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Articles for the ‘Economics 9e: Ch 18’ Category

US interest rates: edging upwards

On 14 December, the US Federal Reserve announced that its 10-person Federal Open Market Committee (FOMC) had unanimously decided to raise the Fed’s benchmark interest rate by 25 basis points to a range of between 0.5% and 0.75%. This is the first rise since this time last year, which was the first rise for nearly 10 years.

The reasons for the rise are two-fold. The first is that the US economy continues to grow quite strongly, with unemployment edging downwards and confidence edging upwards. Although the rate of inflation is currently still below the 2% target, the FOMC expects inflation to rise to the target by 2018, even with the rate rise. As the Fed’s press release states:

Inflation is expected to rise to 2% over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further.

The second reason for the rate rise is the possible fiscal policy stance of the new Trump administration. If, as expected, the new president adopts an expansionary fiscal policy, with tax cuts and increased government spending on infrastructure projects, this will stimulate the economy and put upward pressure on inflation. It could also mean that the Fed will raise interest rates again more quickly. Indeed, the FOMC indicated that it expects three rate rises in 2017 rather than the two it predicted in September.

However, just how much and when the Fed will raise interest rates again is highly uncertain. Future monetary policy measures will only become more predictable when Trump’s policies and their likely effects become clearer.

Articles
US Federal Reserve raises interest rates and flags quicker pace of tightening in 2017 Independent, Ben Chu (14/12/16)
US Federal Reserve raises interest rates: what happens next? The Telegraph, Szu Ping Chan (15/12/16)
Holiday traditions: The Fed finally manages to lift rates in 2016 The Economist (14/12/16)
US raises key interest rate by 0.25% on strengthening economy BBC News (14/12/16)
Fed Raises Key Interest Rate, Citing Strengthening Economy The New York Times, Binyamin Appelbaum (14/12/16)
US dollar surges to 14-year high as Fed hints at three rate hikes in 2017 The Guardian, Martin Farrer and agencies (15/12/16)

Questions

  1. What determines the stance of US monetary policy?
  2. How does fiscal policy impact on market interest rates and monetary policy?
  3. What effect does a rise in interest rates have on exchange rates and the various parts of the balance of payments?
  4. What effect is a rise in US interest rates likely to have on other countries?
  5. What is meant by ‘forward guidance’ in the context of monetary policy? What are the benefits of providing forward guidance?
  6. What were the likely effects on the US stock market of the announcement by the FOMC?
  7. Following the FOMC announcement, two-year US Treasury bond yields rose to 1.231%, the highest since August 2009. Explain why.
  8. For what reason does the FOMC believe that the US economy is already expanding at roughly the maximum sustainable pace?
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Too tough or not tough enough? Developing Basel III banking rules

Under the auspices of the Bank for International Settlements (BIS), banks around the world are working their way towards implementing tougher capital requirements. These tougher rules, known as ‘Basel III’, are due to come fully into operation by 2019.

This third version of international banking rules was agreed after the financial crisis of 2008, when many banks were so undercapitalised that they could not withstand the dramatic decline in the value of many of their assets and a withdrawal of funds.

Basel III requires banks to have much more capital, especially common equity capital. The point about equity (shares) is that it’s a liability that does not have to be repaid. If people hold bank shares, the bank does not have to repay them and does not even have to pay any dividends. In other words, the money raised by issuing shares carries no obligation on the part of the bank and can thus provide a buffer against large-scale withdrawal of funds.

Under Basel III, banks have to maintain sufficiently large ‘capital-adequacy ratios’. As Essentials of Economics (7th edition) explains:

Capital adequacy is a measure of a bank’s capital relative to its assets, where the assets are weighted according to the degree of risk. The more risky the assets, the greater the amount of capital that will be required.

A measure of capital adequacy is given by the capital adequacy ratio (CAR). This is given by the following formula:

Common Equity Tier 1 (CET1) capital includes bank reserves (from retained profits) and ordinary share capital (equities), where dividends to shareholders vary with the amount of profit the bank makes… Additional Tier 1 (AT1) capital consists largely of preference shares. These pay a fixed dividend (like company bonds), but although preference shareholders have a prior claim over ordinary shareholders on the company’s (i.e. the bank’s) profits, dividends need not be paid in times of loss.

Tier 2 capital is subordinated debt with a maturity greater than 5 years. Subordinated debt holders only have a claim on a company (a bank) after the claims of all other bondholders have been met.

Risk-weighted assets are the total value of assets, where each type of asset is multiplied by a risk factor. Under the Basel III accord, cash and government bonds have a risk factor of zero and are thus not included. Interbank lending between the major banks has a risk factor of 0.2 and is thus included at only 20 per cent of its value; residential mortgages under 60% of the value of the property have a risk factor of 0.35; personal loans, credit-card debt and overdrafts have a risk factor of 1; loans to companies carry a risk factor of 0.2, 0.5, 1 or 1.5, depending on the credit rating of the company. Thus the greater the average risk factor of a bank’s assets, the greater will be the value of its risk weighted assets, and the lower will be its CAR.

