Category: Essential Economics for Business: Ch 10

What do tulips, nickel mining in Australia, South Seas trading, Beanie Babies and cryptocurrencies have in common? The answer is that they have all been the subject of speculative bubbles. In the first four cases the bubble burst. A question currently being asked is whether it will happen to bitcoin.

Bitcoin
Bitcoin was created in 2009 by an unknown person, or people, using the alias Satoshi Nakamoto. It is a digital currency in the form of a line of computer code. Bitcoins are like ‘electronic cash’ which can be held or used for transactions, with holdings and transactions heavily encrypted for security – hence it is a form of ‘crytocurrency’. People can buy and sell bitcoins for normal currencies as well as using them for transactions. People’s holdings are held in electronic ‘wallets’ and can be accessed on their computers or phones via the Internet. Transfers of bitcoins from one person or organisation to another are recorded in a public electronic ledger in the form of a ‘blockchain‘.

The supply of bitcoins is not controlled by central banks; rather, it is determined by a process known as ‘mining’. This involves individuals or groups solving complex and time-consuming mathematical problems and being rewarded with a new block of bitcoins.

The supply of bitcoins is currently growing at around 150 per hour and the current supply is around ₿16.7 million. However, the number of new bitcoins in a block is halved for every 210,000 blocks. This means that the rate of increase in the supply of bitcoins is slowing – the number generated being halved roughly every four years. The supply will eventually reach a maximum of ₿21 million, probably sometime in the next century, but around 99% will have been mined by around 2032.

The bitcoin bubble
The price of bitcoins has soared in recent months and especially in the past two. On 4 October, the price of a bitcoin was $4226; by 7 December it was nearly four times higher, at $16,858 – a rise of 399% in just nine weeks. Many people have claimed that this is a bubble, which will soon burst. Already there have been severe fluctuations. By December 10, for example, the price had fallen at one point to $13,152 – a fall of nearly 22% in just two days – only to recover to over $15,500 within a few hours.

So what determines the price of bitcoin? The simple answer is very straightforward – it’s determined by demand and supply. But what has been happening to demand and supply and why? And what will happen in the near and more distant future?

As we have seen, the supply is limited by the process of mining, which allows a relatively stable, but declining, increase. The explanation of the recent price rise and what will happen in the future lies on the demand side. Increasing numbers of people have been buying bitcoin, not because they want to use it for transactions, whether legitimate or illegal over the dark web, but because they want to invest in bitcoin. In other words, they want to hold bitcoin as an asset which is increasing in value. These people are known as ‘hodlers’ – a deliberate misspelling of ‘holders’.

But this speculation is of the destabilising form. The more prices have risen, the more people have bought bitcoin, thus pushing the price up further. This is a classic bubble, whereby the price does not reflect an underlying value, but rather the exuberance of buyers.

The problem with bubbles is that they will burst, but just when is virtually impossible to predict with any accuracy. If the price of bitcoins falls, what will happen next depends on how the fall is interpreted. It could be interpreted as a temporary fall, caused by some people cashing in to take advantage of the higher prices. At the same time, other people, believing that it is only a temporary fall, will rush to buy, snapping up bitcoins at the temporary low price. This ‘stabilising speculation’ will move the price back up again.

However, the fall in price may be seen as the bubble bursting, with even bigger falls ahead. In this case, people will rush to sell before it falls further, thereby pushing the price even lower. This destabilising speculation will amplify the fall in prices.

But even if the bubble does burst, people may believe that another bubble will then occur and, once they think the bottom has been reached, will thus start buying again and there will be a second speculative rise in the price.

The crash could be very short-lived. This happened with the second biggest cryptocurrency, Ethereum. On 21 June this year, the price at the beginning of the day was $360. It then began to fall during the say. Once its price reached $315, it then collapsed by 96% to $13 with massive selling, much of it automatic with computers programmed to sell when the price falls by more than a certain amount. But then, on the same day, it rebounded. Within minutes it had bounced back and was trading at $337 at the end of the day. It is now trading at around $450 – up from around $300 four weeks ago.

Whether the bubble in bitcoin has more to inflate, when it will burst, and when it will rebound and by how much, depends on people’s expectations. But what we are looking at here is people’s expectations of what other people are likely to do – in other words, of other people’s expectations, which in turn depend on their expectations of other people’s expectations. This situation is known as a Keynesian Beauty Contest (see the blog, A stock market beauty contest of the machines). Perhaps we need a crystal ball.

Articles

Is Bitcoin a bubble? Here’s what two bubble experts told us Trade Online, Timothy B. Lee (8/12/17)
Bitcoin and tulipmania have a lot more in common than you might think Business Insider, Seth Archer (8/12/17)
Bitcoin ends dramatic week with 20% slump followed by recovery The Guardian, Jill Treanor (8/12/17)
Putting a price on Bitcoin The Economist, Buttonwood’s notebook (8/12/17)
Is Bitcoin a Bubble Waiting to Pop? InvestorPlace, Matt McCall (8/12/17)
Bitcoin bubble follows classic pattern of investment mania Financial Times, John Authers (8/12/17)
The Bitcoin bubble – how we know it will burst The Conversation, Larisa Yarovaya and Brian Lucey (6/12/17)
Bitcoin isn’t a currency – and unless it becomes one it could be worthless The Conversation, Vili Lehdonvirta (6/12/17)
How Bitcoin futures trading could burst the cryptocurrency’s bubble The Conversation, Nafis Alam (13/12/17)
Op-ed: Bitcoin Is Not a Bubble; It’s in an S-Curve and It’s Just Getting Started Bitcoin Magazine, Brandon Green (8/12/17)
Bitcoin vs history’s biggest bubbles: They never end well CNN Money, Daniel Shane (8/12/17)
The 10 Most Ridiculous Price Bubbles In History Business Insider, Vincent Fernando and Anika Anand (11/10/10)
After bitcoin’s wild week, traders brace for futures launch Reuters, Saqib Iqbal Ahmed (10/12/17)

