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Articles for the ‘Essentials of Economics 6e: Ch 08’ Category

Eurozone deflation risk

The eurozone is made up of 18 countries (19 in January) and, besides sharing a common currency, they also seem to be sharing the trait of weak economic performance. The key macroeconomic variables across the eurozone nations have all seemingly been moving in the wrong direction and this is causing a lot of concern for policy-makers.

Some of the biggest players in the eurozone have seen economic growth on the down-turn, unemployment rising and consumer and business confidence falling once again. Germany’s economic growth has been revised down and in Italy, unemployment rose to a record of 13.2% in September and around 25% of the workforce remains out of work in Spain and Greece. A significant consequence of the sluggish growth across this 18-nation bloc of countries is the growing risk of deflation.

Whilst low and stable inflation is a macroeconomic objective across nations, there is such a thing as inflation that is too low. When inflation approaches 0%, the spectre of deflation looms large (see the blog post Deflation danger). The problem of deflation is that when people expect prices to fall, they stop spending. As such, consumption falls and this puts downward pressure on aggregate demand. After all, if you think prices will be lower next week, then you are likely to wait until next week. This decision by consumers will cause aggregate demand to shift to the left, thus pushing national income down, creating higher unemployment. If this expectation continues, then so will the inward shifts in AD. This is the problem facing the eurozone. In November, the inflation rate fell to 0.3%. One of the key causes is falling energy prices – normally good news, but not if inflation is already too low.

Jonathan Loynes, Chief European Economist at Capital Economics said:

“[the inflation and jobless data] gives the ECB yet another nudge to take urgent further action to revive the recovery and tackle the threat of deflation…We now expect the headline inflation rate to drop below zero at least briefly over the next six months and there is a clear danger of a more prolonged bout of falling prices.”

Some may see the lower prices as a positive change, with less household income being needed to buy the same basket of goods. However, the key question will be whether such low prices are seen as a temporary change or an indication of a longer-term trend. The answer to the question will have a significant effect on business decisions about investment and on the next steps to be taken by the ECB. It also has big consequences for other countries, in particular the UK. The data over the coming months across a range of macroeconomic variables may tell us a lot about what is to come throughout 2015. The following articles consider the eurozone data.

Euro area annual inflation down to 0.3% EuroStat News Release (28/11/14)
Eurozone inflation weakens again, adding pressure on ECB Nasdaq, Brian Blackstone (28/11/14)
Eurozone inflation rate falls in October BBC News (28/11/14)
Eurozone recovery fears weigh on UK plc, says report Financial Times, Alison Smith (30/11/14)
€300bn Jean-Claude Juncker Eurozone kickstarter sounds too good to be true The Guardian, Larry Elliott (26/11/14)
Eurozone area may be in ‘persistent stagnation trap’ says OECD BBC News (25/11/14)
Euro area ‘major risk to world growth’: OECD CNBC, Katy Barnato (25/11/14)
OECD sees gradual world recovery, urges ECB to do more Reuters, Ingrid Melander (25/11/14)

Questions

  1. What is deflation and why is it such a concern?
  2. Illustrate the impact of falling consumer demand in an AD/AS diagram.
  3. What policies are available to the ECB to tackle the problem of deflation? How successful are they likely to be and which factors will determine this?
  4. To what extent is the economic stagnation in the Eurozone a cause for concern to countries such as the UK and US? Explain your answer.
  5. How effective would quantitative easing be in combating the problem of deflation?
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Oil prices continue to fall

Over the past three months oil prices have been falling. From the beginning of September to the end of November Brent Crude has fallen by 30.8%: from $101.2 to a four-year low of $70.0 per barrel (see chart below: click here for a PowerPoint). The fall in price has been the result of changes in demand and supply.

As the eurozone, Japan, South America and other parts of the world have struggled to recover, so the demand for oil has been depressed. But supply has continued to expand as the USA and Canada have increased shale oil production through fracking. As far as OPEC is concerned, rather than cutting production, it decided at a meeting on 27 November to maintain the current target of 30 million barrels a day.

The videos and articles linked below look at these demand and supply factors and what is likely to happen to oil prices over the coming months.

They also look at the winners and losers. Although falling prices are likely in general to benefit oil importing countries and harm oil exporting ones, it is not as simple as that. The lower prices could help boost recovery and that could help to halt the oil price fall and be of benefit to the oil exporting countries. But if prices stay low for long enough, this could lower inflation and even cause deflation (in the sense of falling prices) in many countries. This, in turn, could dampen demand (see the blog post, Deflation danger). This is a particular problem in Japan and the eurozone. Major oil importing developing countries, such as China and India, however, should see a boost to growth from the lower oil prices.