Basel III gives minimum capital requirements that are higher than under its predecessor, Basel II. Thus, by 2019, banks must have a common equity capital to risk-weighted assets of at least 4.5% and a Tier 1 ratio of at least 6.0%. The overall CAR should be at least 8%. In addition, the phased introduction of a ‘capital conservation buffer’ from 2016 will raise the overall CAR to at least 10.5 per cent.

Over the past few years, banks have increased their capital cushions significantly and many have exceeded the Basel III requirements, even for 2019.

But the Basel Committee has been reconsidering the calculation of risk-weighted assets. Because of the complexity of banks’ asset structures, which tend to vary significantly from country to country, it is difficult to ensure that banks’ are meeting the Basel III requirements. Under proposed amendments to Basel III (which some commentators have dubbed ‘Basel IV’), banks would have to compare their own calculations with a ‘standardised’ model. Their own calculations of risk-based assets would then not be allowed to be lower than 60–90% (known as ‘the output floor’) of the standardised approach.

While, on the surface, this may seem reasonable, European banks have claimed that this would penalise them, as some of their assets are less risky than the equivalent assets in other countries. For example, Germany has argued that mortgage defaults have been rare and thus German mortgage debt should be given a lower weighting than US mortgage debt, where defaults have been more common. If all assets were assessed according to the output floor, several banks, especially in Europe, would be judged to be undercapitalised. As The Economist article states:

Analysts at Morgan Stanley estimate that global, non-American banks could see risk-weighted assets rise by an average of 18–30%, depending on the level of the output floor. Extra capital of €250bn–410bn could be needed, a tall order when earnings are thin and investors wary. The committee’s reviews of operational and market risks would add even more.

This question of an output floor was a sticking point at the Basel Committee meeting in Santiago, which ended on 30 November. Although some progress was made about agreeing to rules on risk weighting that could be applied globally, a final agreement will have to wait until the next meeting, in January – at the earliest.

Articles
Basel bust-up: A showdown looms over bank-capital rules The Economist (26/11/16)
Bank regulators fail to agree on new rules Manila Standard (2/12/16)
Bank chief Claudio Borio urges regulators to ‘stay strong’ Weekend Australian, Michael Bennet (29/11/16)
Final Basel III rules meet resistance from Europe The Straits Times (2/12/16)
This Is the Absolutely Worst Time to Weaken Global Bank Rules American Banker, Mayra Rodriguez Valladares (2/12/16)
New Basel banking rules’ impact on European economy Financial Times, Frédéric Oudéa (28/12/16)
Banks like RBS still look risky, but getting too tough could cause greater problems The Conversation, Alan Shipman (1/12/16)

BIS publications
International banking supervisory community meets to discuss the regulatory framework BIS Press Release (1/12/16)
Basel III: international regulatory framework for banks Bank for International Settlements
Basel III phase-in arrangements Basel Committee on Banking Supervision, BIS
Basel Committee on Banking Supervision reforms – Basel III, Summary Table Basel Committee on Banking Supervision, BIS

Questions

  1. Why do reserves in banks have a zero weighting in terms of risk-based assets?
  2. What items have a 100% weighting? Explain why.
  3. Examine the table, Basel III phase-in arrangements, and explain each of the terms.
  4. If banks are forced to operate with a higher capital adequacy ratio, what is this likely to do to bank lending? Explain. How are funding costs relevant to your answer?
  5. Explain each of the items in the Basel III capital-adequacy requirements shown in the chart above.
  6. What is the American case for imposing an output floor?
  7. What is the European banks’ case for using their own risk weighting?
  8. Why is it proposed that larger ‘systemically important banks’ (SIBs) should have an additional capital requirement?
  9. How does the balance of assets of American banks differ from that of European banks?
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The future of capitalism

Some commentators have seen the victory of Donald Trump and, prior to that, the Brexit vote as symptoms of a crisis in capitalism. Much of the campaigning in the US election, both by Donald Trump on the right and Bernie Sanders on the left focused on the plight of the poor. Whether the blame was put on immigration, big government, international organisations, the banks, cheap imports undercutting jobs or a lack of social protection, the message was clear: capitalism is failing to improve the lot of the majority. A small elite is getting significantly richer while the majority sees little or no gain in their living standards and a rise in uncertainty.

The articles below look at this crisis. They examine the causes, which they agree go back many years as capitalism has evolved. The financial crash of 2008 and the slow recovery since are symptomatic of the underlying changes in capitalism.

The Friedman article focuses on the slowing growth in technological advance and the problem of aging populations. What technological progress there is is not raising incomes generally, but is benefiting a few entrepreneurs and financiers. General rises in income may eventually come, but it may take decades before robotics, biotechnological advances, e-commerce and other breakthrough technologies filter through to higher incomes for everyone. In the meantime, increased competition through globalisation is depressing the incomes of the poor and economically immobile.

All the articles look at the rise of the rich. The difference with the past is that the people who are gaining the most are not doing so from production but from financial dealing or rental income; they have gained while the real economy has stagnated.

The gains to the rich have come from the rise in the value of assets, such as equities (shares) and property, and from the growth in rental incomes. Only a small fraction of finance is used to fund business investment; the majority is used for lending against existing assets, which then inflates their prices and makes their owners richer. In other words, the capitalist system is moving from driving growth in production to driving the inflation of asset prices and rental incomes.

