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Articles for the ‘Essential Economics for Business: Ch 10’ Category

Rising inflation

The latest figures from the ONS show that UK inflation rose to 2.3% for the 12 months to February 2017 – up from 1.9% for the 12 months to January. The rate is the highest since September 2013 and has steadily increased since late 2015.

The main price index used to measure inflation is now CPIH, as opposed to CPI. CPIH is the consumer prices index (CPI) adjusted for housing costs and is thus a more realsitic measure of the cost pressures facing households. As the ONS states:

CPIH extends the consumer prices index (CPI) to include a measure of the costs associated with owning, maintaining and living in one’s own home, known as owner occupiers’ housing costs (OOH), along with Council Tax. Both of these are significant expenses for many households and are not included in the CPI.

But why has inflation risen so significantly? There are a number of reasons.

The first is a rise in transport costs (contributing 0.15 percentage points to the overall inflation rate increase of 0.4 percentage points). Fuel prices rose especially rapidly, reflecting both the rise in the dollar price of oil and the depreciation of the pound. In February 2016 the oil price was $32.18; in February 2017 it was $54.87 – a rise of 70.5%. In February 2016 the exchange rate was £1 = $1.43; in February 2017 it was £1 = $1.25 – a depreciation of 12.6%.

The second biggest contributor to the rise in inflation was recreation and culture (contributing 0.08 percentage points). A wide range of items in this sector, including both goods and services, rose in price. ‘Notably, the price of personal computers (including laptops and tablets) increased by 2.3% between January 2017 and February 2017.’ Again, a large contributing factor has been the fall in the value of the pound. Apple, for example, raised its UK app store prices by a quarter in January, having raised prices for iPhones, iPads and Mac computers significantly last autumn. Microsoft has raised its prices by more than 20% this year for software services such as Office and Azure. Dell, HP and Tesla have also significantly raised their prices.

The third biggest was food and non-alcoholic beverages (contributing 0.06 percentage points). ‘Food prices, overall, rose by 0.8% between January 2017 and February 2017, compared with a smaller rise of 0.1% a year earlier.’ Part of the reason has been the fall in the pound, but part has been poor harvests in southern Europe putting up euro prices. This is the first time that overall food prices have risen for more than two-and-a-half years.

It is expected that inflation will continue to rise over the coming months as the effect of the weaker pound and higher raw material and food prices filter though. The current set of pressures could see inflation peaking at around 3%. If there is a futher fall in the pound or further international price increases, inflation could be pushed higher still – well above the Bank of England’s 2% target. (Click here for a PowerPoint of the chart.)

The higher inflation means that firms are facing a squeeze on their profits from two directions.

First, wage rises have been slowing and are now on a level with consumer price rises. It is likely that wage rises will soon drop below price rises, meaning that real wages will fall, putting downward pressure on spending and squeezing firms’ revenue.

Second, input prices are rising faster than consumer prices. In the 12 months to February 2017, input prices (materials and fuels) rose by 19.1%, putting a squeeze on producers. Producer prices (‘factory gate prices’), by contrast, rose by 3.7%. Even though input prices are only part of the costs of production, the much smaller rise of 3.7% reflects the fact that producer’s margins have been squeezed. Retailers too are facing upward pressure on costs from this 3.7% rise in the prices of products they buy from producers.

One of the worries about the squeeze on real wages and the squeeze on profits is that this could dampen investment and slow both actual and potential growth.

So will the Bank of England respond by raising interest rates? The answer is probably no – at least not for a few months. The reason is that the higher inflation is not the result of excess demand and the economy ‘overheating’. In other words, the higher inflation is not from demand-pull pressures. Instead, it is from higher costs, which are in themselves likely to dampen demand and contribute to a slowdown. Raising interest rates would cause the economy to slow further.