Some oil exporting countries will be harder hit than others. Russia, in particular, has been badly affected, especially as it is also suffering from the economic sanctions imposed by Western governments in response to the situation in Ukraine. The rouble has fallen by some 32% this year against the US dollar and nearly 23% in the past three months alone.

Then there are the environmental effects. Cheaper oil puts less pressure on companies and governments to invest in renewable sources of energy. And then there are the direct effects on the environment of fracking itself – something increasingly being debated in the UK as well as in the USA and Canada.

Videos
Oil price at four-year low as Opec meets BBC News, Mark Lobel (27/11/14)
Opec losing control of oil prices due to US fracking BBC News, Nigel Cassidy (4/12/13)
How the price of oil is set – video explainer The Telegraph, Oliver Duggan (28/11/14)
How Oil’s Price Plunge Impacts Wall Street Bloomberg TV, Richard Mallinson (28/11/14)
Oil Prices Plummet: The Impact on Russia’s Economy Bloomberg TV, Martin Lindstrom (28/11/14)

Articles
Oil prices plunge after Opec meeting BBC News (28/11/14)
Crude oil prices extend losses Financial Times, Dave Shellock (28/11/14)
Oil price plunges after Opec split keeps output steady The Guardian, Terry Macalister and Graeme Wearden (27/11/14)
Falling oil prices: Who are the winners and losers? BBC News, Tim Bowler (17/10/14)Hooray for cheap oil BBC News, Robert Peston (1/12/14)
Russian Recession Risk at Record as Oil Price Saps Economy Bloomberg, Andre Tartar and Anna Andrianova (28/11/14)
Rouble falls as oil price hits five-year low BBC News (1/12/14)

Data
Brent Spot Price US Energy Information Administration (select daily, weekly, monthly or annual: can be downloaded to Excel)
Spot exchange rate of Russian rouble against the dollar Bank of England

Questions

  1. Use a diagram to illustrate the effects of changes in the demand and supply of oil on oil prices.
  2. How does the price elasticity of demand and supply of oil affect the magnitude of these price changes?
  3. Explain whether (a) the demand for and (b) the supply of oil are likely to be relatively elastic or relatively inelastic? How are these elasticities likely to change over time?
  4. Distinguish between the spot price and forward prices of oil? If the three-month forward price is below the spot price, what are the implications of this?
  5. Analyse who gains and who loses from the recent price falls.
  6. What are the effects of a falling rouble on the Russian economy?
  7. What are likely to be the effects of further falls in oil prices on the eurozone economy?
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Deflation danger

The articles linked below look at the dangers of deflation and policies of central banks to counter it.

Deflation in economics has three meanings. The first is falling prices: i.e. negative inflation. The second, more traditional meaning, is a fall in real aggregate demand, resulting in lower output, higher unemployment and lower inflation – and quite possibly an actual fall in the price level. These first two definitions describe what is generally seen as an undesirable situation. The third is a slowing down in the growth of real aggregate demand, perhaps as a result of a deliberate act of fiscal and/or monetary policy. This third meaning could describe a desirable situation, where unsustainable growth is reduced and inflation is reduced from an above-target level.

Here we focus on the first definition. The first two articles look at the dangers of a fall in the price level. The chart below shows falling inflation, although not actually deflation, in China, France, Germany and the UK (click here for a PowerPoint). Several European countries, however, are experiencing actual deflation. These include: Greece, Spain, Hungary, Poland and Sweden. Inflation in the eurozone for 2014 is expected to be a mere 0.5%.

The most obvious danger of deflation (or expected deflation) is that people will delay spending on durable goods, such as cars, furniture and equipment, hoping to buy the items cheaper later. The result could be a fall in aggregate demand and a fall in output and employment.

For retailers, this is all spelling Christmas doom. Already the runup to the most crucial time of the year for shops is being characterised by a game of chicken. Shoppers are wondering how long they can leave their festive buying in the hope of late bargains.

Interest rates may be low, but for people with debts, this is being offset by the fact that inflation is no longer reducing the real value of that debt. For people with credit card debt, personal loans and most mortgages, the interest rate they pay is significantly above the rate of inflation. In other words, the real interest rate on their debt is still significantly positive. This may well discourage people from borrowing and spending, further dampening aggregate demand. And, with a Bank Rate of just 0.5%, there is virtually no scope for lowering the official interest rate further.

