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Articles for the ‘Economics for Business: Ch 28’ Category

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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How sustainable is the UK’s appetite for credit?

The latest Bank of England’s Money and Credit release shows net lending (lending net of repayments) by Monetary Financial Institutions (MFIs) to individuals in February was £4.9 billion. Although down on the £5.4 billion in January, it nonetheless means that over the last 12 months the flow of net lending amounted to £52.8 billion. This is the highest 12-month figure since October 2008.

The latest credit data raise concerns about levels of lending and their potential to again impact on the financial well-being of individuals, particularly in light of the falling proportion of income that households are saving. As we saw in UK growth fuelled by consumption as households again lose affection for their piggy banks the saving ratio fell to an historic low of 4.2 per cent for 2015.

An important factor affecting the financial well-being of individuals and households is the extent of their indebtedness. Flows of credit accumulate to become stocks of debt. Stocks of debt affect the extent to which household incomes becomes prey to debt servicing costs. Put simply, more and more income, all other things being equal, is needed for interest payments and capital repayments as debt stocks rise. Rising stocks of debt can also affect the ability of people to further fund borrowing, particularly if debt levels grow more quickly than asset values, such as the value of financial assets accumulated through saving. Consequently, the growth of debt can result in households incurring what is called balance sheet congestion with deteriorating financial well-being or increased financial stretch.

Chart 1 shows the stocks of debt acquired by individuals from MFIs, i.e. deposit-taking financial institutions. It shows both secured debt stocks (mortgage debt) and unsecured debt stocks (consumer credit). The scale of debt accumulation, particularly from the mid 1990s up to the financial crisis of the late 2000s is stark.

At the start of 1995 UK individuals had debts to MFIs of a little over £430 billion, the equivalent of roughly 55 per cent of annual GDP (Gross Domestic Product). By the autumn of 2008 this had hit £1.39 trillion, the equivalent of roughly 90 per cent of annual GDP. At both points around 85 per cent of the debt was secured debt, though around the start of the decade it had fallen back a little to around 80 per cent. (Click here to download a PowerPoint of Chart 1.)

The path of debt at the start of the 2010s is consistent with a story of consolidation. Both financially-distressed individuals and MFIs took steps to repair their balance sheets following the financial crisis. These steps, it is argued, are what resulted in a balance sheet recession. This saw the demand for and supply of additional credit wane. Consequently, as Chart 1 shows debt accumulation largely ceased.

More recently the indebtedness to MFIs of individuals has started to rise again. At the end of February 2014 the stock of debt was just shy of £1.4 trillion. By the end of February 2016 it had risen to £1.47 trillion (a little under 80 per cent of annual GDP). This is an increase of 4.7 per cent. Interestingly, the rise was largely driven by unsecured debt. It rose by 13.4 per cent from £159.4 billion to £180.7 billion. Despite the renewed buoyancy of the housing market, particularly in South East England, the stock of secured debt has risen by just 3.6 per cent from £1.24 trillion to £1.28 trillion.

Chart 2 shows the annual flow of lending extended to individuals, net of repayments. (Click here to download a PowerPoint of Chart 2.) 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 2 shows, we can see that net lending to individuals is again on the rise. As we noted earlier, part of this this reflects a rebound in parts of the UK housing market. It is perhaps worth noting that secured lending helps individuals to purchase housing and thereby acquire physical wealth. While secured lending can find its way to fuelling spending, for example, through the purchase of goods and services when people move into a new home, consumer credit more directly fuels spending and so aggregate demand. Furthermore, consumer credit is not matched on the balance sheets by an asset in the same way that secured credit is.

Chart 3 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 the stocks of debt can also be affected by the writing off of debts. What the chart nicely shows is the strong rates of growth in net unsecured lending from MFIs. In fact, it is the strongest annual rate of growth since January 2006 (Click here to download a PowerPoint of the chart.)