Videos
UK inflation shoots above two percent, adding to Bank of England conundrum Reuters, William Schomberg, David Milliken and Richard Hunter (21/3/17)
Bank target exceeded as inflation rate rises to 2.3% ITV News, Chris Choi (21/3/17)
Steep rise in inflation Channel 4 News, Siobhan Kennedy (21/3/17)
U.K. Inflation Gains More Than Forecast, Breaching BOE Goal Bloomberg, Dan Hanson and Fergal O’Brien (21/3/17)

Articles
Inflation leaps in February raising prospect of interest rate rise The Telegraph, Julia Bradshaw (21/3/17)
Brexit latest: Inflation jumps to 2.3 per cent in February Independent, Ben Chu (21/3/17)
UK inflation rate leaps to 2.3% BBC News (21/3/17)
UK inflation: does it matter for your income, debts and savings? Financial Times, Chris Giles (21/3/17)
Rising food and fuel prices hoist UK inflation rate to 2.3% The Guardian, Katie Allen (21/3/17)
Reality Check: What’s this new measure of inflation? BBC News (21/3/17)

Data
UK consumer price inflation: Feb 2017 ONS Statistical Bulletin (21/3/17)
UK producer price inflation: Feb 2017 ONS Statistical Bulletin (21/3/17)
Inflation and price indices ONS datasets
Consumer Price Inflation time series dataset ONS datasets
Producer Price Index time series dataset ONS datasets
European Brent Spot Price US Energy Information Administration
Statistical Interactive Database – interest & exchange rates data Bank of England

Questions

  1. If pries rise by 10% and then stay at the higher level, what will happen to inflation (a) over the next 12 months; (b) in 13 months’ time?
  2. Distinguish between demand-pull and cost-push inflation. Why are they associated with different effects on output?
  3. If producers face rising costs, what determines their ability to pass them on to retailers?
  4. Why is the rate of real-wage increase falling, and why may it beome negative over the coming months?
  5. What categories of people are likely to lose the most from inflation?
  6. What is the Bank of England’s remit in terms of setting interest rates?
  7. What is likely to affect the sterling exchange rate over the coming months?
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A fall in the UK natural rate of unemployment?

When UK unemployment was 7.7% in July 2013, Mark Carney, the newly arrived governor of the Bank of England, said that the Bank would probably have to rise interest rates when the unemployment rate dropped below 7%. Below that rate, it was expected that inflation would rise. In other words, 7% was the NAIRU – the non-accelerating rate of inflation. The most recent figure for the unemployment rate is 4.8% and yet the Bank of England has not raised interest rates. In fact, in response to the Brexit vote, it cut Bank Rate from 0.5% to 0.25% in August last year. (Click here for a PowerPoint of the chart below.)

The NAIRU is a similar, although not identical, concept to the natural rate of unemployment. The natural rate is the equilibrium rate consistent with an overall long-term balance of aggregate labour demand and supply: i.e. the rate after short-term cyclical movements in unemployment have been discounted. It is thus a long-term concept.

The NAIRU, although similar, focuses on the relationship between inflation and unemployment. With inflation caused solely by demand-side factors, the natural rate and the NAIRU will be similar if not identical. However, if cost-push factors change – say there is a poor harvest, which pushes up food prices and inflation (temporarily), or a substantial depreciation of the exchange rate caused by political factors (such as Brexit) – the NAIRU would increase, at least in the short term, as a higher rate of unemployment would be necessary to stop inflation rising. In the long term, although being defined differently, the NAIRU and the natural rate will be the same.

In practice, because the Bank of England is targeting inflation at a 24-month time horizon, the NAIRU for the UK at that point could also be seen as the natural rate.

So with the Bank of England not raising interest rates despite the considerable fall in the unemployment rate, does this imply a fall in the natural rate of unemployment? The answer is yes. The reason has to do with changes in the structure of the labour market.

The proportion of young people and women with children returning to the labour market has fallen. Such people have a higher-than-average rate of unemployment since they typically spend a period of time searching for a job.

Tax and benefit reforms over the years have increased the incentive for the unemployed to take work.

Perhaps the biggest factor is a greater flexibility in the labour market. As union power has waned and as people are increasingly working on flexible contracts, including zero-hour contracts, so this has moderated wage increases. At the same time, many firms are facing increased competition both from abroad and domestically via the Internet. This has put downward pressure on prices and hence on the wages firms are willing to pay.

