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Posts Tagged ‘balance sheets’

Interest rates – too low, for too long?

Interest rates have been at record lows across the developed world since 2009. Interest rates were reduced to such levels in order to stimulate recovery from the financial crisis of 2007–8 and the resulting recession. The low interest rates were accompanied by extraordinary increases in money supply under various rounds of quantitative easing in the USA, UK, Japan and eventually the eurozone. But have such policies done harm?

This is the contention of Brian Sturgess in a new paper, published by the Centre for Policy Studies. He maintains that the policy has had a number of adverse effects:

 •  There will be nothing left in the monetary policy armoury when the next downturn occurs other than even more QE, which will compound the following problems.
 •  It has had little effect in stimulating aggregate demand and economic growth. Instead the extra money has been used to repair balance sheets and support unprofitable businesses.
 •  It has inflated asset prices, especially shares and property, which has encouraged funds to flow to the secondary market rather than to funding new investment.
 •  The inflation of asset prices has benefited the already wealthy.
 •  By keeping interest rates down to virtually zero on savings accounts, it has punished small savers.
 •  By rewarding the rich and penalising small savers, it has contributed to greater inequality.
 •  By keeping interest rates down to borrowers, it has encouraged households to take on excessive amounts of debt, which will be hard to service if interest rates rise.
 •  It has lowered the price of risk, thereby encouraging more risky types of investment and the general misallocation of capital.

Sturgess argues that it is time to end the policy of low interest rates. Currently, in all the major developed economies, central bank rates are below the rate of inflation, making the real central bank interest rates negative.

He welcomes the two small increases by the Federal Reserve, but this should be followed by further rises, not just by the Fed, but by other central banks too. As Sturgess states in the paper (p.12):

In place of ever more extreme descents into the unknown, central banks should quickly renormalise monetary policy. That would involve ending QE and allowing interest rates to rise steadily so that interest rates can carry out their proper functions. Failure to do so will leave the global financial system vulnerable to potential shocks such as the failure of the euro, or the fiscal stresses in the US resulting from the unfinanced spending plans announced by Donald Trump in his presidential campaign.

Although Sturgess argues that the initial programmes of low interest rates and QE were a useful response to the financial crisis, he argues that they should have only been used as a short-term measure. However, if they were, and if interest rates had gone up within a few months, many argue that the global economy would rapidly have sunk back into recession. This has certainly been the position of central banks. Sturgess disagrees.

Articles
Damaging low interest rates and QE must end now, think thank warns The Telegraph, Julia Bradshaw (23/1/17)
QE has driven pension deficits up, think-tank argues Money Marketing, Justin Cash (23/1/17)
Hold: The ECB keeps interest rates and QE purchases steady as Mario Draghi defends loose policy from hawkish critics City A.M., Jasper Jolly (19/1/17)
Preparing for the Post-QE World Bloomberg, Jean-Michel Paul (12/10/16)

Paper
Stop Depending on the Kindness of Strangers: Low interest rates and the Global Economy Centre for Policy Studies, Brian Sturgess (23/1/17)

Questions

  1. Find out what the various rounds of quantitative easing have been in the USA, the UK, Japan and the eurozone.
  2. What are the arguments in favour of quantitative easing as it has been practised?
  3. How might interest rates close to zero result in the misallocation of capital?
  4. Sturgess claims that the existence of ‘spillover’ effects has had damaging effects on many emerging economies. What are these spillover effects and what damage have they done to such economies?
  5. How do low interest rates affect interest rate spreads?
  6. Have pensioners gained or lost from QE? Explain how the answer may vary between different pensioners.
  7. What is meant by a ‘natural’ or ‘neutral’ rate of interest (see section 3.2 in the paper)? Why, according to Janet Yellen (currently Federal Reserve Chair, writing in 2005), is this somewhere between 3.5% and 5.5% (in nominal terms)?
  8. What are the arguments for and against using created money to finance programmes of government infrastructure investment?
  9. Would helicopter money be more effective than QE via asset purchases in achieving faster economic growth? (See the blog posts: A flawed model of monetary policy and New UK monetary policy measures – somewhat short of the kitchen sink.)
  10. When QE comes to an end in various countries, what are the arguments for absorbing rather than selling the assets purchased by central banks? (See the Bloomberg article.)
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OECD goes public

In an attempt to prevent recession following the financial crisis of 2007–8, many countries adopted both expansionary monetary policy and expansionary fiscal policy – and with some success. It is likely that the recession would have been much deeper without such policies

But with growing public-sector deficits caused by the higher government expenditure and sluggish growth in tax receipts, many governments soon abandoned expansionary fiscal policy and relied on a mix of loose monetary policy (with ultra low interest rates and quantitative easing) but tight fiscal policy in an attempt to claw down the deficits.