At least in the UK, economic growth is now positive – for the time being at any rate. The danger is becoming more serious, however, in many eurozone countries, which are already back in recession or close to being so. The ECB, despite its tentative steps to ease credit conditions, it moving closer to the day when it announces full-blown quantitative easing and buys sovereign bonds of eurozone countries. The Bank of Japan has already announced that it is stepping up it QE programme – a vital ingredient in getting Abenomics back on track and pulling Japan out of its latest recession.

In the USA, by contrast, there is little danger of deflation, as the US economy continues to grow strongly. The downside of this, has been a large rise in consumer debt (but not mortgages) – the ingredients of a possible future bubble and even a new financial crisis.

Forget what central bankers say: deflation is the real monster The Observer, Katie Allen (23/11/14)
Why Deflation Is Such A Big Worry For Europe NPR, Jim Zarroli (31/10/14)
Exclusive: China ready to cut rates again on fears of deflation – sources Reuters, Kevin Yao (23/11/14)
Central Banks in New Push to Prime Pump Wall Street Journal Jon Hilsenrath, Brian Blackstone and Lingling Wei (21/11/14)
Are Central Banks Panicking? Seeking Alpha, Leo Kolivakis (21/11/14)

Questions

  1. What are (a) the desirable and (b) the undesirable consequences of deflation? Does the answer depend on how deflation is defined?
  2. What is meant by a ‘deflationary gap’? In what sense is ‘deflationary’ being used in this term?
  3. Why have oil prices been falling? How desirable are these falls for the global economy?
  4. Is there an optimal rate of inflation? If so, how would this rate be determined?
  5. The chart shows that inflation in Japan is likely to have risen in 2014. This in large part is the result to a rise in the sales tax earlier this year. If there is no further rise in the sales tax, which there will probably not be if Mr Abe’s party wins the recently called election, what is likely to be the effect of the 2014 tax rise on inflation in 2015?
  6. If the Bank Rate is below the rate of inflation, why are people facing a positive real rate of interest? Does this apply equally to borrowers and savers?
  7. In what sense is there a cultural revolution at the Bank of England?
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Japan’s arrows missing their target

Since coming to office two years ago, Shinzo Abe’s government has been determined to revive the Japanese economy. The policy has involved ‘three arrows‘: expansionary fiscal policy, expansionary monetary policy and supply-side reforms. But figures just out show that the Japanese economy is back in recession. The economy shrank by 0.4% in quarter 3, having shrunk by 1.9% in quarter 2.

This has come as a huge disappointment for Mr Abe, who has staked his political reputation on escaping from deflation and achieving sustained economic growth. In response, he has called a general election to put a revised economic plan to the electorate.

The main cause of the reversal into recession has been an increase in the sales tax on all goods, which has dampened spending. The tax rise, planned by the previous government, was to help reduce the deficit and start tackling the huge public-sector debt, which, at over 230% of GDP, is by far the highest in the developed world. Another rise in sales tax is due in October 2015 – from 8% to 10%. Mr Abe hopes to cancel the rise and it is this that he may put to the electorate.

So what is the outlook for Japan? Will quarter 4 show economic growth, or will pessimism have set in? Will the Bank of Japan introduce even more quantitative easing, or will it wait for the latest increase in QE to take effect (see the blog post, All eased out: at least for the USA and UK)?

The following articles look at the implications of the latest news, both for Japan and globally, and at the options for the government and central bank.

Articles
Japanese economy falls into surprise recession Independent, Maria Tadeo (17/11/14)
Japan’s economy makes surprise fall into recession BBC News (17/11/14)
Coming to a crunch: Time is running out for Abenomics The Economist (20/11/14)
Japan’s economy: Delay the second consumption tax hike The Economist (17/11/14)
Defying Expectations, Japan’s Economy Falls Into Recession New York Times, Jonathan Soble (16/11/14)
Japan shocks as economy slips into recession CNBC, Li Anne Wong (17/11/14)
Japan Unexpectedly Enters Recession as Abe Weighs Tax: Economy Bloomberg, Keiko Ujikane and Toru Fujioka (17/11/14)
The world should be wary: Japan’s economic woes are contagious The Guardian, Larry Elliott (17/11/14)
Why is Japan heading to the polls? BBC News (18/11/14)

Previous news items on this site
A new economic road for Japan? (January 2013)
A J-curve for Japan? (May 2013)
Japan’s three arrows (June 2013)
Abenomics – one year on (December 2013)
Japan’s recovery (January 2014)
Japan’s CPI: An Update (May 2014)
All eased out: at least for the USA and UK (November 2014)

Data
Quarterly Estimates of GDP Japanese Cabinet Office
Japan and the IMF IMF Country Reports
Economic Outlook Annex Tables OECD