The effect has been a fall in the NAIRU and probably the natural rate. Frictions in the labour market have reduced and people losing their jobs because of changes in industrial structure find it easier to get jobs in low-skilled service industries, where employers’ risks of taking on such workers have fallen because of the loss of rights for such workers.

So what is the natural rate of unemployment today? It is certainly much lower than 7%; the consensus is that it is probably below 5%. As Kristin Forbes, External MPC Member of the Bank of England stated in a recent speech:

[Unemployment] is forecast to increase gradually from its current 4.8% to a high of 5.0% in the second half of 2017, before falling back to its current rate by the end of 2019. To put this in context, 5.0% was previously believed to be around the UK’s natural rate of unemployment – the rate below which unemployment could not fall without wages picking up to levels inconsistent with sustaining inflation around the 2% target. Unemployment at 5.0% is also below the average unemployment rate for the UK over the pre-crisis period from 1997 to 2007 (when it was 5.5%).

She went on to discuss just what the figure is for the natural, or ‘equilibrium’, rate of unemployment (U*). One problem here is that there is considerable uncertainty over the figure in the current forecast made by the Bank.

[An] assumption in the forecast about which there is substantial uncertainty is of the equilibrium unemployment rate – or U* for short. Since I have been on the MPC, the Committee has assumed that U* was around 5%. This implied that the more by which unemployment exceeded 5%, the more slack existed in the economy, and the less upward momentum would be expected in wages (controlling for other factors, such as productivity growth).

As part of our annual assessment of regular supply-side conditions this January, Bank staff presented several pieces of analysis that suggested U* may be lower than 5% today [see, for example]. The majority of the MPC voted to lower our estimate of U* to 4.5%, based partly on the persistent weakness of wage growth over the past few years after accounting for other factors in our models. [See page 20 of the February 2017 Inflation Report.]

My own assessment, however, suggested that although U* was likely lower than 5% today, it is likely not as low as 4.5%. If true, this would suggest that there is less slack in the economy than in the MPC’s central forecast, and wage growth and inflation could pick up faster than expected.

Against that, however, uncertainty related to Brexit negotiations could make firms more cautious about raising wages, thereby dampening wage growth no matter where unemployment is relative to its equilibrium. Moreover, even if we could accurately measure the level of U* in the economy today, it could easily change over the next few years as the labour force adjusts to any changes in the movement of labour between the UK and European Union.

Determining the precise figure of the current natural rate of unemployment, and predicting it for the medium term, is very difficult. It involves separating out demand-side factors, which are heavily dependent on expectations. It also involves understanding the wage elasticity of labour supply in various markets and how this has been affected by the increased flexibility of these markets.

Articles
When will Britons get a pay rise? The Guardian, Phillip Inman (26/2/17)
BoE decision, Inflation Report – Analysts react DigitalLook, Alexander Bueso (2/2/17)
Bank of England hikes UK economic growth forecasts but warns of rising inflation The Telegraph, Szu Ping Chan (2/2/17)

Bank of England publications
Inflation Report Bank of England (February 2017)
A MONIAC (not manic) economy Bank of England Speeches, Kristin Forbes (8/2/17)
The labour market Bank of England Speeches, Michael Saunders (31/1/17)

Questions

  1. Distinguish between the following terms: natural rate of unemployment, NAIRU, equilibrium rate of unemployment, disequilibrium rate of unemployment.
  2. For what reasons did the Monetary Policy Committee members feel that the equilibrium rate of unemployment might be as low as 4.25%?
  3. Why might it be as high as 5%?
  4. How are changes in migration trends likely to affect (a) wage growth and (b) unemployment?
  5. How is the amount of slack in an economy measured? What impact does the degree of slack have on wage growth and inflation?
  6. What is meant by the ‘gig’ economy? How has the development of the gig economy impacted on unemployment and wages?
  7. Why has there been a considerable rise in self employment?
  8. How may questions of life style choice and control over the hours people wish to work impact on the labour market?
  9. If people are moving jobs less frequently, does this imply that the labour market is becoming less flexible?
  10. Why may firms in the current climate be cautious about raising wages even if aggregate demand picks up?
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Irrational exuberance

Both the financial and goods markets are heavily influenced by sentiment. And such sentiment tends to be self-reinforcing. If consumers and investors are pessimistic, they will not spend and not invest. The economy declines and this further worsens sentiment and further discourages consumption and investment. Banks become less willing to lend and stock markets fall. The falling stock markets discourage people from buying shares and so share prices fall further. The despondency becomes irrational and greatly exaggerates economic fundamentals.