But such ‘austerity’ policies made it much harder for loose monetary policy to boost aggregate demand. The problem was made worse by the attempt of both banks and individuals to ‘repair’ their balance sheets. In other words banks became more cautious about lending, seeking to build up reserves; and many individuals sought to reduce their debts by cutting down on spending. Both consumer spending and investment were slow to grow.

And yet government and central banks, despite the arguments of Keynesians, were reluctant to abandon their reliance solely on monetary policy as a means of boosting aggregate demand. But gradually, influential international institutions, such as the IMF (see also) and World Bank, have been arguing for an easing of austerity fiscal policies.

The latest international institution to take a distinctly more Keynesian stance has been the Organisation for Economic Co-operation and Development (OECD). In its November 2015 Economic Outlook it had advocated some use of public-sector investment (see What to do about slowing global growth?. But in its Interim Economic Outlook of February 2016, it goes much further. It argues that urgent action is needed to boost economic growth and that this should include co-ordinated fiscal policy. In introducing the report, Catherine L Mann, the OECD’s Chief Economist stated that:

“Across the board there are lower interest rates, except for the United States. It allows the authorities to undertake a fiscal action at very very low cost. So we did an exercise of what this fiscal action might look like and how it can contribute to global growth, but also maintain fiscal sustainability, because this is an essential ingredient in the longer term as well.

So we did an experiment of a two-year increase in public investment of half a percentage point of GDP per annum undertaken by all OECD countries. This is an important feature: it’s everybody doing it together – it’s a collective action, because it’s global growth that is at risk here – our downgrades [in growth forecasts] were across the board – they were not just centred on a couple of countries.

So what is the effect on GDP of a collective fiscal action of a half a percentage point of GDP [increase] in public investment in [high] quality projects. In the United States, the euro area, Canada and the UK, who are all contributors to this exercise, the increase in GDP is greater than the half percentage point [increase] in public expenditure that was undertaken. Even if other countries don’t undertake any fiscal expansion, they still get substantial increases in their growth rates…

Debt to GDP in fact falls. This is because the GDP effect of quality fiscal stimulus is significant enough to raise GDP (the denominator in the debt to GDP ratio), so that the overall fiscal sustainability [debt to GDP] improves.”

What is being argued is that co-ordinated fiscal policy targeted on high quality infrastructure spending will have a multiplier effect on GDP. What is more, the faster growth in GDP should outstrip the growth in government expenditure, thereby allowing debt/GDP ratios to fall, not rise.

This is a traditional Keynesian approach to tackling sluggish growth, but accompanied by a call for structural reforms to reduce inefficiency and waste and improve the supply-side of the economy.

Articles
Osborne urged to spend more on infrastructure by OECD Independent, Ben Chu (18/2/16)
OECD blasts reform fatigue, downgrades growth and calls for more rate cuts Financial Review (Australia), Jacob Greber (18/2/16)
OECD calls for less austerity and more public investment The Guardian, Larry Elliott (18/2/15)
What’s holding back the world economy? The Guardian, Joseph Stiglitz and Hamid Rashid (8/2/16)
OECD calls for urgent action to combat flagging growth Financial Times, Emily Cadman (18/2/16)
Central bankers on the defensive as weird policy becomes even weirder The Guardian, Larry Elliott (21/2/16)
Keynes helped us through the crisis – but he’s still out of favour The Guardian, Larry Elliott (7/2/16)
G20 communique says monetary policy alone cannot bring balanced growth
Reuters (27/2/15)

OECD publications
Global Economic Outlook and Interim Economic Outlook OECD, Catherine L Mann (18/2/16)
Interim Economic Outlook OECD (18/2/16)