The process whereby financial markets grow and in turn drive up asset prices is known as ‘financialisation’. Not only is the process moving away from funding productive investment and towards speculative activity, it is leading to a growth in ‘short-termism’. The rewards of senior managers often depend on the price of their companies’ shares. This leads to a focus on short-term profit and a neglect of long-term growth and profitability – to a neglect of investment in R&D and physical capital.

The process of financialisation has been driven by deregulation, financial innovation, the growth in international financial flows and, more recently, by quantitative easing and low interest rates. It has led to a growth in private debt which, in turn, creates more financial instability. The finance industry has become so profitable that even manufacturing companies are moving into the business of finance themselves – often finding it more profitable than their core business. As the Foroohar article states, “the biggest unexplored reason for long-term slower growth is that the financial system has stopped serving the real economy and now serves mainly itself.”

So will the election of Donald Trump, and pressure from populism in other countries too, mean that governments will focus more on production, job creation and poverty reduction? Will there be a movement towards fiscal policy to drive infrastructure spending? Will there be a reining in of loose monetary policy and easy credit?

Or will addressing the problem of financialisation and the crisis of capitalism result in the rich continuing to get richer at the expense of the poor, but this time through more conventional channels, such as increased production and monopoly profits and tax cuts for the rich? Trump supporters from among the poor hope the answer is no. Those who supported Bernie Sanders in the Democratic primaries think the answer will be yes and that the solution to over financialisation requires more, not less, regulation, a rise in minimum wages and fiscal policies aimed specifically at the poor.

Articles
Can Global Capitalism Be Saved? Project Syndicate, Alexander Friedman (11/11/16)
American Capitalism’s Great Crisis Time, Rana Foroohar (12/5/16)
The Corruption of Capitalism by Guy Standing review – work matters less than what you own The Guardian, Katrina Forrester (26/10/16)

Questions

  1. Do you agree that capitalism is in crisis? Explain.
  2. What is meant by financialisation? Why has it grown?
  3. Will the policies espoused by Donald Trump help to address the problems caused by financialisation?
  4. What alternative policies are there to those of Trump for addressing the crisis of capitalism?
  5. Explain Schumpeter’s analysis of creative destruction.
  6. What technological innovations that are currently taking place could eventually benefit the poor as well as the rich?
  7. What disincentives are there for companies investing in R&D and new equipment?
  8. What are the arguments for and against a substantial rise in the minimum wage?
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No exit for credit as annual credit flows to individuals remain at £58 billion

We have frequently looked at patterns in lending by financial institutions in our blogs given that many economies, like the UK, display cycles in credit. Central banks now pay considerable attention to the possibility of such cycles destabilising economies and causing financial distress to people and businesses. There is also increased interest here in the UK in bank lending data in light of Brexit. Patterns in credit flows may indicate whether it is affecting the lending choices of financial institutions and borrowing choices of people and businesses.

Data from the Bank of England’s Money and Credit – September 2016 statistical release shows net lending (lending net of repayments) by monetary financial institutions (MFIs) to individuals in September 2016 was £4.65 billion. This compares with £8.89 billion back in March 2016 which then was the highest monthly total since August 2007. However, the March figure was something of a spike in lending and this September’s figure is actually very slightly above the monthly average over the last 12 months, excluding March, of £4.5 billion. In other words, as yet, there is no discernible change in the pattern of credit flows post-Brexit.

Leaving aside the question of the economic impact of Brexit, we still need to consider what the credit data mean for financial stability and for our financial well-being. Chart 1 shows the annual flows of lending by banks and building societies since the mid 1990s. The chart evidences the cycles in secured lending and in consumer credit (unsecured lending) with its consequent implications for economic and financial-welling being.(Click here to download a PowerPoint of Chart 1.)

After the financial crisis, as Chart 1 shows, net lending to individuals collapsed. More recently, net lending has been on the rise both through secured lending and in consumer credit. The latest data show that annual flows have begun to plateau. Nonetheless, the total flow of credit in the 12 months to September of £58 billion compares with £33 billion and £41 billion in the 12 months to September 2014 and 2015 respectively. Having said this, in the 12 months to September 2007 the figure was £112 billion! £58 billion is currently equivalent to around about 3 per cent of GDP.

To more readily see the effect of the credit flows on debts stocks, Chart 2 shows the annual growth rate of net lending by MFIs. In essence, this mirrors the growth rate in the stocks of debt which is an important metric of financial well-being. The chart nicely captures the pick up in the growth of lending from around the start of 2013. What is particularly noticeable is the very strong rates of growth in net unsecured lending from MFIs. The growth of unsecured lending remains above 10 per cent, comparable with rates in the mid 2000s. (Click here to download a PowerPoint of Chart 2.)

The growth in debt stocks arising from lending continues to demonstrate the need for individuals to be mindful of their financial well-being. This caution is perhaps more important given the current economics uncertainties. The role of the Financial Policy Committee in the UK is to monitor the financial well-being of economic agents in the context of ensuring the resilience of the financial system. It therefore analyses the data on credit flows and debt stocks referred to in this blog along with other relevant metrics. At this moment its stance is not to apply any additional buffer – known as the Countercyclical Capital Buffer – on a financial institution’s exposures in the UK over and above internationally agreed standards. Regardless, the fact that it explicitly monitors financial well-being and risk shows just how significant the relationship between the financial system and economic outcomes is now regarded.