This same irrationality applies in a boom. Here it becomes irrational exuberance. A boom encourages confidence and stimulates consumer spending and investment. This further stimulates the boom via the multiplier and accelerator and further inspires confidence. Banks are more willing to lend, which further feeds the expansion. Stock markets soar and destabilising speculation further pushes up share prices. There is a stock market bubble.

But bubbles burst. The question is whether the current global stock market boom, with share prices reaching record levels, represents a bubble. One indicator is the price/earnings (PE) ratio of shares. This is the ratio of share prices to earnings per share. Currently the ratio for the US index, S&P 500, is just over 26. This compares with a mean over the past 147 years of 15.64. The current ratio is the third highest after the peaks of the early 2000s and 2008/9.

An alternative measure of the PE ratio is the Shiller PE ratio (see also). This is named after Robert Shiller, who wrote the book Irrational Exuberance. Unlike conventional PE ratios, which only look at average earnings over the past four quarters, the Shiller PE ratio uses average earnings over the past 10 years. “Because this factors in earnings from the previous ten years, it is less prone to wild swings in any one year.”

The current level of the Shiller PE ratio is 29.14, the third highest on record, this time after the period running up to the Wall Street crash of 1929 and the dot-com bubble of the late 1990s. The mean Shiller PE ratio over the past 147 years is 16.72.

So are we in a period of irrational exuberance? And are stock markets experiencing a bubble that sooner or later will burst? The following articles explore these questions.

Articles
2 Clear Instances of Irrational Exuberance Seeking Alpha, Jeffrey Himelson (12/2/17)
Promised land of Trumpflation-inspired global stimulus has been slow off the mark South China Morning Post, David Brown (20/2/17)
A stock market crash is a way off, but this boom will turn to bust The Guardian, Larry Elliott (16/2/17)
The “boring” bubble is close to bursting – the Unilever bid proves it MoneyWeek, John Stepek (20/2/17)

Questions

  1. Find out what is meant by Minksy’s ‘financial instability hypothesis’ and a ‘Minsky moment’. How might they explain irrational exuberance and the sudden turning point from a boom to a bust?
  2. Is it really irrational to buy shares with a very high PE ratio if everyone else is doing so?
  3. Why are people currently exuberant?
  4. What might cause the current exuberance to end?
  5. How does irrational exuberance affect the size of the multiplier?
  6. How might the behaviour of banks and other financial institutions contribute towards a boom fuelled by irrational exuberance?
  7. Compare the usefulness of a standard PE ratio with the Shiller PE ratio.
  8. Other than high PE ratios, what else might suggest that stock markets are overvalued?
  9. Why might a company’s PE ratio differ from its price/dividends ratio (see)? Which is a better measure of whether or not a share is overvalued?
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Being an economist

Is too much expected of economists? When economic forecasts turn out to be wrong, as they often are, economists are criticised for having inaccurate or unrealistic models. But is this a fair criticism?

The following article by Richard Whittle from Manchester Metropolitan University looks at what economists can and cannot do. The article highlights two key problems for economic forecasting.

The first concerns human behaviour, which is influenced by a whole range of factors and can change very rapidly in response to changing circumstances. Moods of optimism or pessimism can quickly spread in response to a news item, such as measures announced by Donald Trump or latest data on growth or the housing market.

The second concerns the whole range of possible economic shocks. Such shocks, by their very nature, are hard to predict and can quickly make forecasts wrong. They could be a surprise election result, a surprise government policy change, a natural disaster, a war or a series of terrorist attacks. And these shocks, in turn, affect human behaviour. Consumption and investment may rise or fall as the events affect confidence and herd behaviour.