Questions

  1. Give details of the Japanese government’s three arrows.
  2. Discuss the pros and cons of the rise in the sales tax. Is it possible for the rise in the sales tax to increase the size of the public-sector deficit?
  3. What have been the effects of Japanese government policies on (a) prices of goods and services; (b) living standards; (c) asset prices?
  4. Who have been the gainers and losers of the policies?
  5. How is the Japanese situation likely to effect the value of the yen? How is this, in turn, likely to affect its trading partners? Could this set off a chain reaction?
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The G20 Summit

This weekend, Australia will play host to the world’s leaders, as the G20 Summit takes place. The focus of the G20 Summit will be on global growth and how it can be promoted. The Eurozone remains on the brink, but Germany did avoid for recession with positive (just) growth in the third quarter of this year. However, despite Australia’s insistence on returning the remit of the G20 to its original aims, in particular promoting growth, it is expected that many other items will also take up the G20’s agenda.

In February, the G20 Finance Ministers agreed various measures to boost global growth and it is expected that many of the policies discussed this weekend will build on these proposals. The agreement contained a list of new policies that had the aim of boosting economy growth of the economies by an extra 2% over a five year period. If this were to happen, the impact would be around £1.27 trillion. The agreed policies will be set out in more detail as part of the Brisbane Action Plan.

As well as a discussion of measures to promote global growth as a means of boosting jobs across the world, there will also be a focus on using these measures to prevent deflation from becoming a problem across Europe. Global tax avoidance by some of the major multinationals will also be discussed and leaders will be asked to agree on various measures. These include a common reporting standard; forcing multinationals to report their accounts country by country and principles about disclosing the beneficial ownership of companies. It it also expected that the tensions between Russia and Ukraine will draw attention from the world leaders. But, the main focus will be the economy. Australia’s Prime Minister, Tony Abbott said:

“Six years ago, the impacts of the global financial crisis reverberated throughout the world. While those crisis years are behind us, we still struggle with its legacy of debt and joblessness…The challenge for G20 leaders is clear – to lift growth, boost jobs and strengthen financial resilience. We need to encourage demand to ward off the deflation that threatens the major economies of Europe.”

Many people have protested about the lack of action on climate change, but perhaps this has been addressed to some extent by the deal between China and the USA on climate change and Barak Obama’s pledge to make a substantial contribution to the Green Climate Fund. This has caused some problems and perhaps embarrassment for the host nation, as Australia has remained adamant that despite the importance of climate change, this will not be on the agenda of the G20 Summit. Suggestions now, however, put climate change as the final communique.

Some people and organisations have criticised the G20 and questioned its relevance, so as well as discussing a variety of key issues, the agenda will more broadly be aiming to address this criticism. And of course, focus will also be on tensions between some of the key G20 leaders. The following articles consider the G20 Summit.

Articles
Ukraine and Russia take center stage as leaders gather for G20 Reuters, Matt Siegel (14/11/14)
The G20 Summit: World leaders gather in Brisbane BBC News (14/11/11)
G20: Obama to pledge $2.5bn to help poor countries on climate change The Guardian, Suzanne Goldenberg (14/11/14)
G20 in 20: All you need to know about Brisbane Leaders summit in 20 facts Independent, Mark Leftly (13/11/14)
G20 leaders to meet in Australia under pressure to prove group’s relevance The Guardian, Lenore Taylor (13/11/14)
Australia PM Abbott accuses Putin of bullying on eve of G20 Financial Times, George Parker and Jamie Smyth (14/11/14)
G20: David Cameron in Australia for world leaders’ summit BBC News (13/11/14)
G20 summit: Australian PM Tony Abbott tries to block climate talks – and risks his country becoming an international laughing stock Independent, Kathy Marks (13/11/14)
Incoming G20 leader Turkey says groups must be more inclusive Reuters, Jane Wardell (14/11/14)
Behind the motorcades and handshakes, what exactly is the G20 all about – and will it achieve ANYTHING? Mail Online, Sarah Michael (14/11/14)
Is the global economy headed for the rocks? BBC News, Robert Peston (17/11/14)

Official G20 site
G20 Priorities G20
Australia 2014 G20
News G20

Questions

  1. What is the purpose of the G20 and which countries are members of it? Should any others be included in this type of organisation?
  2. What are the key items on the agenda for the G20 Summit in Brisbane?
  3. One of the main objectives of this Summit is to discuss the policies that will be implemented to promote growth. What types of policies are likely to be important in promoting global economic growth?
  4. What types of policies are effective at addressing the problem of deflation?
  5. What impact will the tensions between Russia and Ukraine have on the progress of the G20?
  6. Why are multinationals able to engage in tax evasion? What policies could be implemented to prevent this and to what extent is global co-operation needed?
  7. Discuss possible reforms to the IMF and the G20′s role in promoting such reforms.
  8. Should the G20 be scrapped?
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Indebted to the bank? You are not alone!