The growth in consumer credit, the fall in the saving ratio and the growth in consumer spending point to a need for individuals to be mindful of their financial well-being. What is for sure, is that you can expect to see considerable comment in the months ahead about consumption, credit and income data. Fundamental to these discussions will be the sustainability of current lending patterns.

Articles
Consumer Lending Growth Highest Since 2005 Sky News, (31/3/16)
Britons raid savings to fund spending as economists warn recovery ‘built on sand’ Telegraph, Szu Ping Chan (31/3/16)
Household debt binge has no end in sight, says OBR Telegraph, Szu Ping Chan (17/3/16)
Surge in borrowing… as savings dwindle: Household savings are at an all-time low as families turn to cheap loans and credit cards Daily Mail, James Burton (1/4/16)
George Osborne banks on household debt time bomb to meet his Budget targets Mirror, Ben Glaze (29/3/16)
Britain’s free market economy isn’t working Guardian (13/1/16)

Data
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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Global warning

Project Syndicate is an organisation which produces articles on a range of economic, political and social topics written by eminent scholars, political and business leaders, policymakers and civic activists. It then makes these available to news media in more than 150 countries. Here we look at four such articles which assess the outlook for the European and global economies and even that of capitalism itself.

The general tone is one of pessimism. Despite unconventional monetary policies, such as quantitative easing (QE) and negative nominal interest rates, the global recovery is anaemic. As the Nouriel Roubini articles states:

Unconventional monetary policies – entrenched now for almost a decade – have themselves become conventional. And, in view of persistent lacklustre growth and deflation risk in most advanced economies, monetary policymakers will have to continue their lonely fight with a new set of ‘unconventional unconventional’ monetary policies.

Perhaps this will involve supplying additional money directly to consumers and/or business in a so-called ‘helicopter drop’ of money. Perhaps it will be supplying money directly to governments to finance infrastructure projects – a policy dubbed ‘people’s quantitative easing‘. Perhaps it will involve taxing the holding of cash by banks to encourage them to lend.

The Hans-Werner Sinn article looks at some of the consequences of the huge amount of money created through QE and continuing to be created in the eurozone. Although it has not boosted consumption and investment nearly as much as desired, it has caused bubbles in various asset markets. For example, the property market has soared in many countries:

Property markets in Austria, Germany, and Luxembourg have practically exploded throughout the crisis, as a result of banks chasing borrowers with offers of loans at near-zero interest rates, regardless of their creditworthiness.

The German property boom could be reined in with an appropriate jump in interest rates. But, given the ECB’s apparent determination to head in the opposite direction, the bubble will only grow. If it bursts, the effects could be dire for the euro.

The Jean Pisani-Ferry article widens the analysis of the eurozone’s problems. Like Roubini, he considers the possibility of a helicopter drop of money, which “would be functionally equivalent to a direct government transfer to households, financed by central banks’ permanent issuance of money”.

Without such drastic measures he sees consumer and business pessimism (see chart) undermining recovery and making the eurozone vulnerable to global shocks, such as further weakening in China. (Click here for a PowerPoint of the chart.)

Finally, Anatole Kaletsky takes a broad historical view. He starts by saying that “All over the world today, there is a sense of the end of an era, a deep foreboding about the disintegration of previously stable societies.” He argues that the era of ‘leaving things to the market’ is coming to an end. This was an era inspired by the monetarist and supply-side revolutions of the 1960s and 1970s that led to the privatisation and deregulation policies of Reagan, Thatcher and other world leaders.

But if the market cannot cope with the complexities of today’s world, neither can governments.

If the world is too complex and unpredictable for either markets or governments to achieve social objectives, then new systems of checks and balances must be designed so that political decision-making can constrain economic incentives and vice versa. If the world is characterized by ambiguity and unpredictability, then the economic theories of the pre-crisis period – rational expectations, efficient markets, and the neutrality of money – must be revised.