But is it a fair criticism of economics that it cannot foretell the future? Do economists, as the article says, throw up their hands and curse economics as a futile endeavour? Not surprisingly, the answer given is no! The author gives an analogy with medicine.

A doctor cannot definitely prevent illness, but can offer advice on prevention and hopefully offer a cure if you do get ill. This is the same for the work economists do.

Economists can offer advice on preventing crises or slowdowns but cannot definitively prevent them from happening. Economists can also offer robust advice on restoring growth, although when the advice is that the economy has grown too fast and should slow, it is often not welcomed by policy makers.

Helping understanding the various drivers in an economy and how humans are likely to respond to various incentives is a key part of what economists do. But making predictions with 100% certainty is asking too much of economists.

And just as medical professionals can predict that if you smoke, eat unhealthy food or take no exercise you are likely to be less healthy and die younger, but cannot say precisely when an individual will die, so too economists can predict that certain policy measures are likely to increase or decrease GDP or employment or inflation, but they cannot say precisely how much they will be affected.

As the article says, “the true value of the economist lies not in mystical fortune telling, but in achieving a better understanding of the nature of the economies in which we live and work.”

Article
How to be an economist in 2017 The Conversation, Richard Whittle (24/1/17)

Questions

  1. For what reasons has economics been ‘in crisis’? What is the solution to this crisis?
  2. Look at some macroeconomic forecasts for a country of your choice made two years ago for today (see, for example, forecasts made by the IMF, OECD or a central bank). How accurate were they? Explain any inaccuracies.
  3. To what extent is economic forecasting like weather forecasting?
  4. What is meant by cumulative causation? Give some examples. Why does cumulative causation make economic forecasting difficult?
  5. How is the increased usage of contactless card payments likely to affect spending patterns? Explain why.
  6. Why is it difficult to forecast the effects of Brexit?
  7. How can economic advisors help governments in designing policy?
  8. Why do people tend to overweight high probabilities and underweight low ones?
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A bridge to somewhere

Many politicians throughout the world,
not just on the centre and left, are arguing for increased spending on infrastructure. This was one of the key proposals of Donald Trump during his election campaign. In his election manifesto he pledged to “Transform America’s crumbling infrastructure into a golden opportunity for accelerated economic growth and more rapid productivity gains”.

Increased spending on inffrastructure has both demand- and supply-side effects.

Unless matched by cuts elsewhere, such spending will increase aggregate demand and could have a high multiplier effect if most of the inputs are domestic. Also there could be accelerator effects as the projects may stimulate private investment.

On the supply side, well-targeted infrastructure spending can directly increase productivity and cut costs of logistics and communications.

The combination of the demand- and supply-side effects could increase both potential and actual output and reduce unemployment.

So, if infrastructure projects can have such beneficial effects, why are politicians often so reluctant to give them the go-ahead?

Part of the problem is one of timing. The costs occur in the short run. These include demolition, construction and disruption. The direct benefits occur in the longer term, once the project is complete. And for complex projects this may be many years hence. It is true that demand-side benefits start to occur once construction has begun, but these benefits are widely dispersed and not easy to identify directly with the project.

Then there is the problem of externalities. The external costs of projects may include environmental costs and costs to local residents. This can lead to protests, public hearings and the need for detailed cost–benefit analysis. This can delay or even prevent projects from occurring.

The external benefits are to non-users of the project, such as a new bridge or bypass reducing congestion for users of existing routes. These make the private construction of many projects unprofitable, except with public subsidies or with public–private partnerships. So there does need to be a macroeconomic policy that favours publicly-funded infrastructure projects.

One type of investment that is less disruptive and can have shorter-term benefits is maintenance investment. Maintenance expenditure can avoid much more costly rebuilding expenditure later on. But this is often the first type of expenditure to be cut when public-sector budgets as squeezed, whether at the local or national level.