The spectre of debt has awoken many of us in the night. Indebtedness is a key economic issue in the 2010s. Economists are devoting ever increasing amounts of research time trying to understand its impact on economic behaviour. This will not surprise you when you learn that the debt owed by the UK non-bank private sector to banks stood at £2.17 trillion at the end of September. This is the equivalent to 150% of annual GDP.

Chart 1 shows the stock of outstanding lending by Monetary Financial Institutions (banks and building societies) to the non-bank private sector bank since 1979. Back then the non-bank private sector had bank debt to the tune of around £70 billion or 10 per cent of GDP. Today’s figure is nearly 3000 per cent higher! Of this debt, around about 55 per cent is currently held by the household sector, 27 per cent by Other Financial Corporations (such as insurance companies and pension funds) and 18 per cent by private non-financial corporations. (Click here for a PowerPoint of the chart.)

Chart 2 shows the stocks of debt as percentages of annual GDP. We can infer from it that there are waves of growth in bank debt. Two notable periods are during the 1980s and again from the late 1990s up to the financial crisis of the late 2000s. During the early and mid 1990s the relative size of debt stocks tended to stabilise while in the early 2010s the actual stocks of debt, as well as relative to GDP, declined. A credit binge seems to be followed by a period of consolidation. (Click here for a PowerPoint of the chart.)

It is important that we understand the drivers of the growth of debt. The impact of debt on the balance sheets of the non-bank private sector and on banks themselves has implications for economic behaviour. In the early 2010s this has been to markedly slow the pace of growth through its impact on aggregate demand. Economic agents have, in general, looked to consolidate. There is no doubt that this partly reflects a precautionary motive. An important means by which debt and the balance sheets on which it is recorded affect behaviour is through a precautionary mechanism. This is difficult to accurately quantify because it represents a psychological influence on spending. Furthermore, it is affected by the prevailing circumstances of the time.

In looking to understand the factors that affect the growth of debt we may, as a result, learn more about the framework within which we may want banks and their customers to operate. Consequently, we may be in a better position to ensure sustainable longer-term growth and development. If there are cycles in credit it is important that we understand why they arise and whether, as some have suggested, they are an inherent part of the financialised economy in which we live. If they are, can we mitigate their potentially destabilising effects?

Articles
Retail shares facing nightmare before Christmas The Telegraph, John Ficenec (9/11/14)
Growing wealth inequality in the UK is a ticking timebomb The Guardian, Danny Dorling (15/10/14)
Richest 10% of Britons now control more than half the country’s wealth: Nation is only member of G7 where inequality between rich and poor has increased this century Mail Online, Mark Duell and Corey Charlton, (15/11/14)
Household debt is growing as families struggle Yorkshire Evening Post (31/10/14)
Consumer spending forecast to be the highest for four years The Telegraph, Ashley Armstrong (10/11/14)

Data
Statistical Interactive Database Bank of England
Quarterly National Accounts, Q2 2014 Dataset Office for National Statistics

Questions

  1. What is the non-bank private sector?
  2. What factors might affect the rate at which non-bank private sector debt stocks grow?
  3. How might we go about assessing whether the aggregate level of lending by financial institutions to the non-bank private sector is sustainable?
  4. How might we go about assessing whether the level of lending by individual financial institutions to the non-bank private sector is sustainable?
  5. What information is conveyed in the balance sheets of economic agents, such as households and private non-financial corporations
  6. What is meant by precautionary saving?
  7. Can precautionary saving occur when the economy is growing strongly?
  8. What are the mechanisms by which non-bank private sector debt could impact on economic behaviour?
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German confidence down again

In the Blog, A VW recession for the eurozone, as German growth revised down?, we discussed the pessimistic outlook for the eurozone, in part driven by the problems facing the engine of Europe: Germany. While the German government noted that the weak growth figures are due to external factors, it appears as though these external factors are now sending waves through the domestic economy.

Over the past 6 months, German confidence has fallen continuously and now stands at almost its lowest level in 2 years. Think tank data from a survey of 7000 firms in Germany fell from 104.7 to 103.2 for October – the weakest reading since December 2012. Confidence is always a key factor in the strength of an economy, as it affects consumers and businesses. Without consumer and business confidence, two key components of aggregate demand are weak and this downward pressure on total spending in the economy depresses economic growth. An economist from Ifo, the think-tank that produced this business climate index, said that firms felt ‘downbeat about both their current situation and the future.’