Articles
Higher inflation and rising debt threaten millions in UK The Guardian, Angela Monaghan (5/11/16)
Consumer spending has saved the economy in the past – but we cannot bet on it forever Sunday Express, Geff Ho (13/11/16)
Warning as household debts rise to top £1.5 trillion BBC News, Hannah Richardson (7/11/16)
Household debt hits record high – How to get back on track if you’re in the red Mirror, Graham Hiscott (7/12/16)

Data
Money and Credit – September 2016 Bank of England
Bankstats (Monetary and Financial Statistics) – Latest Tables Bank of England
Statistical Interactive Database Bank of England

Questions

  1. Explain the difference between secured debt and unsecured debt.
  2. What does it mean if individuals are financially distressed?
  3. How would we measure the financial well-being of individuals and households?
  4. What actions might individuals take it they are financially distressed? What might the economic consequences be?
  5. How might uncertainty, such as that following the UK vote to leave the European Union, affect spending and savings’ decisions by households?
  6. What measures can institutions, like the UK’s Financial Policy Committee, take to reduce the likelihood that flows of credit become too excessive?
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End of the era of liquidity traps?

The linked article below from The Economist looks at whether the election of Donald Trump, the effects of the Brexit vote and policies being pursued elsewhere in the world mark a new macroeconomic era. We may be about to witness rising inflation and the end of the era of tight fiscal policy and loose monetary policy. We might see a return of a more Keynesian approach to macreconomic policy.

According to the article, since the financial crisis of 2008, we have been witnessing economies stuck in a liquidity trap. In such cases, there is little scope for further reductions in interest rates. And increases in money supply, in the form of quantitative easing, tend to be held in idle balances, rather than being spent on goods and services. The idle balances take the form of increased bank reserves to rebuild their capital base and increased purchases of assets such as shares and property.

Even if people did believe that monetary policy would work to boost aggregate demand and result in higher inflation, then they would also believe that any such boost would be temporary as central banks would then have to tighten monetary policy to keep inflation within the target they had been set. This would limit spending increases, keeping the economy in the liquidity trap.

With a liquidity trap, fiscal policy is likely to be much more effective than monetary policy in boosting aggregate demand. However, its scope to pull an economy out of recession and create sustained higher growth depends on the extent to which governments, and markets, can tolerate higher budget deficits and growing debt. With governments seeking to claw down deficits and ultimately debt, this severely limits the potential for using fiscal policy.

With the election of Donald Trump, we might be entering a new era of fiscal policy. He has promised large-scale infrastructure spending and tax cuts. Although he has also promised to reduce the deficit, he is implying that this will only occur when the economy is growing more rapidly and hence tax revenues are increasing.

Is Donald Trump a Keynesian? Or are such promises merely part of campaigning – promises that will be watered down when he takes office in January? We shall have to wait and see whether we are about to enter a new era of macroeconomic policy – an era that has been increasingly advocated by international bodies, such as the IMF and the OECD (see the blog post, OECD goes public).

Article
Slumponomics: Trump and the political economy of liquidity traps The Economist (10/11/16)

Questions

  1. Explain what is meant by ‘the liquidity trap’.
  2. Why is monetary policy relatively ineffective in a liquidity trap? Use a diagram to support your argument.
  3. Why is fiscal policy (in the absence of public-sector deficit targets) relatively effective in a liquidity trap? Again, use a diagram to support your argument.
  4. Examine how the Japanese government attempted to escape the liquidity trap? (Search this site for ‘Abenomics’.)
  5. In what ways may the depreciation of the pound since the Brexit vote help the UK to escape the liquidity trap?
  6. Could a different form of quantitative easing, known as ‘helicopter money’, whereby government or private spending is financed directly by new money, allow countries to escape the liquidity trap? (Search this site for ‘helicopter money’.)
  7. Why may a political upheaval be necessary for a country to escape the liquidity trap?
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Relaxing the inflation target

The Bank of England’s monetary policy is aimed at achieving an inflation rate of 2% CPI inflation ‘within a reasonable time period’, typically within 24 months. But speaking in Nottingham in one of the ‘Future Forum‘ events on 14 October, the Bank’s Governor, Mark Carney, said that the Bank would be willing to accept inflation above the target in order to protect growth in the economy.

“We’re willing to tolerate a bit of an overshoot in inflation over the course of the next few years in order to avoid rising unemployment, to cushion the blow and make sure the economy can adjust as well as possible.”

But why should the Bank be willing to relax its target – a target set by the government? In practice, a temporary rise above 2% can still be consistent with the target if inflation is predicted to return to 2% within ‘a reasonable time period’.

But if even if the forecast rate of inflation were above 2% in two years’ time, there would still be some logic in the Bank not tightening monetary policy – by raising Bank Rate or ending, or even reversing, quantitative easing. This would be the case when there was, or forecast to be, stagflation, whether actual or as a result of monetary policy.

The aim of an inflation target of 2% is to help create a growth in aggregate demand consistent with the economy operating with a zero output gap: i.e. with no excess or deficient demand. But when inflation is caused by rising costs, such as that caused by a depreciation in the exchange rate, inflation could still rise even though the output gap were negative.