Questions

  1. Draw an AD/AS diagram to illustrate the effect of a successful programme of public-sector infrastructure projects on GDP and prices.
  2. Draw a Keynesian 45° line diagram to illustrate the effect of a successful programme of public-sector infrastructure projects on actual and potential GDP.
  3. Why might an individual country benefit more from a co-ordinated expansionary fiscal policy of all OECD countries rather than being the only country to pursue such a policy?
  4. What determines the size of the multiplier effect of such policies?
  5. How might a new classical/neoliberal economist respond to the OECD’s recommendation?
  6. Why may monetary policy have ‘run out of steam’? Are there further monetary policy measures that could be adopted?
  7. Compare the relative effectiveness of increased government investment in infrastructure and tax cuts as alterative forms of expansionary fiscal policy.
  8. Should quantitative easing be directed at financing public-sector infrastructure projects? What are the benefits and problems of such a policy? (See the blog post People’s quantitative easing.)
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Acquiring a taste for credit (again)

The Bank of England’s Money and Credit release on 1 Feb provides us with data up to the end of 2015 on lending by banks and building societies to the rest of the UK private sector. In this post we update our blog of 17 December 2015 – is Minsky right yet again? – to analyse the latest data on lending. The headline numbers show that the flow of lending (net of repayments) by banks and building societies to UK households in 2015 was £40.8 billion up from £29.9 billion in 2014 taking their amount of outstanding lending to households to £1.26 trillion. Was American economist Minsky (1919-1996) right to have argued that cycles in credit are inevitable?

Chart 1 shows the stocks of debt acquired by both households and private non-financial corporations from MFIs (Monetary Financial Institutions), i.e. deposit-taking institutions. The scale of debt accumulation in the late 1980s and again from the mid 1990s up to the financial crisis of the late 2000s is stark. At the start of 1980 the UK household sector had debts to MFIs of around £53 billion. By the start of 2009 this had hit £1.29 trillion. To put these figures into context this corresponds to an increase in indebtedness to MFIs from 25 per cent of GDP to 86 per cent of GDP.

The chart also shows the increase in indebtedness of private non-financial corporations which are effectively every day businesses. They saw their debts to MFIs rise from around £25 billion to over £500 billion which is equivalent to an increase from 12 per cent of GDP to 33 per cent of GDP. (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. Although the term is readily used in the context of the public sector and measures to reduce public-sector deficits the term is also relevant for the private sector. Financially-distressed households, private non-financial corporations and MFIs took steps to repair their balance sheets following the financial crisis. Indeed the term is synonymous with the idea of a balance sheet recession which some economists argue describe the late 2000s. The result was that the demand for and supply of additional credit waned. Debt accumulation largely ceased and, as we can see from Chart 1, debt numbers fell.

More recently the indebtedness to MFIs of households has started to edge up again, though, as yet, not for private non-financial corporations. From the end of the first quarter of 2013 to the end of 2015 household indebtedness to MFIs has increased by 7 per cent to £1.26 trillion.

Chart 2 focuses on flows rather than stocks. (Click here to download a PowerPoint of Chart 2.) It allows us to see the accumulation of new credit (i.e. less repayments of debt). What is even more apparent from this chart is the evidence of cycles in credit. The growth in new credit during the 2000s is stark as is the subsequent squeeze on credit that followed. Across 2006 net flows of credit from MFIs to households reached £106 billion while the peak for PNFCs was across 2007 when they reached £71 billion. Subsequently, net credit numbers crashed with negative numbers for PNFCs indicating net repayments to MFIs.

The size of the credit flows emanating from MFIs and the magnitude of the resulting credit cycles is even more stark when presented as percentages of GDP. The annual flow of credit to households in the late 1980s reached 9.4 per cent of GDP while that to PNFCs peaked at the end of the decade at 5.2 per cent of GDP. Meanwhile, across 2006 net credit to households reached 7.5 per cent of GDP while the peak of lending to PNFCs was in the 12-month period to the end of 2007 Q1 equivalent to 4.8 per cent of GDP. In 2015, credit from MFIs to households reached 2.2 per cent of GDP while that to PNFCs was a mere 0.2 per cent of GDP.

Of course, the key question now is the path of credit. Clearly flows of credit to households are again on the rise. In part, this is driven by the rebound in the UK housing market. But, significantly there has been a significant rise in flows of consumer credit, i.e. unsecured debt.