The problem of lack of infrastructure investment is very much a political problem. The politicians who give the go-ahead to such projects, such as high-speed rail, come in for criticisms from those bearing the short-run costs but they are gone from office once the benefits start to occur. They get the criticism but not the praise.

Articles
Are big infrastructure projects castles in the air or bridges to nowhere? The Economist, Buttonwood’s notebook (16/1/17)
Trump’s plans to rebuild America are misguided and harmful. This is how we should do it. The Washington Post, Lawrence H. Summers (17/1/17)

Questions

  1. Identify the types of externality from (a) a new high-speed rail line, (b) new hospitals.
  2. How is discounting relevant to decisions about public-sector projects?
  3. Why are governments often unwilling to undertake (a) new infrastructure projects, (b) maintenance projects?
  4. Is a programme of infrastructure investment necessarily a Keynesian policy?
  5. What accelerator effects would you expect from infrastructure investment?
  6. Explain the difference between the ‘spill-out’ and ‘pull-in’ effects of different types of public investments in a specific location. Is it possible for a project to have both effects?
  7. What answer would you give to the teacher who asked the following question of US Treasury Secretary, Larry Summers? “The paint is chipping off the walls of this school, not off the walls at McDonald’s or the movie theatre. So why should the kids believe this society thinks their education is the most important thing?”
  8. What is the ‘bridge to nowhere’ problem? Why does it occur and what are the solutions to it?
  9. Why is the ‘castles in the air’ element of private projects during a boom an example of the fallacy of composition?
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Economic forecasts: are they of any value?

Economic forecasting came in for much criticism at the time of the financial crisis and credit crunch. Few economists had predicted the crisis and its consequences. Even Queen Elizabeth II, on a visit to the London School of Economics in November 2008, asked why economists had got it so wrong. Similar criticisms have emerged since the Brexit vote, with economic forecasters being accused of being excessively pessimistic about the outcome.

The accuracy of economic forecasts was one of the topics discussed by Andy Haldane, Chief Economist at the Bank of England. Speaking at the Institute for Government in London, he compared economic forecasting to weather forecasting (see section from 15’20″ in the webcast):

“Remember that? Michael Fish getting up: ‘There’s no hurricane coming but it will be very windy in Spain.’ Very similar to the sort of reports central banks – naming no names – issued pre-crisis, ‘There is no hurricane coming but it might be very windy in the sub-prime sector.” (18’40″)

The problem with the standard economic models which were used for forecasting is that they were essentially equilibrium models which work reasonably well in ‘normal’ times. But when there is a large shock to the economic system, they work much less well. First, the shocks themselves are hard to predict. For example, the sub-prime crisis in 2007/8 was not foreseen by most economists.

Then there is the effect of the shocks. Large shocks are much harder to model as they can trigger strong reactions by consumers and firms, and governments too. These reactions are often hugely affected by sentiment. Bouts of pessimism or even panic can grip markets, as happened in late 2008 with the collapse of Lehman Brothers. Markets can tumble way beyond what would be expected by a calm adjustment to a shock.

It can work the other way too. Economists generally predicted that the Brexit vote would lead to a fall in GDP. However, despite a large depreciation of sterling, consumer sentiment held up better than was expected and the economy kept growing.

But is it fair to compare economic forecasting with weather forecasting? Weather forecasting is concerned with natural phenomena and only seeks to forecast with any accuracy a few days ahead. Economic forecasting, if used correctly, highlights the drivers of economic change, such as government policy or the Brexit vote, and their likely consequences, other things being equal. Given that economies are constantly being affected by economic shocks, including government or central bank actions, it is impossible to forecast the state of the macroeconomy with any accuracy.

This does not mean that forecasting is useless, as it can highlight the likely effects of policies and take into account the latest surveys of, say, consumer and business confidence. It can also give the most likely central forecast of the economy and the likely probabilities of variance from this central forecast. This is why many forecasts use ‘fan charts’: see, for example, Bank of England forecasts.

What economic forecasts cannot do is to predict the precise state of the economy in the future. However, they can be refined to take into account more realistic modelling, including the modelling of human behaviour, and more accurate data, including survey data. But, however refined they become, they can only ever give likely values for various economic variables or likely effects of policy measures.