… It is obvious that new technology and the integration of billions of additional workers into global markets have created opportunities that should mean greater prosperity in the decades ahead than before the crisis. Yet ‘responsible’ politicians everywhere warn citizens about a ‘new normal’ of stagnant growth. No wonder voters are up in arms.

His solution has much in common with that of Roubini and Pisani-Ferry. “Money could be printed and distributed directly to citizens. Minimum wages could be raised to reduce inequality. Governments could invest much more in infrastructure and innovation at zero cost. Bank regulation could encourage lending, instead of restricting it.”

So will there be a new era of even more unconventional monetary policy and greater regulation that encourages rather than restricts investment? Read the articles and try answering the questions.

Articles
Unconventional Monetary Policy on Stilts Project Syndicate, Nouriel Roubini (1/4/16)
Europe’s Emerging Bubbles Project Syndicate, Hans-Werner Sinn (28/3/16)
Preparing for Europe’s Next Recession Project Syndicate, Jean Pisani-Ferry (31/3/16)
When Things Fall Apart Project Syndicate, Anatole Kaletsky (31/3/16)

Questions

  1. Explain how a ‘helicopter drop’ of money would work in practice.
  2. Why has growth in the eurozone been so anaemic since the recession of 2009/10?
  3. What is the relationship between tightening the regulations about capital and liquidity requirements of banks and bank lending?
  4. Explain the policies of the different eras identified by Anatole Kaletsky.
  5. Would it be fair to describe the proposals for more unconventional monetary policies as ‘Keynesian’?
  6. If quantitative easing was used to finance government infrastructure investment, what would be the effect on the public-sector deficit and debt?
  7. If the inflation of asset prices is a bubble, what could cause the bubble to burst and what would be the effect on the wider economy?
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UK growth fuelled by consumption as households again lose affection for their piggy banks

The latest data in the Quarterly National Accounts show that UK households in 2015 spent £1.152 trillion, the equivalent of 62 per cent of the country’s Gross Domestic Product (GDP). In real terms, household spending rose by 2.8 per cent in 2015 in excess of the 2.3 per cent growth observed in GDP. In the final quarter of 2015 real household spending rose by 0.6 per – the same rate of growth as that recorded for the UK economy. This was the tenth consecutive quarter of positive consumption growth and the twelfth of economic growth.

It is the consistent growth seen over the recent past in real household spending that marks it out from the other components of aggregate demand. Consequently, household spending remains the bedrock of UK growth.

Chart 1 helps to evidence the close relationship between consumption and economic growth. It picks out nicely the stark turnaround both in economic growth and consumer spending following the financial crisis. Over the period from 2008 Q1 to 2011 Q2, real consumer spending typically fell by 0.4 per cent each quarter. This weakness in consumption was mirrored by economic growth. Real GDP contracted over this period by an average of 0.2 per cent each quarter. (Click here to download a PowerPoint of the chart.)

Since 2011 Q3 real consumption growth has averaged 0.6 per cent per quarter – the rate at which consumption grew in 2015 Q4 – while, real GDP growth has averaged 0.5 per cent per quarter. Over this same period the real disposable income (post-tax income) of the combined household and NPISH (non-profit institutions serving households), has typically grown by 0.4 per cent per quarter. (NPISHs are charities and voluntary organisations.)

The strength of consumption relative to income is evidenced by the decline in the saving ratio as can be observed in Chart 2. The ratio captures the percentage of disposable income that households (and NPISHs) choose to save. In 2010 Q3 the proportion of income saved hit 11.9 per cent having been as low as 4.5 per cent in 2008 Q1. By 2015 Q4 the saving ratio had fallen to 3.8 per cent, the lowest value since the series began in 1963 Q1. (Click here to download a PowerPoint.)

The historic low in the saving ratio in the final quarter of 2015 reflects the strength of consumption alongside a sharp fall in real disposable income of 0.6 per cent in the quarter. However, the bigger picture shows a marked downward trend in the saving ratio over the period from 2012.