Chart 3 shows the flows of consumer credit to individuals (excluding student loans involving the Student Loans Company) from MFIs and other credit providers. Again, we see the marked evidence of cycles. Across 2015 these net consumer credit flows amounted to £14.5 billion, the highest annual figure since 2005. (Click here to download a PowerPoint of the chart.)

To put the current rise in consumer credit into context, the net flow of consumer credit to individuals as percentage of GDP across 2015 as a whole amounts to about 0.8 per cent of GDP. This is the highest figure since the second half of 2006. While it might be a little early to say that credit numbers are a cause for concern, they do need to be seen in the context of a still relatively highly indebted household sector. Policymakers will be keeping a keen eye on credit patterns and assessing whether we have again acquired a real appetite for credit.

Articles
Households put another £4.4 billion on credit cards and personal loans in December as debt rises at fastest pace in a decade ThisisMoney.co.uk, Rachel Rickard Straus (1/2/16)
One in four ‘living for the day’ as 700,000 more expected to default on debt Independent, Simon Read (2/1/16)
Surprise mortgage jump confounds expectations Independent, Russell Lynch (1/2/16)
U.K. consumer credit slows; mortgage approvals up MarketWatch, Jon Sindreu (1/2/16)
Family debt continues to rise – report BBC News (13/1/16)

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

Questions

  1. How can the financial system affect the economy’s business cycle?
  2. What does it mean if households or firms are financially distressed? What responses might they take to this distress and what might the economic consequences be?
  3. How would you measure the net worth (or wealth) of an individual or a firm? What factors might affect their net worth?
  4. How might uncertainty affect spending and saving by households and businesses?
  5. What does it mean if bank lending is pro-cyclical?
  6. Why might lending be pro-cyclical?
  7. Are there measures that policymakers can take to reduce the likelihood that flows of credit become too excessive?
  8. What do you understand by a consolidation by the private sector? Discuss the possible macroeconomic effects of such a consolidation.
  9. What is meant by a balance sheet recession?
  10. How might the effect of attempts by a large number of individuals to improve their financial well-being differ from those when only a small numbers of individuals do so?
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Is Minsky right yet again?

To what extent does history repeat itself? Minsky’s Financial Instability Hypothesis infers that credit cycles are fairly inevitable. We have seem them in the past and we will see them in the future. Human beings are subject to emotion, to irrational exuberance and to a large dose of forgetfulness! To what extent do the latest UK credit numbers suggest that we might be embarking on another credit binge? Are the credit data consistent with evidence of another credit cycle?

Chart 1 shows the stocks of debt acquired by households and private non-financial corporations from MFIs (Monetary Financial Institutions). The scale of debt accumulation in the late 1980s and again from the mid 1990s up to the financial crisis of the late 2000s is stark. At the start of 1985 the UK household sector had debts to MFIs of around £140 billion. By the start of 2009 this had hit £1.29 trillion. Meanwhile, private non-financial corporations saw their debts to MFIs rise from around £45 billion to over £500 billion. (Click here to download a PowerPoint of the chart.)

The path of debt at the start of the 2010s is consistent with a story of consolidation. Financially-distressed households, private non-financial corporations and, of course, MFIs themselves meant that corrective action was needed to repair their balance sheets. The demand for and supply of additional credit waned. Debt accumulation largely ceased and, in fact, debt numbers fell. This trend continues today for private non-financial corporations. But, for households debt accumulation resumed in the middle of 2013. At the end of the third quarter of 2015 the household sector had debt obligations to MFIs of £1.246 trillion.

Chart 2 focuses on flows rather stocks. It allows us to see the accumulation of new credit (i.e. less repayments of debt). What is even more apparent from this chart is the evidence of cycles in credit. The growth in new credit during the 2000s is stark as is the subsequent squeeze on credit that followed.

The question that follows is what path are we now on? Clearly flows of credit to households are again on the rise. In part, this is driven by the rebound in the UK housing market. But, in fact there is a more rapid increase in consumer credit, i.e. unsecured debt. (Click here to download a PowerPoint of the chart.)

Chart 3 shows the flows of consumer credit from MFIs and other credit providers. Again, we see the marked evidence of cycles. In the year to the end of Q1 of 2015 net consumer credit flows amounted to £22.8 billion, the highest figure since the 12-month period up to the end of Q3 of 2005. Click here to download a PowerPoint of the chart.)

