical variable mortgage interest rate from 4.25% to 4.5% represents a 5.9% increase. Any resulting decline in consumer spending could dent business confidence and reduce investment.

Nevertheless, the Bank estimates that the effect of higher mortgage rates is likely to be small, given that some 60% of mortgages are at fixed rates. However, people need to refinance such rates every two or three years and may also worry about the rises to come promised by the Bank.

Articles
Bank of England deputy says interest rate rise means pain for households and more hikes could be in store Independent, Ben Chapman (3/11/17)
UK interest rates: Bank of England shrugs off Brexit nerves to launch first hike in over a decade Independent, Ben Chu (2/11/17)
Bank of England takes slow lane after first rate hike since Reuters, David Milliken, William Schomberg and Julian Satterthwaite (2/11/17)
First UK rate rise in a decade will be a slow burn Financial Times, Gemma Tetlow (2/11/17)
The Bank of England’s Rate Rise Could Spook Britain’s Economy Bloomberg, Fergal O’Brien and Brian Swint (3/11/17)
Bank of England hikes rates for the first time in a decade CNBC, Sam Meredith (2/11/17)
Interest rates rise in Britain for the first time in a decade The Economist (2/11/17)

Bank of England publications
Bank of England Inflation Report Press Conference, Opening Remarks Financial Times on YouTube, Mark Carney (2/11/17)
Bank of England Inflation Report Press Conference, Opening Remarks Bank of England, Mark Carney (2/11/17)
Inflation Report Press Conference (full) Bank of England on YouTube (2/11/17)
Inflation Report Bank of England (November 2017)
Monetary Policy Summary and minutes of the Monetary Policy Committee meeting ending on 1 November 2017 Bank of England (2/11/17)

Questions

  1. Why did the majority of MPC members feel that now was the right time to raise interest rates whereas a month ago was the wrong time?
  2. Why did the exchange rate fall when the announcement was made?
  3. How does a monetary policy of targeting the rate of inflation affect the balance between aggregate demand and aggregate supply?
  4. Can monetary policy affect potential output, or only actual output?
  5. If recent forecasts have downgraded productivity growth and hence long-term economic growth, does this support the argument for raising interest rates or does it suggest that monetary policy should be more expansionary?
  6. Why does the MPC effectively target inflation in the future (typically in 24 months’ time) rather than inflation today? Note that Mark Carney at the press conference said, “… it isn’t so much where inflation is now, but where it’s going that concerns us.”
  7. To what extent can the Bank of England’s monetary policy be described as ‘discretionary’?
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Do countries have the right tools to steer economies though turbulent times?

In three interesting articles, linked below, the authors consider the state of economies since the financial crisis of 2007–8 and whether governments have the right tools to tackle future economic shocks.

There have been some successes over the past 10 years, in particular keeping inflation close to central bank targets despite considerable shocks (see the Vox article). Also unemployment has fallen in most countries and to very low levels in some, including the UK.

But economic growth has generally remained well below the levels prior to the financial crisis, with low productivity growth being the main culprit. Indeed, many people have seen no growth at all in their real incomes over the past 10 years, with low unemployment being bought at the cost of a growth in zero-hour contracts and work in the gig economy. And what economic growth we have seen has been largely the result of taking up slack through unprecedentedly loose monetary policy.

Fiscal policy, except in the period directly following the financial crisis, has generally been tight as governments have sought to reduce their deficits and slow down the growth in their debt.

But what will happen if economies once more slow? Or, worse still, what will happen if there is another global recession? Do countries have the policies to tackle the problem this time round?

Quantitative easing could be used again, but many economists believe that it will have more limited scope if confined to the purchase of assets in the secondary market. Also, there is little scope for reducing interest rates, which, despite some modest rises in the USA, remain at close to zero in most developed countries.

One possibility is a combination of monetary and fiscal policy, where new money is used to finance government expenditure on infrastructure, such as road and rail, broadband, green energy, hospitals and schools and colleges. This would avoid the need for governments to borrow on open markets as the spending would be financed by new government securities purchased directly by the central bank.

An objection to such ‘people’s quantitative easing‘, as it has been dubbed, is that it would effectively end the independence of central banks. This independence has been credited by many with giving central banks credibility in controlling inflation. Would inflationary expectations rise with people’s quantitative easing and, with it, actual inflation? A lot would depend on the extent to which this QE could still be conducted within a framework of targeting inflation and whether people’s expectations of inflation could be managed jointly by the government and central bank.