Webcast
Andy Haldane in Conversation Institute for Government (5/1/17)

Articles
‘Michael Fish’ Comments From Andy Haldane Pounced Upon By Brexit Supporters Huffington Post, Chris York (6/1/17)
Crash was economists’ ‘Michael Fish’ moment, says Andy Haldane BBC News (6/1/17)
The Bank’s ‘Michael Fish’ moment BBC News, Kamal Ahmed (6/1/17)
Bank of England’s Haldane admits crisis in economic forecasting Financial Times, Chris Giles (6/1/17)
Chief economist of Bank of England admits errors in Brexit forecasting BBC News, Phillip Inman (5/1/17)
Economists have completely failed us. They’re no better than Mystic Meg The Guardian, Simon Jenkins (6/1/17)
Five things economists can do to regain trust The Guardian, Katie Allen and Phillip Inman (6/1/17)
Andy Haldane: Bank of England has not changed view on negative impact of Brexit Independent, Ben Chu (5/1/17)
Big data could help economists avoid any more embarrassing Michael Fish moments Independent, Hamish McRae (7/1/17)

Questions

  1. In what ways does economic forecasting differ from weather forecasting?
  2. How might economic forecasting be improved?
  3. To what extent were the warnings of the Bank of England made before the Brexit vote justified? Did such warnings take into account actions that the Bank of England was likely to take?
  4. How is the UK economy likely to perform over the coming months? What assumptions are you making here?
  5. Brexit hasn’t happened yet. Why is it extremely difficult to forecast today what the effects of actually leaving the EU will be on the UK economy once it has happened?
  6. If economic forecasting is difficult and often inaccurate, should it be abandoned?
  7. The Bank of England is forecasting that inflation will rise in the coming months. Discuss reasons why this forecast is likely to prove correct and reasons why it may prove incorrect.
  8. How could economic forecasters take the possibility of a Trump victory into account when making forecasts six months ago of the state of the global economy a year or two ahead?
  9. How might the use of big data transform economic forecasting?
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What’s Next?

The economic climate remains uncertain and, as we enter 2017, we look towards a new President in the USA, challenging negotiations in the EU and continuing troubles for High Street stores. One such example is Next, a High Street retailer that has recently seen a significant fall in share price.

Prices of clothing and footwear increased in December for the first time in two years, according to the British Retail Consortium, and Next is just one company that will suffer from these pressures. This retail chain is well established, with over 500 stores in the UK and Eire. It has embraced the internet, launching its online shopping in 1999 and it trades with customers in over 70 countries. However, despite all of the positive actions, Next has seen its share price fall by nearly 12% and is forecasting profits in 2017 to be hit, with a lack of growth in earnings reducing consumer spending and thus hitting sales.

The sales trends for Next are reminiscent of many other stores, with in-store sales falling and online sales rising. In the days leading up to Christmas, in-store sales fell by 3.5%, while online sales increased by over 5%. However, this is not the only trend that this latest data suggests. It also indicates that consumer spending on clothing and footwear is falling, with consumers instead spending more money on technology and other forms of entertainment. Kirsty McGregor from Drapers magazine said:

“I think what we’re seeing there is an underlying move away from spending so much money on clothing and footwear. People seem to be spending more money on going out and on technology, things like that.”

Furthermore, with price inflation expected to rise in 2017, and possibly above wage inflation, spending power is likely to be hit and it is spending on those more luxury items that will be cut. With Next’s share price falling, the retail sector overall was also hit, with other companies seeing their share prices fall as well, although some, such as B&M, bucked the trend. However, the problems facing Next are similar to those facing other stores.

But for Next there is more bad news. It appears that the retail chain has simply been underperforming for some time. We have seen other stores facing similar issues, such as BHS and Marks & Spencer. Neil Wilson from ETX Capital said:

“The simple problem is that Next is underperforming the market … UK retail sales have held up in the months following the Brexit vote but Next has suffered. It’s been suffering for a while and needs a turnaround plan … The brand is struggling for relevancy, and risks going the way of Marks & Spencer on the clothing front, appealing to an ever-narrower customer base.”