While it might be a little early to say that another Minsky cycle is well under way, policymakers will be keeping a keen eye on credit patterns. Is history repeating itself?

Articles
Average UK mortgage debt rises to £85,000 The Guardian, Phillip Inman (15/12/15)
Consumer spending rise troubles Bank of England The Guardian, Heather Stewart (24/11/15)
Recovery ‘too reliant on consumer debt’ as BCC downgrades forecast The Guardian, Heather Stewart (9/12/15)
BCC: UK Growth Too Reliant On Consumer Debt Sky News (9/12/15)
Interest rates will stay low for longer – but household debt is a worry, says BoE The Telegraph, Szu Ping Chan (24/11/15)
IMF: UK’s economic performance ‘very strong’, but risks remain BBC News (11/12/15)

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

Questions

  1. How can the financial system affect the economy’s business cycle?
  2. What does it mean if households or firms are financially distressed? What responses might they take to this distress and what might the economic consequences be?
  3. How would you measure the net worth (or wealth) of an individual or a firm? What factors might affect their net worth?
  4. How might uncertainty affect spending and saving by households and businesses?
  5. What does it mean if bank lending is pro-cyclical?
  6. Why might lending be pro-cyclical?
  7. Are there measures that policymakers can take to reduce the likelihood that flows of credit become too excessive?
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Rising consumer debt in the UK

George Osborne in his recent Autumn Statement, once again stressed that ‘the government is committed to strong, sustainable and balanced growth’. But while he plans to reduce government debt as a percentage of GDP, consumer debt is rising, both absolutely and as a percentage of household disposable income. The rise in household borrowing, and the resulting rise in consumer expenditure, has been the main factor driving economic growth. It has not been exports nor, until recently, investment, as the Chancellor had hoped. Indeed, investment in new housing is falling.

The Office for Budget Responsibility in its latest Economic and Fiscal Outlook forecasts that gross household debt will reach 163 per cent of household disposable income by 2021, up from 146% at the end of 2015.

Consumer gross debt includes both secured debt and unsecured debt. Secured debt is essentially debt secured on property (i.e. mortgages), while unsecured debt is largely in the form of credit card debt, overdrafts and personal loans.

The chart shows that from 2008 to 2013, gross debt fell as a percentage of personal disposable income. Following the financial crisis, banks were more cautious about lending as they sought to increase their capital and liquidity ratios. And consumers were more cautious about borrowing as the uncertainty made many people keen to reduce their debts. This decline in credit reversed the massive growth in household debt from 2000 to 2008: one of the contributing factors to the financial crisis. (Click here for a PowerPoint of the chart.)

But since late 2013, household debt – both secured and unsecured – has been rising. In absolute (nominal) terms, individuals’ debt is now £1.43 trillion, slightly above the previous high in 2008. And as the chart shows, the OBR forecasts that it will continue rising. This makes consumers more vulnerable to adverse economic shocks, such as a downturn in emerging markets, another crisis in the eurozone or financial crises in other parts of the world.

And as consumer debt has been rising, the personal saving ratio (the ratio of saving to personal disposable incomes) has been falling and is now lower than before the financial crisis.

The rise in consumer borrowing has been of some concern to the Bank of England. Andy Haldane, the Bank’s Chief Economist, appearing before the Treasury Select Committee, warned that consumer credit, and in particular personal loans, had been ‘picking up at a rate of knots. That ultimately might be an issue that the Financial Policy Committee might want to look at fairly carefully.’

Articles
The UK economy may be growing, but in a highly unbalanced way The Guardian, Phillip Inman (27/11/15)
UK growth hit by biggest drag from net trade on record The Telegraph, Szu Ping Chan (27/11/15)
Surge in consumer lending could prompt Bank of England intervention The Guardian, Patrick Collinson and Jill Treanor (30/11/15)
Consumer spending rise troubles Bank of England The Guardian, Heather Stewart (24/11/15)
Between Debt and the Devil by Adair Turner review – should the government start printing money? The Guardian, Tom Clark (25/11/15)
Lending rises as Bank of England ponders new curbs Financial Times, Ferdinando Giugliano (30/11/15)
Carney indicates BoE’s willingness to rein in credit Financial TImes, Chris Giles (5/11/15)
FCA sounds alarm at rising credit card debt Financial Times, Emma Dunkley (3/11/15)
Interest rates will stay low for longer – but household debt is a worry, says BoE The Telegraph, Szu Ping Chan (24/11/15)
Seven years after the crisis, Britain is still addicted to the drug of debt Independent, James Moore (1/12/15)
Vince Cable: Former Business Secretary warns that ‘severe economic storms’ are on the way Independent, Ben Chu (14/11/15)
The risks stalking the UK economy BBC News, Kamal Ahmed (1/12/15)