A rise in interest rates in these circumstances could cause the negative output gap to widen. The economy could slip into stagflation: rising prices and falling output. Hopefully, if the exchange rate stopped falling, inflation would fall back once the effects of the lower exchange rate had fed through. But that might take longer than 24 months or a ‘reasonable period of time’.

So even if not raising interest rates in a situation of stagflation where the inflation rate is forecast to be above 2% in 24 months’ time is not in the ‘letter’ of the policy, it is within the ‘spirit’.

But what of exchange rates? Mark Carney also said that “Our job is not to target the exchange rate, our job is to target inflation. But that doesn’t mean we’re indifferent to the level of sterling. It does matter, ultimately, for inflation and over the course of two to three years out. So it matters to the conduct of monetary policy.”

But not tightening monetary policy if inflation is forecast to go above 2% could cause the exchange rate to fall further. It seems as if trying to arrest the fall in sterling and prevent a fall into recession are conflicting aims when the policy instrument for both is the rate of interest.

Articles
BoE’s Carney says not indifferent to sterling level, boosts pound Reuters, Andy Bruce and Peter Hobson (14/10/16)
Bank governor Mark Carney says inflation will rise BBC News, Kamal Ahmed (14/10/16)
Stagflation Risk May Mean Carney Has Little Love for Marmite Bloomberg, Simon Kennedy (14/10/16)
Bank can ‘let inflation go a bit’ to protect economy from Brexit, says Carney – but sterling will be a factor for interest rates This is Money, Adrian Lowery (14/10/16)
UK gilt yields soar on ‘hard Brexit’ and inflation fears Financial Times, Michael Mackenzie and Mehreen Khan (14/10/16)
Brexit latest: Life will ‘get difficult’ for the poor due to inflation says Mark Carney Independent, Ben Chu (14/10/16)
Prices to continue rising, warns Bank of England governor The Guardian, Katie Allen (14/10/16)

Bank of England
Monetary Policy Bank of England
Monetary Policy Framework Bank of England
How does monetary policy work? Bank of England
Future Forum 2016 Bank of England

Questions

  1. Explain the difference between cost-push and demand-pull inflation.
  2. If inflation rises as a result of rising costs, what can we say about the rate of increase in these costs? Is it likely that cost-push inflation would persist beyond the effects of a supply-side shock working through the economy?
  3. Can interest rates be used to control both inflation and the exchange rate? Explain why or why not.
  4. What is the possible role of fiscal policy in the current situation of a falling exchange rate and rising inflation?
  5. Why does the Bank of England target the rate of inflation in 24 months’ time and not the rate today? (After all, the Governor has to write a letter to the Chancellor explaining why inflation in any month is more than 1 percentage point above or below the target of 2%.)
  6. What is meant by a zero output gap? Is this the same as a situation of (a) full employment, (b) operating at full capacity? Explain.
  7. Why have UK gilt yields soared in the light of a possible ‘hard Brexit’, a falling exchange rate and rising inflation?
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Don’t bank on Italy’s economy

The Brexit vote has caused shockwaves throughout European economies. But there is a potentially larger economic and political problem facing the EU and the eurozone more specifically. And that is the state of the Italian banking system and the Italian economy.

Italy is the third largest economy in the eurozone after Germany and France. Any serious economic weaknesses could have profound consequences for the rest of the eurozone and beyond.

At 135% of GDP, Italy’s public-sector debt is one the highest in the world; its banks are undercapitalised with a high proportion of bad debt; and it is still struggling to recover from the crisis of 2008–9. The Economist article elaborates:

The adult employment rate is lower than in any EU country bar Greece. The economy has been moribund for years, suffocated by over-regulation and feeble productivity. Amid stagnation and deflation, Italy’s banks are in deep trouble, burdened by some €360 billion of souring loans, the equivalent of a fifth of the country’s GDP. Collectively they have provisioned for only 45% of that amount. At best, Italy’s weak banks will throttle the country’s growth; at worst, some will go bust.

Since 2007, the economy has shrunk by 10%. And potential output has fallen too, as firms have closed. Unemployment is over 11%, with youth unemployment around 40%.

Things seem to be coming to a head. As confidence in the Italian banking system plummets, the Italian government would like to bail out the banks to try to restore confidence and encourage deposits and lending. But under new eurozone rules designed to protect taxpayers, it requires that the first line of support should be from bondholders. Such support is known as a ‘bail-in’.

If bondholders were large institutional investors, this might not be such a problem, but a significant proportion of bank bonds in Italy are held by small investors, encouraged to do so by tax relief. Bailing in the banks by requiring bondholders to bear significant losses in the value of their bonds could undermine the savings of many Italians and cause them severe hardship, especially those who had saved for their retirement.

So what is the solution? Italian banks need recapitalising to restore confidence and prevent a more serious crisis. However, there is limited scope for bailing in, unless small investors can be protected. And eurozone rules provide little scope for government funding for the banks. These rules should be relaxed under extreme circumstances. At the same time, policy needs to focus on making Italian banking more efficient.