As confidence continues to decline in Germany, the economic situation is unlikely to improve. Unfortunately, it is something of a vicious circle in that without economic growth confidence won’t return and without confidence, economic growth won’t improve. The industrial sector is crucial to Germany and the data is concerning, according to Chief economist at Commerzbank, Joerg Kraemer:

The latest numbers from the industrial sector are very worrisome…The third quarter was probably worse than expected, the economy may have stagnated at best.

Numerous factors continue to depress the German economy and while negative growth is not expected, estimates for quarterly growth from July to September remain at around 0.3%. As Europe’s largest economy, such low growth rates will be of concern to the rest of the Eurozone and may also bring worry to other countries, such as the US and UK. With growing interdependence between nations, the success of countries such as Germany and Europe as a whole influences the economic situation abroad. Commentators will be looking for any signal that Germany is strengthening in the coming months and an improvement in business confidence will be essential for any prolonged recovery.

German business confidence falters again in October Wall Street Journal, Todd Buell (27/10/14)
German business morale weakens to lowest level in almost two years Reuters, Michelle Martin (27/10/14)
Zero growth best hope for Germany as confidence disappears The Telegraph, Szu Ping Chan (27/10/14)
German Ifo business confidence drops for sixth month Bloomberg, Stefan Riecher (27/10/14)
German business confidence plunges again as analysts urge fiscal stimulus International Business Times, Finnbarr Bermingham (27/10/14)
German business confidence falls again, Ifo says BBC News (27/10/14)
German business confidence tumbles The Guardian, Philip Inman (24/9/14)
The German way of stagnating BBC News, Robert Peston (11/11/14)

Questions

  1. Why is consumer and business confidence such an important element in explaining the state of an economy?
  2. Use an AD/AS diagram to illustrate the impact on national output of a decline business confidence. What are the other consequences for the macroeconomic objectives?
  3. What actions can a government take to boost confidence in an economy?
  4. If economic growth is weak and confidence is low, is there any point in cutting interest rates as a means of stimulating investment?
  5. If the eurozone did move back into recession, what could be the possible consequences for countries such as the UK and US?
  6. How useful are indices that measure business confidence?
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Does a shrinking banking sector balance sheet signal the end for credit cycles?

Following the financial crisis, all sectors of the economy continue to repair their balance sheets. As well as households, non-financial corporations and government, this is true of the banking sector. In part, the repairing and rebalancing of their balance sheets is being brought about by regulatory pressures. The objective is to make banks more resilient to shocks and less susceptible to financial distress.

The need for banks to repair and rebalance their balance sheets is significant because of their systemic importance to the modern-day economy. Financial institutions that are systemically important to national economies are know as SIFIs (systemically important financial institutions) while those of systemic importance to the global economy are know as G-SIFIs or G-SIBs (global systemically important banks). The increasing importance of financial institutions to economic activity is known as financialisation.

One way of measuring the degree of financialisation here in the UK is to consider the aggregate size of the balance sheet of resident UK banks and building societies (including foreign subsidiaries operating here). The chart shows that the balance sheet grew from £2.6 trillion in 1998 Q1 to £8.5 trillion in 2010 Q1. Another way of looking at this is to consider this growth relative to GDP. This reveals that the aggregate balance sheet of banks and building societies grew over this period from 3 times annual GDP to a staggering 5.6 times GDP. (Click here for a PowerPoint of the chart.)

But, now consider the aggregate banking balance sheet in the 2010s. This reveals a shrinking balance sheet. At the end of the second quarter of this year (2014 Q2) it had fallen back to £7.1 trillion or 4 times GDP. As a share of GDP, this was the smallest the aggregate balance sheet had been since 2005 Q1.

Does a shrinking balance sheet matter? This is where the analysis becomes tricky and open to debate. If the smaller size is consistent with a more stable financial system then undoubtedly that is a good thing. But, size is not that all matters. The composition of the balance sheet matters too. This requires an analysis of, among other things, the liquidity of assets (i.e. assets that can be readily turned in a given amount of cash), the reliability of the income flow from assets and the resources available to withstand periods of slow economic growth, including recessions, or periods of financial difficulty.