OBR publications
Economic and fiscal outlook Office for Budget Responsibility (25/11/15)
Economic and fiscal outlook charts and tables (Excel file) Office for Budget Responsibility (25/11/15)

Questions

  1. Does it matter if economic growth is driven by a rise in consumer demand, in turn driven by a risen in consumer credit?
  2. Is there an inflation risk from growth being driven by a rise in consumer credit?
  3. What is the precise relationship between the household saving ratio and the household debt ratio? (Which of these ratios is a stock and which is a flow?)
  4. What might cause a fall in consumer borrowing? Would this be a good thing?
  5. Why did consumer borrowing fall following the financial crisis of 2007–8?
  6. What could the Bank of England’s Financial Policy Committee do to curb consumer borrowing?
  7. If banks were forced to hold more reserves, how could aggregate demand be maintained? Would ‘helicopter money’ be a good idea?
  8. What are ‘countercyclical buffers for banks’? What are the arguments for raising them at the current time?
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Indebted to the bank? You are not alone!

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

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

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

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

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

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

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

Questions

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

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

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

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

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

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

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

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

Data
Statistical Interactive Database Bank of England

Questions

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

In our blog How sustainable is UK consumer spending? we considered concerns of some commentators that consumer spending was growing unduly quickly given the absence of any sustained growth in disposable income. The Second Estimate of GDP, Q2 2013 reports that the economy grew by 0.7 per cent in the second quarter of the year, with household expenditure growing by 0.4 per cent.

Because household spending makes up about two-thirds of aggregate demand in the UK it is important to keep an eye on it. The latest figures show that the real value of consumer spending by British households has risen in each quarter since 2011 Q4. In other words, the volume of household purchases has risen for seven consecutive quarters. Over the period, the growth in real consumer spending has averaged 0.4 per cent per quarter.

The chart helps to demonstrate the stark turnaround in the growth in consumer spending. Over the period from 2008 Q1 to 2011 Q3, real consumer spending typically fell by 0.4 per cent each quarter. As we noted in our previous blog, this was a period when the global financial system was in distress, with the availability of credit severely dampened, but also a period when households were concerned about their own financial balances and the future prospects for growth. Over the same period, real GDP typically fell by a little under 0.3 per cent each quarter. (Click here to download a PowerPoint of the chart.)

The real value of consumer spending has yet to return to its 2007 Q4 peak (£242 billion at 2010 prices). In 2013 Q2 the real value of consumer spending is estimated still to be 3 per cent below this level (£235 billion at 2010 prices). These figures are mirrored by the economy at large. Real GDP peaked in 2008 Q1 (£393 billion at 2010 prices). Despite the back-to-back quarterly increases in real GDP of 0.3 per cent in Q1 and 0.7 per cent in Q2, output in 2013 Q2 (£380 billion at 2010 prices) remains 3.2 per cent below the 2008 Q1 peak.

While real consumption values are below their 2007 Q4 peak, the concern is whether current rates of growth in consumer spending are sustainable. In particular, should this growth cause the household sector financial distress there would be real pain for the economy further down the line. Some commentators argue that the latest GDP figures are consistent with a more balanced recovery. In Q2 economic growth was supported too by other parts of the economy. For instance, we saw a 3.6 per cent rise in export volumes and a 1.7 per cent rise in gross fixed capital formation (i.e. investment expenditure).

Nonetheless, it is the protracted period over which consumer spending has been growing robustly that concerns some economists. Hence, we will need to continue to monitor the growth in all components of aggregate demand and, in particular, changes in household consumption, income, saving and borrowing.