When seen in a more historic context the latest numbers taken on even greater significance. Chart 3 shows the annual saving ratio since 1963. From it we can see that the 2015 value of 4.2 was the first year when the ratio fell below 5 per cent. With 2014 being the previous historic low, there must be some concern that UK consumption growth is not being underpinned by income growth. (Click here to download a PowerPoint.)

Of course, consumption theory places great emphasis on expected future income in determining current spending. To some extent it may be argued that households were liquidity-constrained following the financial crisis. They were unable to borrow to support spending and, as time moved on, to borrow against the expectation of stronger income growth in the future. This would have depressed consumption growth. But, there may also have been a self-imposed liquidity constraint as the financial crisis unfolded. Heightened uncertainty may have led households to be more prudent and divert resources to saving. Such precautionary saving would tend to boost the saving ratio and so may be a factor in the sharp rise we observed in the ratio.

The easing of credit constraints as we headed through the early 2010s allied with stronger economic growth may help to explain the strength of the recovery in consumption growth. However, it is the extent and, in particular, the duration of this strong consumption growth that is fuelling a debate over its sustainability. The current uncertainty around future income growth and the need for households to be mindful of the indebtedness built up prior to the financial crisis point to households needing to retain a degree of caution. Consequently, the debates around the financial well-being of households and the need to rebalance the UK economy away from consumer spending are likely to be further intensified by the latest consumption and saving data.

Data
All data related to Quarterly National Accounts: Quarter 4 (Oct to Dec) 2015 Office for National Statistics
Office for National Statistics Office for National Statistics

Articles
Britons raid savings to fund spending as economists warn recovery ‘built on sand’ Telegraph, Szu Ping Chan (31/3/16)
UK Growth Higher But Deficit Hits New Record Sky News, (31/3/16)
Britain is a nation that has forgotten how to save Telegraph, Jeremy Warner (31/3/16)
A vulnerable economy: the true cost of Britain’s current account deficit Guardian, Larry Elliott (31/3/16)
U.K. Manufacturing ‘In the Doldrums’ Leaves Growth Lopsided Bloomberg, Emma Charlton (1/4/16)
Pound drops as UK manufacturing languishes in the doldrums Telegraph, Szu Ping Chan (1/4/16)

Questions

  1. Why is the distinction between nominal and real growth an important one when looking at many macroeconomic variables.
  2. Examine the argument that the historic low saving ratio in the UK is a cause for concern.
  3. What factors might we expect to impact on the saving ratio?
  4. To what extent do you think the current growth in consumer spending is sustainable?
  5. How important are expectations in determining consumer behaviour?
  6. Explain what you understand by consumption smoothing.
  7. Why would we would typically expect consumption growth to be less variable than that in disposable income?
  8. Why might consumption sometimes be observed to be less sensitive or more sensitive to income changes?
  9. What factors might cause households to be liquidity constrained?
  10. What is precautionary saving? What might affect its perceived importance among households?
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Accelerating interest in the interesting case of UK interest rates

As John reminds us in his blog A seven year emergency we have now seen the official Bank Rate at 0.5 per cent for the past seven years. Understandably many attribute the financial crisis that led to the easing of monetary policy to the lending practices of commercial banks. Consequently, it is important that we better understand (and monitor) banks’ behaviour. Some argue that these practices are affected by the macroeconomic environment, with credit conditions varying across the business cycle. We consider here what recent patterns in interest rates might tell us about credit conditions.

One way in the macroeconomic environment might affect commercial banks’ lending practices 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. In other words, the greater are commercial borrowing rates relative to the Bank Rate, the greater the credit premium being demanded by banks. On the other hand, the lower the interest rate on borrowing relative to the Bank Rate, the smaller the credit premium.

Some economists argue 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. If this is the case, it will tend to amplify the business cycle, since economic shocks will have larger affects on economic activity.