As we have identified before (see Financialisation: Banks and the economy after the crisis), the financial crisis could herald new norms for the banking system with important implications for the economy. If so, we may need to become accustomed to consistently lower flows of credit and not to the levels that we saw prior to the financial crisis of the late 2000s. However, an alternative view is that we are merely experiencing a pause before the next expansionary phase of the credit cycle. This is consistent with the financial instability hypothesis (see Keeping a Minsky-eye on credit) which argues that credit cycles are an integral part of modern financialised economies. Only time will tell which view will turn out to be right.

Articles
‘Cleaning up bank balance sheets is key’ Irish Examiner, John Walsh (10/10/14)
More action needed at European banks: Fitch Courier Mail, (17/10/14)
Bank lending to small businesses falls by £400m The Telegraph, Rebecca Burn-Callander (20/10/14)
Bank lending to SMEs falls by £400m SME insider, Lindsey Kennedy (21/10/14)
Record world debt could trigger new financial crisis, Geneva report warns The Guardian, Phillip Inman (29/10/14)
RBS shares jump as bank’s bad debts improve The Guardian, Jill Treanor (30/10/14)

Data
Statistical Interactive Database Bank of England

Questions

  1. Using examples, demonstrate your understanding of financialisation.
  2. Draw up a list of the alternative ways in which we might measure financialisation.
  3. What factors are likely to explain the recent reduction in the aggregate balance sheet of resident banks and building societies in the UK?
  4. How might we go about assessing whether the aggregate level of lending by financial institutions is sustainable?
  5. How might we go about assessing whether the level of lending by individual financial institutions is sustainable?
  6. How would reduced flows of credit be expected to impact on the economy both in the short term and in the longer term?
  7. Are credit cycles inevitable?
  8. Of what significance are credit cycles in explaining the business cycle?
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A VW recession for the eurozone, as German growth revised down?

Europe’s largest economy is Germany and the prospects and growth figures of this country are crucial to the growth of the Eurozone as a whole. The EU is a key trading partner for the UK and hence the growth data of Germany and in turn of the Eurozone is also essential in creating buoyant economic conditions within our borders. The bad news is that the economic growth forecast for Germany has been cut by the German government.

The German government had previously estimated that the growth rate for this year would be 1.8%, but the estimate has now been revised down to 1.2% and next year’s growth rate has also been revised downwards from 2% to 1.3%. Clearly the expectation is that low growth is set to continue.

Whenever there are changes in macroeconomic variables, a key question is always about the cause of such change, for example is inflation caused by demand-pull or cost-push factors. The German government has been quick to state that the lower growth rates are not due to internal factors, but have been affected by external factors, in particular the state of the global economy. As such, there are no plans to make significant changes to domestic policy, as the domestic economy remains in a strong position. The economy Minister said:

“The German economy finds itself in difficult external waters … Domestic economic forces remain intact, with the robust labour market forming the foundation … As soon as the international environment improves, the competitiveness of German companies will bear fruit and the German economy will return to a path of solid growth … [for this reason there is] no reason to abandon or change our economic or fiscal policy.”

The global picture remains relatively weak and while some economies, including the UK, have seen growth pick up and unemployment fall, there are concerns that the economic recovery is beginning to slow. With an increasingly interdependent world, the slowing down of one economy can have a significant impact on the growth rate of others. If country A begins to slow, demand for imports will fall and this means a fall in the demand for exports of country B. For countries that are dependent on exports, such as Germany and China, a fall in the demand for exports can mean a big decline in aggregate demand and in August, Germany saw a 5.8% drop in exports.

Adding to the gloom is data on inflation, suggesting that some other key economies have seen falls in the rate of inflation, including China. The possibility of a triple-dip recession for the Eurozone has now been suggested and with its largest economy beginning to struggle, this suggestion may become more real. The following articles consider the macroeconomic picture.

Articles
Germany cuts growth forecasts amid recession fears, as Ireland unveils budget The Guardian, Graeme Wearden (14/10/14)
As cracks in its economy widen, is Germany’s miracle about to fade? The Observer, Philip Oltermann (19/10/14)
Why the German economy is in a rut The Economist (21/10/14)
Germany’s flagging economy: Build some bridges and roads, Mrs Merkel The Economist (18/10/14)
Germany cuts 2014 growth forecast from 1.8% to 1.2% BBC News (14/10/14)
IMF to cut growth forecast for Germany – der Spiegel Reuters (5/10/14)
Fears of triple-dip eurozone recession, as Germany cuts growth forecast The Guardian, Phillip Inman (15/10/14)
Germany slashes its economic forecasts Financial Times, Stefan Wagstyl (14/10/14)
Merkel vows austerity even as growth projection cut Bloomberg, Brian Parkin, Rainer Buergin and Patrick Donahue (14/10/14)
Is Europe’s economic motor finally stalling? BBC News, Damien McGuinness (17/10/14)
Why Germany won’t fight deflation BBC News, Robert Peston (16/10/14)