Meanwhile, the IMF is forecasting that Italian economic growth will be less than 1% this year and little better in 2017. Part of the problem, claims the IMF, is the Brexit vote. This has heightened financial market volatility and increasead the risks for Italy with its fragile banking system. But the problems of the Italian economy run deeper and will require various supply-side policies to tackle low productivity, corruption, public-sector inefficiency and a financial system not fit for purpose. What the mix of these policies should be – whether market based or interventionist – is not just a question of effectiveness, but of political viability and democratic support.

Articles
The Italian Job The Economist (9/7/16)
IMF warns Italy of two-decade-long recessionThe Guardian, Larry Elliott (11/7/16)
Italy economy: IMF says country has ‘two lost decades’ of growth BBC News (12/7/16)
What’s the problem with Italian banks? BBC News, Andrew Walker (10/7/16)
Why Italy’s banking crisis will shake the eurozone to its core The Telegraph, Tim Wallace Szu Ping Chan (16/8/16)
If You Thought Brexit Was Bad Wait Until The Italian Banks All Go Bust Forbes, Tim Worstall (17/7/16)
In the euro zone’s latest crisis, Italy is torn between saving the banks or saving its people Quartz, Cassie Werber (13/7/16)
Why Italy could be the next European country to face an economic crisis Vox, Timothy B. Lee (8/7/16)
Forget Brexit, Quitaly is Europe’s next worry The Guardian, Larry Elliott (26/7/16)

Report
Italy IMF Country Report No. 16/222 (July 2016)

Data
Economic Outlook OECD (June 2016) (select ‘By country’ from the left-hand panel and then choose ‘Italy’ from the pull-down menu and choose appropriate time series)

Questions

  1. Can changes in aggregate demand have supply-side consequences? Explain.
  2. Explain why there may be a downward spiral of asset sales by banks.
  3. How might the principle of bail-ins for undercapitalised Italian banks be pursued without being at the expense of the small saver?
  4. What lessons are there from Japan’s ‘three arrows’ for Italy? Does being in the eurozone constrain Italy’s ability to adopt any or all of these three categories of policy?
  5. Why may the Brexit vote have more serious consequences for Italy than many other European economies?
  6. Find out what reforms have already been adopted or are being pursued by the Italian government. How successful are they likely to be in increasing Italian growth and productivity?
  7. What external factors are currently (a) favourable, (b) unfavourable to improving Italian growth and productivity?
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Are households ravenous for credit?

In April we asked how sustainable is the UK’s appetite for credit? Data in the latest Bank of England’s Money and Credit publication suggest that such concerns are likely grow. It shows net lending (lending net of repayments) by monetary financial institutions (MFIs) to individuals in March 2016 was £9.3 billion, the highest monthly total since August 2007. This took net borrowing over the previous 12 months to £58.6 billion, the highest 12-month figure since September 2008.

The latest credit data raise fears about the impact on the financial well-being of individuals. The financial well-being of people, companies, banks and governments can have dramatic effects on economic activity. These were demonstrated vividly in the late 2000s when a downturn resulted from attempts by economic agents to improve their financial well-being. Retrenchment led to recession. Given the understandable concerns about financial distress we revisit our April blog.

Chart 1 shows the annual flow of lending extended to individuals, net of repayments. (Click here to download a PowerPoint of Chart 1.) The chart provides evidence of cycles both in secured lending and in consumer credit (unsecured lending).

The growth in net lending during the 2000s was stark as was the subsequent squeeze on lending that followed. During 2004, for example, annual net flows of lending from MFIs to individuals exceeded £130 billion, the equivalent of close on 10.5 per cent of annual GDP. Secured lending was buoyed by strong house price growth with UK house price inflation rising above 14 per cent. Nonetheless, consumer credit was very strong too equivalent to 1.8 per cent of GDP.

Net lending collapsed following the financial crisis. In the 12 months to March 2011 the flow of net lending amounted to just £3.56 billion, a mere 0.2 per cent of annual GDP. Furthermore, net consumer credit was now negative. In other words, repayments were exceeding new sums being extended by MFIs.

Clearly, as Chart 1 shows, net lending to individuals is again on the rise. This partly reflects a rebound in sections of the UK housing market. Net secured lending in March was £7.435 billion, the highest monthly figure since November 2007. Over the past 12 months net secured lending has amounted to £42.1 billion, the highest 12-month figure since October 2008.

Yet the growth of unsecured credit has been even more spectacular. In March net consumer credit was £1.88 billion (excluding debt extended by the Student Loans Company). This is the highest month figure since March 2005. It has taken the amount of net consumer credit extended to individuals over the past 12 months to £16.435 billion, the highest figure since December 2005.

Chart 2 shows the annual growth rate of both forms of net lending by MFIs. In essence, this mirrors the growth rate in the stocks of debt – though changes in debt stocks can also be affected by the writing off of debts. The chart captures the very strong rates of growth in net unsecured lending from MFIs. We are now witnessing the strongest annual rate of growth in consumer credit since November 2005. (Click here to download a PowerPoint of the chart.)

The growth in household borrowing, especially that in consumer credit, evidences the need for individuals to be mindful of their financial well-being. Given that these patterns are now becoming well-established you can expect to see considerable comment in the months ahead about our appetite for credit. Can such an appetite for borrowing be sustained without triggering a further balance sheet recession as experienced at the end of the 2000s?