Articles
How should recessions be fought when interest rates are low? The Economist. Free exchange (21/10/17)
The economy is failing. We need to think radically about how to fix it The Guardian, Liam Byrne (25/10/17)
Elusive inflation and the Great Recession Vox, David Miles, Ugo Panizza, Ricardo Reis, Ángel Ubide (25/10/17)

Videos
Economics since the crisis Vox on YouTube. Charles Goodhart (11/10/17)
Is the system broken? Vox on YouTube, Anat Admati (12/10/17)
Signs of a crisis Vox on YouTube, Christian Thimann (19/10/17)
Policy stances since 2007 Vox on YouTube, Paul Krugman (29/10/17)
Did policymakers get it right? Vox on YouTube, Paul Krugman (4/10/17)

Questions

  1. Why, during the next recession, will the “zero lower bound” (ZLB) on interest rates almost certainly bite again?
  2. Why would the scope for QE, as conducted up to now, be more limited in the future if a recession were to occur?
  3. Why have central banks appeared to have been so successful in keeping inflation close to target despite negative and positive demand- and supply-side shocks?
  4. Why are the pressures on government expenditure likely to increase in the coming years?
  5. How would a temporary price-level target help to tackle a recession when the economy next bumps into the ZLB? What would limit its success?
  6. Is it appropriate for central banks to stick to an inflation target in times when there is an adverse supply-side shock resulting in cost-push inflation?
  7. Why might monetary policy conducted in a framework of inflation targeting tend to lessen the impact of a fiscal stimulus?
  8. What are the arguments for and against relaxing central bank independence and pursuing a co-ordinated fiscal and monetary policy?
  9. What are the arguments for and against using helicopter money to boost private expenditure during a future recession where interest rates are already near the ZLB?
  10. What are the arguments for and against using ‘people’s QE’?
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Shaking the magic money tree

‘There is no magic money tree’, said Theresa May on several occasions during the 2017 election campaign. The statement was used to justify austerity policies and to criticise calls for increased government expenditure.

But, in one sense, money is indeed fruit of the magic money tree. There is no fixed stock of money, geared to the stock of gold or some other commodity. Money is created – as if by magic. And most of broad money is not created by government or the central bank. Rather it is created by banks as they use deposits as the basis for granting loans, which become money as they are redeposited in the banking system. Banks are doing this magic all the time – creating more and more money trees as the forest grows. As the Bank of England Quarterly Bulletin explains:

Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.

However, most of the country’s MPs are unaware of this process of money creation. As the linked Guardian article below states:

Responding to a survey commissioned by Positive Money just before the June election, 85% were unaware that new money was created every time a commercial bank extended a loan, while 70% thought that only the government had the power to create new money.

And yet the role of money and monetary policy is central to many debates in Parliament about the economy. It is disturbing to think that policy debates could be based on misunderstanding. Perhaps MPs would do well to study basic monetary economics! After all, credit creation is not a difficult topic.

Articles
How the actual magic money tree works The Guardian, Zoe Williams (29/10/17)
“Shocking ignorance” from MPs who don’t know where money actually comes from CITY A.M., Jasper Jolly (27/10/17)
Money creation in the modern economy Bank of England Quarterly Bulletin, Michael McLeay, Amar Radia and Ryland Thomas of the Bank’s Monetary Analysis Directorate (2014 Q1)
Politicians get lost in search of the fabled Magic Money Tree CITY A.M., Vince Cable (12/10/17)

Positive Money poll
Poll shows 85% of MPs don’t know where money comes from Positive Money, David Clarke (27/10/17)

Questions

  1. Do central banks create money and, if so, what form(s) does it take?
  2. Explain how credit creation works.
  3. What determines the amount of credit that banks create?
  4. How can the central bank influence the amount of credit created?
  5. Distinguish between narrow and broad money supply.
  6. What is the relationship between government spending and broad money supply (M4 in the UK)?
  7. Why is there no simple money multiplier whereby total broad money supply is a simple and predictable multiple of narrow money?
  8. What determines the relationship between money supply and real output?
  9. Does it matter what type of lending is financed by money creation?
  10. Comment on the statement: “The argument marshalled against social investment such as education, welfare and public services, that it is unaffordable because there is no magic money tree, is nonsensical.”
  11. Could quantitative easing be used to finance social investment? Would there be any dangers in the process?
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Brazil nut price rises – a case study of demand and supply

Food prices often rise or fall with good or bad harvests or because of a change in demand. A recent example is the price of brazil nuts, which by May this year had risen over 60% on European markets.

Part of the reason for the price rise has been on the demand side. Consumption of brazil nuts has increased as more people switch to healthier diets. This includes the purchase of the nuts themselves and as part of healthier snack foods. With supply being relatively inelastic, any rise in demand tends to have a relatively large effect on price.

A more acute reason is on the supply side. There has been a very poor harvest of brazil nuts. The nuts are grown largely in the Amazon basin which has been hit by drought linked to the El Niño effect. This, however, is only a temporary effect and future harvests should increase again as rainfall returns to normal. However, in the longer term, rainfall patterns may change with the effects of global warming.