Brand identity and targeting customers are becoming ever more important in a highly competitive High Street that is facing growing competition from online traders. Next is not the first company to suffer from this and will certainly not be the last as we enter what many see as one of the most economically uncertain years since the financial crisis.

Next’s gloomy 2017 forecast drags down fashion retail shares The Guardian, Sarah Butler and Julia Kollewe (4/1/17)
Next shares plummet after ‘difficult’ Christmas trading The Telegraph, Sam Dean (4/1/17)
Next warns 2017 profits could fall up to 14% as costs grow Sky News, James Sillars (4/1/17)
Next warns on outlook as sales fall BBC News (4/1/17)
Next chills clothing sector with cut to profit forecast Reuters, James Davey (4/1/17)
Next shares drop after warning of difficult winter Financial Times, Mark Vandevelde (22/10/15)

Questions

  1. With Next’s warning of a difficult winter, its share price fell. Using a diagram, explain why this happened.
  2. Why have shares in other retail companies also been affected following Next’s report on its profit forecast for 2017?
  3. Which factors have adversely affected Next’s performance over the past year? Are they the same as the factors that have affected Marks & Spencer?
  4. Next has seen a fall in profits. What is likely to have caused this?
  5. How competitive is the UK High Street? What type of market structure would you say that it fits into?
  6. With rising inflation expected, what will this mean for consumer spending? How might this affect economic growth?
  7. One of the factors affecting Next is higher import prices. Why have import prices increased and what will this mean for consumer spending and sales?
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A worrying rise in unsecured borrowing

Household borrowing on credit cards and through overdrafts and loans has been growing rapidly. This ‘unsecured’ borrowing is now rising at rates not seen since well before the credit crunch of 2008 (click here for a PowerPoint of the chart below). Should this be a cause for concern?

Household confidence is generally high and, as a result, people continue to take out more loans and so household debt continues to increase. Saving rates are falling and, at 5.1% of household disposable income, are the lowest rate since 2008, mirroring the high levels of spending and borrowing.

But as long as the economy keeps growing and as long as interest rates stay at record low levels, people should be able to continue servicing this rising debt. Indeed, with generous balance transfer offers between credit cards and many people paying off their full balance each month, only 56.6% are paying any interest at all on credit card debt, the lowest level on record.

But there could be trouble ahead! Secured borrowing (i.e. on mortgages) is at record highs as house prices have soared, limiting the amount people have to left to spend, even with ultra low interest rates. Student debt is growing, putting a brake on graduate spending.

With economic growth set to slow and inflation set to rise as the effects of the lower pound filter through into retail prices, this could initially boost borrowing further as people seek to maintain levels of consumption. But then, if unemployment starts to rise and consumer confidence starts to fall, real spending could decline, putting further downward pressure on the economy.

Confidence could then fall further and we could witness a repeat of 2008–9, when people became worried about their levels of borrowing and cut back on consumption in an attempt to claw down their debt. The economy was pushed into recession.

The Bank of England is well aware of this scenario and wants banks to ensure that their customers can afford loans before offering them.

Articles
Bank governor Mark Carney warns on household debt BBC News, Brian Milligan (30/11/16)
Credit crunch: Household debt is rising just as the economy’s future is uncertain The Telegraph, Tim Wallace (10/12/16)

Bank of England publication
Financial Stability Report, November 2016 Bank of England (30/11/16)

Data
Money and lending Bank of England Interactive Database
United Kingdom Households Debt To GDP Trading Economics
Household debt OECD Data

Questions

  1. What determines the amount people borrow?
  2. What would cause people to cut back on the amount of debt they have?
  3. Distinguish between secured and unsecured borrowing and debt.
  4. Why has secured borrowing risen? Does this matter?
  5. What is meant by the term ‘re-leveraging’? What is its significance in terms of household borrowing?
  6. Find out what the affordability tests are for anyone wanting to take out a mortgage.
  7. What are the greatest risks to UK financial stability?
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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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