Articles
Consumer credit rises at fastest pace for 11 years The Guardian, Hilary Osborne (29/4/16)
Debt bubble fears increase as consumer credit soars to 11-year high The Telegraph, Szu Ping Chan (29/4/16)
Fears of households over-stretching on borrowing as consumer credit grows The Scotsman, (29/4/16)
History repeating? Fears of another financial crisis as borrowing reaches 11-year high Sunday Express, Lana Clements (29/4/16)
The chart that shows we put more on our credit cards in March than in any month in 11 years Independent, Ben Chu (1/4/16)
Britain’s free market economy isn’t working The Guardian (13/1/16)

Data
Money and Credit – March 2016 Bank of England
Bankstats (Monetary and Financial Statistics) – Latest Tables Bank of England
Statistical Interactive Database Bank of England

Questions

  1. What does it mean if individuals are financially distressed?
  2. How would we measure the financial well-being of individuals and households?
  3. What actions might individuals take it they are financially distressed? What might the economic consequences be?
  4. How might uncertainty affect spending and saving by households?
  5. What measures can policymakers take to reduce the likelihood that flows of credit become too excessive?
  6. What is meant by a balance sheet recession?
  7. Explain the difference between secured debt and unsecured debt.
  8. Should we be more concerned about the growth of consumer credit than secured debt?
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A flawed model of monetary policy

In a recent post, Global Warning, we looked at concerns about the global economy. One of these was about the ineffectiveness of monetary policy to stimulate aggregate demand and to restore growth rates. Despite the use of unconventional monetary policies, such as quantitative easing and negative interest rates, and despite the fact that these policies have become the new convention, they have failed to do enough to bring sustained recovery.

The two articles below argue that the failure has been due to a flawed model of monetary policy: one that takes too little account of the behaviour of banks and the drivers of consumption and of physical investment. Negative interest rates on banks’ holdings of reserves in central banks are hardly likely to push down lending rates to businesses sufficiently to stimulate investment in new plant and machinery if firms already have overcapacity. And consumers are unlikely to borrow more for consumption if their wages are barely rising and they already have debts that they fear will be difficulty to pay off.

As Joseph Stiglitz points out:

As real interest rates have fallen, business investment has stagnated. According to the OECD, the percentage of GDP invested in a category that is mostly plant and equipment has fallen in both Europe and the US in recent years. (In the US, it fell from 8.4% in 2000 to 6.8% in 2014; in the EU, it fell from 7.5% to 5.7% over the same period.) Other data provide a similar picture.

And the unwillingness of many firms and individuals to borrow is matched by banks’ caution about lending in an uncertain economic environment. Many are more concerned about building their capital and liquidity ratios to protect themselves. In these circumstances, negative interest rates have little effect on stimulating bank lending and, by hurting their balance sheets through lower earnings on the money markets, may even encourage them to lend less

What central banks should be doing, argue both Stiglitz and Elliott, is finding ways of directly stimulating consumption and investment. Perhaps this will involve central banks “focusing on the flow of credit, which means restoring and maintaining local banks’ ability and willingness to lend to SMEs.” Perhaps it will mean using helicopter money, as we examined in the previous blog. As Larry Elliott points out:

The fact that economists at Deutsche Bank published a helpful cut-out-and-keep guide to helicopter money last week is a straw in the wind.

As the Deutsche research makes clear, the most basic variant of helicopter money involves a central bank creating money so that it can be handed to the finance ministry to spend on tax cuts or higher public spending. There are two differences with QE. The cash goes directly to firms and individuals rather than being channelled through banks, and there is no intention of the central bank ever getting it back.

So if the model of monetary policy is indeed flawed, prepare for more unconventional measures

Articles
What’s Wrong With Negative Rates?, Project Syndicate, Joseph Stiglitz (13/4/16)
The bad smell hovering over the global economy The Guardian, Larry Elliott (17/4/16)

Questions

  1. What arguments does Stiglitz use to support his claim that the model of monetary policy currently being used is flawed?
  2. In what ways has monetary policy hurt older people and what has been the effect on their spending and on aggregate demand in general?
  3. Why has monetary policy encouraged investors to shift their portfolios toward riskier assets?
  4. Examine the argument that ultra-low interest rates may result in a rise in unemployment in the long term by affecting the relative prices of capital and labour.
  5. What forms might helicopter money take?
  6. Would the use of helicopter money necessarily result in an increase in aggregate demand? What would determine the size of any such increase?
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More interest in the interesting case of UK interest rates

In a recent blog Accelerating interest in the interesting case of UK interest rates we compared the level of the official Bank Rate, which has now been at 0.5 per cent for over seven years, with a representative unsecured borrowing rate. In doing so, we found some evidence that credit conditions might be easing following the credit market disturbance of the late 2000s. Here we take the opportunity not only to review that data again one month on, but also to see whether a similar picture is true for the mortgage market.