Data
World Economic Outlook Database IMF (15/10/14)
World Economic Outlook IMF (October 2014)

Questions

  1. How do we measure economic growth and is it a good indicator of the state of an economy?
  2. What are the key external factors identified by the Germany government as the reasons behind the decline in economic growth?
  3. Angela Merkel has said that austerity measures will continue to balance the budget. Is this a sensible strategy given the revised growth figures?
  4. Why is low inflation in other economies further bad news for those countries that have seen a decline or a slowdown in their growth figures?
  5. Why is interdependence between nations both a good and a bad thing?
  6. Using AS and AD analysis, illustrate the reasons behind the decline German growth. Based on your analysis, what might be expected to happen to some of the other key macroeconomic variables in Germany and in other Eurozone economies?
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The service sector continues to drive the UK business cycle

The latest GDP numbers from the Office for National Statistics contained in Quarterly National Accounts, Q2 2014 show the economy’s output expanded by 0.9 per cent in the second quarter. This follows on the back of a 0.7 per cent increase in output in Q1 2014. The economy’s output is now thought to be 0.7 per cent above its Q1 2008 peak. Yet, the data show very different profiles for the four principal industrial sectors. The service sector appears to be ploughing ahead while the rest (production, construction and agriculture) lag behind.

Chart 1 shows quarterly economic growth since 1980s (click here for a PowerPoint of the chart). It illustrates nicely the inherent volatility of economies – one of the threshold concepts in economics. The average quarterly rate of growth since 1980 has been 0.5 per cent. On the face of it, a quarterly growth number of 0.9 per cent would appear very robust. Of course, this has to been set in the context of the 2008/9 recession. UK output peaked in Q1 2008 (£414.424 billion at 2011 prices). The revised data now show that there followed 5 quarters of declining output (previously, data suggested the duration of the recession was 6 quarters). During this period output shrank 6 per cent (GDP at 2011 prices had fallen by Q2 2009 to £389.388 billion ).

Chart 1 highlights two earlier downturns. First, there is the recession of the early 1980s. We can see the 5-quarter recession that commenced in Q1 1980. By the end of this recession output had shrunk by 4.5 per cent. Second, there is the recession of the early 1990s which commenced in Q3 1990. Again, this recession lasted five quarters. By the time the economy had come out of recession it had shrunk 2.2 per cent.

Consider now Chart 2 (click here for a PowerPoint of the chart). It allows us to analyse more recent events by tracking how industrial output has evolved since 2006. It suggests an unbalanced recovery. From it, we observe that in Q2 2014 service-sector output was 6.5 per cent higher than in Q1 2008. However, a very different picture emerges for the other principal industrial types. Output across the production industries remains 9.7 per cent lower, 9.2 per cent lower in agriculture and 8.9 per cent lower in the construction sector.

In short, the British economy continues to struggle to rebalance its industrial base. The business cycle remains heavily dependent on the service sector.

Articles
UK GDP revised up: what the economists say Guardian, Katie Allen (30/9/14)
UK economy grew 0.9% in second quarter, says ONS BBC News, Katie Allen (9/5/14)
UK GDP: Did the UK economy do well after all? Independent, Ben Chu (30/9/14)
UK economy grew 0.9% Herald, Ian McConnell (1/10/14)
Economy tracker: GDP BBC News (30/9/14).

Data
Quarterly National Accounts, Q2 2014 Dataset Office for National Statistics
Quarterly National Accounts, Q2 2014, Statistical Release Office for National Statistics

Questions

  1. What is the difference between nominal and real GDP? Which of these helps to track changes in economic output?
  2. Looking at Chart 1 above, summarise the key patterns in real GDP since the 1980s.
  3. What is a recession?
  4. What are some of the problems with the traditional definition of a recession?
  5. Can a recession occur if nominal GDP is actually rising? Explain your answer.
  6. What factors lead to economic growth being so variable?
  7. What factors might explain the very different patterns seen since the late 2000s in the volume of output of the four main industrial sectors?
  8. What different interpretations could there be of a ‘rebalancing’ of the UK economy?
  9. What other data might we look at to analyse whether the UK economy is ‘rebalancing’?.
  10. Produce a short briefing paper exploring the prospects for economic growth in the UK over the next 12 to 18 months.
  11. What is the difference between GVA and GDP?
  12. Explain the arguments for and against using GDP as a measure of a country’s economic well-being.
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