Consider a positive demand-side shock, such as a rise in consumer confidence, which lowers the propensity of households to save. As the positive shock causes the economy’s aggregate demand to rise, the economy grows. This growth in economic activity might result in lower borrowing rates offered by commercial banks relative to the official Bank Rate. Since savings rates tend to be close to the official Bank Rate, this also means that the cost of borrowing falls relative to the interest rates on savings. 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.

Similarly, the financial accelerator means that negative shocks depress economic activity by more than would otherwise be the case. A fall in consumer confidence, for example, would cause economic activity to fall as aggregate demand weakens. This, in turn, causes banks to raise borrowing rates relative to the Bank Rate and savings rates. This further dampens economic activity.

The chart shows the Bank Rate along with the average unsecured borrowing rate on loans by Monetary Financial Institutions (MFIs) of £10 000. (Secured borrowing is that which is secured against property.) We use this borrowing rate to capture general trends in commercial borrowing rates.

As expected, we can see that the 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. The UK economy grew over this period by about 2.7 per cent per annum. This would certainly fit with the story that economic growth may have contributed to an easing of credit conditions which, in turn, helped to induce growth. Regardless, the falling interest-rate differential points to credit conditions easing.

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 has steadily declined since its peak at the end of 2009 as the unsecured borrowing rate has fallen. Hence credit conditions have eased. In fact, in February 2016 our indicative interest rate differential stood at 3.8 percentage points, unchanged from its level in January. This is its lowest level since July 2008. Furthermore, today’s differential 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.

Given concerns about the impact of credit cycles on the macroeconomy we can expect the authorities to keep a very keen eye on credit conditions in the months ahead.

Articles
Bank holds UK interest rates at 0.5% BBC News (17/3/16)
UK’s record low interest rates to continue in 2016 The Guardian, Katie Allen (3/3/16)
Big rise in consumer credit in January BBC News, Brian Milligan (29/2/16)
Household debt binge has no end in sight, says OBR The Telegraph, Szu Ping Chan (17/3/16)

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. What factors might lead to a change in the interest-rate differential between banks’ borrowing rates and the official Bank Rate?
  3. How would we expect a credit market disruption to affect the interest-rate differential?
  4. Explain how the financial accelerator affects the change in the size of the economy following a positive demand shock.
  5. Explain how the financial accelerator affects the change in the size of the economy following a negative demand shock.
  6. What is the impact of the financial accelerator of the amplitude of the business cycle?
  7. How might banks’ credit criteria change as the macroeconomic environment changes?
  8. How might regulators intervene to minimise the effect of the financial accelerator?
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A seven-year emergency

Seven years ago (on 5 March 2009), the Bank of England reduced interest rates to a record low of 0.5%. This was in response to a deepening recession. It mirrored action taken by other central banks across the world as they all sought to stimulate their economies, which were reeling from the financial crisis.

Record low interest rates, combined with expansionary fiscal policy, were hoped to be enough to restore rates of growth to levels experienced before the crisis. But they weren’t. One by one countries increased narrow money through bouts of quantitative easing.

But as worries grew about higher government deficits, brought about by the expansionary fiscal policies and by falling tax receipts as incomes and spending fell, so fiscal policy became progressively tighter. Thus more and more emphasis was put on monetary policy as the means of stimulating aggregate demand and boosting economic growth.

Ultra low interest rates and QE were no longer a short-term measure. They persisted as growth rates remained sluggish. The problem was that the higher narrow money supply was not leading to the hoped-for credit creation and growth in consumption and investment. The extra money was being used for buying assets, such as shares and houses, not being spent on goods, services, plant and equipment. The money multiplier fell dramatically in many countries (see chart 1 for the case of the UK: click here for a PowerPoint) and there was virtually no growth in credit creation. Broad money in the UK (M4) has actually fallen since 2008 (see chart 2: click here for a PowerPoint), as it has in various other countries.