The price rise in the UK has also be aggravated by the depreciation of the pound since the Brexit vote, which has fallen some 13% against the dollar since June 2016. A rise in the dollar price of brazil nuts has thus led to an even bigger rise in their sterling price.

Articles
Brazil nuts are rocketing in price – here’s why The Conversation, Iain Fraser (24/10/17)
Brazil nut prices soaring due to reduced harvests after droughts Independent, Zlata Rodianova (16/5/17)

Data
Index Mundi commodities Linked from Economics Network site
Commodity Markets World Bank (see Excel file of monthly prices)

Questions

  1. Explain the specific supply conditions that have affected the price of brazil nuts in 2017.
  2. Why did prices rise ahead of the change in supply?
  3. How has the size of the price rise been affected by the price elasticity of demand for brazil nuts?
  4. What determines the price elasticity of demand for brazil nuts?
  5. Find out what other food prices have risen or fallen a lot in recent months and explain why.
  6. How do real food prices (i.e. prices after correcting for inflation) compare today with 10 and 20 years ago? Explain why.
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Black Monday – 30 years on

Thirty years ago, on Monday 19 October 1987, stock markets around the world tumbled. The day has been dubbed ‘Black Monday’. Wall Street fell by 22% – its biggest ever one-day fall. The FTSE 100 fell by 10.8% and by a further 12.2% the next day.

The crash caught most people totally by surprise and has never been fully explained. The most likely cause was an excessive rise in the previous three years, when share prices more than doubled. This was combined with the lack of ‘circuit breakers’, which today would prevent excessive selling, and a ‘herd’ effect as people rushed to get out of shares before they fell any further, creating a massive wave of destabilising speculation.

Within a few weeks, share prices started rising again and within three years shares were once again trading at levels before Black Monday.

Looking back to the events of 30 years ago, the question many fund managers and others are asking is whether global stock markets are in for another dramatic downward correction. But there is no consensus of opinion about the answer.

Those predicting a downward correction – possibly dramatic – point to the fact that stock markets, apart from a dip in mid-2016, have experienced several years of growth, with yields now similar to those in 1987. Price/earnings ratios, at around 18, are high relative to historical averages.

What is more, the huge increases in money supply from quantitative easing, which helped to inflate share prices, are coming to an end. The USA ceased its programme three years ago and the ECB is considering winding down its programme.

Also, once a downward correction starts, destabilising speculation is likely to kick in, with people selling shares before they go any lower. This could be significantly aggravated by the rise of electronic markets with computerised high-frequency trading.

However, people predicting that there will be little or no downward correction, and even a continuing bull market, point to differences between now and 1987. First, the alternatives to shares look much less attractive than then. Bond yields and interest rates in banks (at close to zero), unlike in 1987, are much lower than the dividend yields on shares (at around 4%). Second, there are circuit breakers in stock markets that suspend dealing in cases of large falls.

But even if there is a downward correction, it will probably be relatively short-lived, with the upward trend in share prices continuing over the long term. If you look at the chart above, you can see this trend, but you can also see periods of falling share prices in the late 1990s/early 2000s and in the financial crisis of 2008–9. Looking back to 1987, it seems like a mere blip from the perspective of 30 years – but it certainly didn’t at the time.

Articles
Three decades since Black Monday – are markets on the verge of another tumble? The Telegraph, Lucy Burton (19/10/17)
Black Monday: 30 years on from the 1987 crash Citywire, Michelle McGagh (19/10/17)
30 Years Ago: Lessons From the 1987 Market Crash U.S.News, Debbie Carlson (12/10/17)
Black Monday: Can a 1987-style stock market crash happen again? USA Today, Adam Shell (19/10/17)
Black Monday anniversary: How the 2017 stock market compares with 1987 MarketWatch, William Watts (19/10/17)
30 years after Black Monday, could stock market crash again? MarketWatch, William Watts (19/10/17)
The Crash of ’87, From the Wall Street Players Who Lived It Bloomberg, Richard Dewey (19/10/17)

Questions

  1. Explain what are meant by ‘bull markets’ and ‘bear markets’.
  2. Share prices are determined by demand and supply. Identify the various demand- and supply-side factors that have led to the current long bull-market run.
  3. What caused the Black Monday crash in 1987?
  4. For what reasons may global stock markets soon (a) experience, (b) not experience a downward correction?
  5. Distinguish between stabilising speculation and destabilising speculation on stock markets.
  6. What determines when a downward correction on stock markets bottoms out?
  7. Explain how stock market circuit breakers work. Can they prevent a fundamental correction?
  8. Does the rise in computerised trading make a stock market crash more or less likely?
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