Data
Second Estimate of GDP, Q2 2013 Dataset Office for National Statistics

Articles

New articles
UK economic growth revised up to 0.7% BBC News, (23/8/13)
UK GDP revised up to 0.7pc in second quarter: reaction Telegraph, (23/8/13)
UK rallying faster than thought as exports leap boosts GDP Independent, Russell Lynch and Ben Chu (24/8/13)
UK economy expanding faster than first thought, GDP revision shows Guardian, Heather Stewart (23/8/13)
Growth upgrade points to ‘sustainable’ recovery Telegraph, Philip Aldrick (23/8/13)

Previous articles
UK wages decline among worst in Europe BBC News, (11/8/13)
Squeezing the hourglass The Economist, (10/8/13)
UK first-quarter growth unchanged BBC News, (28/5/13)
Summer heatwave triggers shopping spree in ‘Wongaland’ economy Telegraph, Steve Hawkes and Steven Swinford (15/8/13)
Retail sales data better than expected as UK economy enjoys summer bounce Guardian, Heather Stewart (15/8/13)
Mark Carney is banking on you to keep spending Telegraph, Philip Aldrick (10/8/13)
NIESR upgrades UK economy but warns on consumer spending Telegraph, Philip Aldrick (2/8/13)
Consumers ‘expect better economy’ Belfast Telegraph, (4/8/13)

Questions

  1. Explain what you understand by a ‘sustainable’ economic recovery.
  2. What are the expenditure components that make up Aggregate Demand?
  3. Explain what you understand by consumption smoothing.
  4. Why would we would typically expect consumption growth to be less variable than that in disposable income?
  5. Would we expect consumption growth to always be less variable than that in disposable income? Explain your answer.
  6. What impact do you think the financial crisis has had on consumer behaviour?
  7. To what extent do you think the current growth in consumer spending is sustainable?
  8. How important are expectations in determining consumer behaviour?
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How sustainable is UK consumer spending?

Household spending makes up about two-thirds of aggregate demand in the UK. Understanding its determinants is therefore important to understanding short-term economic growth. The real value of consumer spending by British households has risen in each quarter since 2011 Q4. Over the same period real disposable income has flat-lined. This suggests that the British household sector has stepped up attempts to smooth their longer-term spending profile despite the current absence of growth in their real incomes.

When viewed over many years, disposable income and consumer spending grow at very similar rates. After stripping out inflation we find that over the past 50 years both have grown at about 2½ per cent per annum. However, if we measure growth from one quarter of the year to the next we tend to find that consumption growth is less variable than disposable income. This is known as consumption smoothing.

Chart 1 shows the quarterly percentage change in consumption and disposable income since 1998. (Click here to download a PowerPoint of the chart).The variability in the disposable income series is generally greater than that in consumption so helping to illustrate consumption smoothing.

Consumption smoothing is facilitated by the financial system enabling us to either borrow to supplement our spending or to save to enjoy more spending in the future. The financial system can help households to avoid large variations in their spending over short periods.

Consumption smoothing does not prohibit falls in consumption nor periods when it is more variable than income. Over the period from 2008 Q1 to 2011 Q3, real consumption typically fell by 0.4 per cent each quarter while disposable income was flat. This was a period when the global financial system was in distress. Sharp contractions in credit meant that the financial system was no longer able to support economic activity as it had previously. Furthermore, households too looked to repair their balance sheets with economic uncertainty acting as an incentive to do so.

What is interesting is the extent to which British households are spending again. Since 2011 Q4 the real value of spending has typically expanded by 0.4 per cent each quarter while income growth remains largely absent. One might argue that this just demonstrates a willingness for households to engage in consumption smoothing. With credit conditions still tight, the growth in spending has been aided by a decline in the saving ratio. This can be seen from Chart 2.

In 2009 Q2 the proportion of income saved hit 8.6 per cent having been as low as 0.2 per cent in 2008 Q1. In 2013 Q1 the saving ratio had fallen back to 4.2 per cent. (Click here to download a PowerPoint of the chart.)

It is of course all too easy to over-interpret data. Nonetheless, there be will concern if households look to maintain consumption growth at rates substantially greater than those in disposable income for too long a period of time. Consumption smoothing could become a real problem for future economic activity if it was to result in a financially distressed household sector. Hence, an important question is the extent to which current rates of consumption growth are sustainable. Future consumption and income trends will therefore be analysed with enormous interest.