Additional monetary measures were put in place, including various schemes to provide money to banks for direct lending to companies or individuals. Central banks increasingly resorted to zero or negative interest rates paid to banks for deposits: see the blog posts Down down deeper and down, or a new Status Quo? and When a piggy bank pays a better rate. But still bank lending has stubbornly failed to take off.

Some indication that the ‘emergency’ was coming to an end occurred in December 2015 when the US Federal Reserve raised interest rates by 0.25 percentage points. However, many commentators felt that that was too soon, especially in the light of slowing Chinese economic growth. Indeed, the Chinese authorities themselves have been engaging in a large scale QE programme and other measures to arrest this fall in growth.

Although it cut interest rates in 2009 (to 1% by May 2009), the ECB was more cautious than other central banks in the first few years after 2008 and even raised interest rates in 2011 (to 1.5% by July of that year). However, more recently it has been more aggressive in its monetary policy. It has progressively cut interest rates (see chart 3: click here for a PowerPoint) and announced in January 2015 that it was introducing a programme of QE, involving €60 billion of asset purchases for at least 18 months from March 2015. In December 2015, it announced that it would extend this programme for another six months.

The latest move by the ECB was on March 10, when it took three further sets of measures to boost the flagging eurozone economy. It cut interest rates, including cutting the deposit rate paid to banks from –0.3% to –0.4% and the main refinancing rate from –0.05% to –0%; it increased its monthly quantitative easing from €60 billion to €80 billion; and it announced unlimited four-year loans to banks at near-zero interest rates.

It would seem that the emergency continues!

Articles
QE, inflation and the BoE’s unreliable boyfriend: seven years of record low rates The Guardian, Katie Allen (5/3/16)
The End of Alchemy: Money, Banking and the Future of the Global Economy by Mervyn King – review The Observer, John Kampfner (14/3/16)
How ‘negative interest rates’ marked the end of central bank dominance The Telegraph, Peter Spence (21/2/16)
ECB stimulus surprise sends stock markets sliding BBC News (10/3/16)
5 Takeaways From the ECB Meeting The Wall Street Journal, Paul Hannon (10/3/16)
ECB cuts interest rates to zero amid fears of fresh economic crash The Guardian, Katie Allen and Jill Treanor (10/3/16)
Economists mixed on ECB stimulus CNBC, Elizabeth Schulze (10/3/16)
ECB’s Draghi plays his last card to stave off deflation The Telegraph, Ambrose Evans-Pritchard (10/3/16)
ECB cuts rates to new low and expands QE Financial Times, Claire Jones (10/3/16)
Is QE a saviour, necessary evil or the road to perdition? The Telegraph, Roger Bootle (20/3/16)

ECB materials
Monetary policy decisions ECB Press Release (10/3/16)
Introductory statement to the press conference (with Q&A) ECB Press Conference, Mario Draghi and Vítor Constâncio (10/3/16)
ECB Press Conference webcast ECB, Mario Draghi

Questions

  1. What are meant by narrow and broad money?
  2. What is the relationship between narrow and broad money? What determines the amount that broad money will increase when narrow money increases?
  3. Explain what is meant by (a) the credit multiplier and (b) the money multiplier.
  4. Explain how the process of quantitative easing is supposed to result in an increase in aggregate demand. How reliable is this mechanism?
  5. Find out and explain what happened to the euro/dollar exchange rate when Mario Draghi made the announcement of the ECB’s monetary measures on 10 March.
  6. Is there a conflict for central banks between trying to strengthen banks’ liquidity and reserves and trying to stimulate bank lending? Explain.
  7. Why are “the ECB’s policies likely to destroy half of Germany’s 1500 savings and co-operative banks over the next five years”? (See the Telegraph article.
  8. What are the disadvantages of quantitative easing?
  9. What are the arguments for and against backing up monetary policy with expansionary fiscal policy? Consider different forms that this fiscal policy might take.
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