Theories of the financial accelerator argue that the macroeconomic environment can affect commercial banks’ lending practices. One way in which this can operate is through the difference between banks’ lending rates and the official Bank Rate. We can think of such interest-rate differentials – or spreads – as a credit premium. The size of the premium may be thought to reflect lenders’ perceived risk of default by borrowers. It is argued by some economists that interest-rate differentials will fall when the economy is doing well and increase when the economy is doing less well. This is because the probability of default by borrowers is seen as smaller when the macroeconomic environment improves.

The effect of interest-rate differentials that are contingent on the macroeconomic environment is to amplify the business cycle. For example, a positive demand-side shock, such as a rise in consumer confidence, which causes the economy’s aggregate demand to rise will, in turn, lead to lower borrowing rates relative to the official Bank Rate. This financial effect further stimulates the demand for credit and, as a consequence, aggregate demand and economic activity. It is an example of what economists called the financial accelerator.

The chart shows the Bank Rate along with the average unsecured borrowing rate on loans by Monetary Financial Institutions (MFIs) of £10 000. Unlike secured borrowing, which we consider shortly, unsecured borrowing is not secured against property.

As expected, we can see that the unsecured borrowing rate is greater than the Bank Rate. In other words, there is a positive interest-rate differential. However, this differential is seen to vary. It falls sharply in the period up to the financial crisis. In early 2002 it was running at 8 percentage points. By summer 2007 the differential had fallen to only 1.7 percentage points. (Click here to download a PowerPoint of the chart.)

The period from 2002 to 2007 was characterised by consistently robust growth with the UK economy growing by about 2.7 per cent per annum over this period. This may point to economic growth can contributing to an easing of credit conditions as implied by the financial accelerator.

The story from 2008 changes very quickly as the interest-rate differential increases very sharply. In 2009, as the official Bank Rate was cut to 0.5 per cent, the unsecured borrowing rate climbed to close to 10.5 per cent. Consequently, the interest-rate differential rose to 10 percentage points. Inter-bank lending had dried up with banks concerned that banks would default on loans. The increase in interest rates on lending to the non-bank private sector was stark and evidence of a credit market disruption.

The interest-rate differential for unsecured borrowing has steadily declined since its peak at the end of 2009 as the unsecured borrowing rate has fallen. This implies that credit conditions have eased. In March 2016 our interest-rate differential for unsecured borrowing stood at 3.8 percentage points, not dissimilar to levels over the past 12 months. Interestingly, today’s differential on unsecured borrowing is lower than the 6.5 percentage point average over the period from 1997 to 2003, before the differential then went on its pre-crisis fall.

Our second chart repeats the analysis but this time for mortgages. The representative mortgage rate is the average standard variable mortgage rate.

Unlike that for unsecured borrowing, the interest-rate differential for mortgages is fairly constant up to the financial crisis. The widely report credit easing in the mortgage market appears to have operated more through amounts lent rather than through price, as evidenced by rising mortgage advance-to-income ratios. (Click here to download a PowerPoint of the chart.)

The second chart shows clear evidence of a credit market disruption from 2009. Hence, the markets for secured and unsecured lending saw credit conditions tighten with interest-rate differentials rising markedly. However, it shows that the higher interest-rate differential for secured lending following the credit market disruption remains. So while the differential has fallen sharply for unsecured lending the situation is quite different in the mortgage market. In fact, February and March 2016 saw the mortgage rate spread at 4.17 percentage points which is an historic high.

Our interest rate data show that interest-rate differentials can vary significantly over time. This is important to understand when we are thinking about the relationships between the macroeconomy and the financial system. Significantly, the data suggest that interest rates on different financial instruments can behave differently such that differences emerge in the patterns of spreads over the official Bank Rate.

The evidence on UK mortgage rates suggests that the market remains affected by the financial crisis and the credit market disruption that arose. Although the level of mortgage rates is historically low – which tends to capture many of the headlines – this masks an historically high premium over the official Bank Rate.

Articles
Bank warns EU vote may hit growth as it holds rates BBC News, (14/4/16)
Carney issues a warning as interest rates are held Belfast Telegraph, (15/4/16)
Bank Of England Leaves Interest Rates On Hold Sky News, (14/4/16)
UK banks plan to boost lending to households but not firms – BoE Reuters, (13/4/16)
Mortgage rates reach record lows as threat of Bank Rate rise evaporates Telegraph, Tara Evans (1/4/16)

Data
Bankstats (Monetary and Financial Statistics) – Latest Tables Bank of England
Statistical Interactive Database – interest and exchange rates data Bank of England

Questions

  1. Why would we expect banks’ borrowing rates to be higher than the official Bank Rate?
  2. How might banks’ credit criteria change as the macroeconomic environment changes? Explain your answer.
  3. As well as the macroeconomic environment, what other factors might lead to a change in the interest-rate differential between banks’ borrowing rates and the official Bank Rate?
  4. How would we expect a credit market disruption to affect the interest-rate differential?
  5. Explain how the financial accelerator affects the change in the size of the economy following a positive demand shock.
  6. Explain how the financial accelerator affects the change in the size of the economy following a negative demand shock.
  7. What is the impact of the financial accelerator of the amplitude of the business cycle?
  8. How might regulators intervene to minimise the effect of the financial accelerator?
  9. Why might explain the high interest-rate differential on mortgages that continues to persist following the financial crisis?
  10. Analyse the ways in which the financial system can stabilise or destabilise economies.
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