Data
Quarterly National Accounts, Q1 2013 Dataset Office for National Statistics

Articles
UK wages decline among worst in Europe BBC News, (11/8/13)
Squeezing the hourglass The Economist, (10/8/13)
UK first-quarter growth unchanged BBC News, (28/5/13)
Summer heatwave triggers shopping spree in ‘Wongaland’ economy Telegraph, Steve Hawkes and Steven Swinford (15/8/13)
Retail sales data better than expected as UK economy enjoys summer bounce Guardian, Heather Stewart (15/8/13)
Mark Carney is banking on you to keep spending Telegraph, Philip Aldrick (10/8/13)
NIESR upgrades UK economy but warns on consumer spending Telegraph, Philip Aldrick (2/8/13)
Consumers ‘expect better economy’ Belfast Telegraph, (4/8/13)

Questions

  1. Explain what you understand by consumption smoothing.
  2. Why would we would typically expect consumption growth to be less variable than that in disposable income?
  3. Would we expect consumption growth to always be less variable than that in disposable income? Explain your answer.
  4. What impact do you think the financial crisis has had on consumer behaviour?
  5. To what extent do you think the current growth in consumer spending is sustainable?
  6. How important are expectations in determining consumer behaviour?
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Saving through housing: Households build firmer foundations

Housing Equity Withdrawal, or HEW for short, is new borrowing that is secured against property which is not reinvested in the housing market. In other words, it is borrowed money that is not used by households to purchase property or to undertake major refurbishments, such as extensions to existing residential properties. The latest HEW statistical release from the Bank of England shows that HEW in Q4 2009 was again negative, making it the seventh consecutive quarter of negative HEW. But, what does a negative HEW figure mean?

Negative HEW occurs when the total saving by households in housing (either by paying back mortgages or by purchasing property directly without borrowing) is greater than new borrowing secured against housing. It results in an increase in housing equity held by the household sector. In the fourth quarter of 2009, the Bank’s seasonally-adjusted figures show that negative HEW was just over £4.3 billion, equivalent to 1.6% of disposable income.

But why might the household sector have wanted to save through housing and how might this impact on consumer spending? In truth there is no single reason, but one potentially important reason is likely to be the sector’s desire to rebuild its balance sheets. In times of uncertainty, such as those that we face now, a perfectly understandable response by households is to try to reduce their exposure to debt. During the seven quarters in which HEW has been negative, households have used housing as a vehicle for saving to the tune of £36.5 billion, equivalent to 2.2% of the sector’s disposable income. To some extent the fact that, as a result of the banking crisis, house-buyers have had to put down larger deposits when purchasing housing helps to reduce their exposure to debt. But, the extent of the negativity of HEW means that households more generally have been actively looking to repay some of their outstanding mortgage debt.

So what of the impact of HEW on consumer spending? Negative sums of HEW mean that consumers are either reducing consumer spending, reducing holdings of financial assets, increasing levels of unsecured debt (e.g. personal loans or credit card debt) or, of course, undertaking some combination of these. Given that the stock of unsecured debt has actually declined by £7.9 billion to £224.8 billion in the 12 months to February, the impact would seem to be falling on consumer spending.

Some commentators are pointing to the weakening pace with which households are saving through housing. The current level of saving through housing is, as we said earlier, equivalent to 1.6% of disposable income, down from the 3.0% recorded in both Q4 2008 and Q1 2009. But, this would seem to simply highlight the extent of the precautionary behaviour by households in the midst of the economic downturn. It would be a surprise to see any significant end soon to the UK household sector’s precautionary behaviour.

Articles
Britons plough cash into repaying debt The Times, James Charles (6/4/10)
The great mortgage payback Reuters, Harry Wallop (6/4/10)
Home owners’ housing equity still increasing BBC News (6/4/10) )
Brits pay off £4bn of mortgage debt Press Association (6/4/10)
UK Q4 housing injection smallest since Q2 2008 – BOE MarketNews.com (6/4/10)

Data
Housing equity withdrawal (HEW) statistical releases Bank of England

Questions

  1. Explain what are meant by positive and negative values of HEW.
  2. What implications might additions to housing equity have for consumer spending?
  3. What factors do you think lie behind the seven consecutive quarters of negative HEW?
  4. If house price inflation were to start picking up in the near future, would you expect to see positive values of HEW and, if so, how strongly positive?
  5. Other than through HEW, how might the housing and mortgage markets impact on consumer spending?
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