Cryptocurrencies current market prices

Bitcoin live exchange prices and volumes ($) CryptoCompare
All cryptocurrencies – live market prices Yahoo Finance

Questions

  1. To what extent does Bitcoin meet the functions of money?
  2. Why is bitcoin unsuitable for normal transactions?
  3. To what extent is bitcoin like gold as a means of holding wealth?
  4. How would you advise someone thinking of buying bitcoin today? Explain why.
  5. Does a rapid rise in the price of an asset always indicate a bubble? Explain
  6. To what extent is the current rise in the price of bitcoin similar to that of the tulip, Poseidon and Beanie Baby bubbles?
  7. If bitcoin is appreciating relative to the dollar and other currencies, does this mean that the price of goods and services valued in bitcoin are falling? Explain.
  8. Explain and comment on the following sentence from the first Conversation article: “Like any asset, Bitcoin has some fundamental value, even if only a hope value, or a value arising from scarcity.”
  9. How might the introduction of futures trading in bitcoin impact on its price and the volatility of price swings?
  10. Explain and assess the argument that the price trend of bitcoin is more likely to be an S curve rather than a roller coaster

‘There is no magic money tree’, said Theresa May on several occasions during the 2017 election campaign. The statement was used to justify austerity policies and to criticise calls for increased government expenditure.

But, in one sense, money is indeed fruit of the magic money tree. There is no fixed stock of money, geared to the stock of gold or some other commodity. Money is created – as if by magic. And most of broad money is not created by government or the central bank. Rather it is created by banks as they use deposits as the basis for granting loans, which become money as they are redeposited in the banking system. Banks are doing this magic all the time – creating more and more money trees as the forest grows. As the Bank of England Quarterly Bulletin explains:

Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.

However, most of the country’s MPs are unaware of this process of money creation. As the linked Guardian article below states:

Responding to a survey commissioned by Positive Money just before the June election, 85% were unaware that new money was created every time a commercial bank extended a loan, while 70% thought that only the government had the power to create new money.

And yet the role of money and monetary policy is central to many debates in Parliament about the economy. It is disturbing to think that policy debates could be based on misunderstanding. Perhaps MPs would do well to study basic monetary economics! After all, credit creation is not a difficult topic.

Articles

How the actual magic money tree works The Guardian, Zoe Williams (29/10/17)
“Shocking ignorance” from MPs who don’t know where money actually comes from CITY A.M., Jasper Jolly (27/10/17)
Money creation in the modern economy Bank of England Quarterly Bulletin, Michael McLeay, Amar Radia and Ryland Thomas of the Bank’s Monetary Analysis Directorate (2014 Q1)
Politicians get lost in search of the fabled Magic Money Tree CITY A.M., Vince Cable (12/10/17)

Positive Money poll

Poll shows 85% of MPs don’t know where money comes from Positive Money, David Clarke (27/10/17)

Questions

  1. Do central banks create money and, if so, what form(s) does it take?
  2. Explain how credit creation works.
  3. What determines the amount of credit that banks create?
  4. How can the central bank influence the amount of credit created?
  5. Distinguish between narrow and broad money supply.
  6. What is the relationship between government spending and broad money supply (M4 in the UK)?
  7. Why is there no simple money multiplier whereby total broad money supply is a simple and predictable multiple of narrow money?
  8. What determines the relationship between money supply and real output?
  9. Does it matter what type of lending is financed by money creation?
  10. Comment on the statement: “The argument marshalled against social investment such as education, welfare and public services, that it is unaffordable because there is no magic money tree, is nonsensical.”
  11. Could quantitative easing be used to finance social investment? Would there be any dangers in the process?

We have reported frequently in our blogs about concerns over rising debt levels among UK households. We previously noted the concerns expressed in July 2014 by the Prudential Regulation Authority (PRA) that the growth in consumer credit (unsecured lending) was stretching the financial well-being of individuals with implications for the resilience of lenders’ credit portfolios. Now the Chief Executive of the Financial Conduct Authority (FCA), Andrew Bailey, in an interview to the BBC has identified the growing problem of debt among young people.

In his interview Mr Bailey stresses that the growth in debt amongst younger people is not ‘reckless borrowing’ and so not borne out of a lack of willpower or ‘present bias’ (see John’s blog Nudging mainstream economists). Rather, it is borrowing simply to meet basic living costs.

In his interview Mr Bailey goes on to identify generational shifts in patterns of wealth and debt. He notes:

There are particular concentrations [of debt] in society, and those concentrations are particularly exposed to some of the forms and practices of high cost debt which we are currently looking at very closely because there are things in there that we don’t like.

There has been a clear shift in the generational pattern of wealth and income, and that translates into a greater indebtedness at a younger age. That reflects lower levels of real income, lower levels of asset ownership. There are quite different generational experiences.

Mr Bailey goes on to echo concerns expressed back in July by the Prudential Regulation Authority in relation to the growth in consumer credit. The chart illustrates the scale of the accumulation of consumer credit (unsecured lending) across all individuals in the UK. In August 2017 the stock of unsecured debt rose to £203 billion, the highest level since December 2008 when the financial crisis was unfolding. (Click here to download a PowerPoint of the chart).

In concluding his BBC interview, Mr Bailey notes that credit should be available to younger people. Credit helps individuals to ‘smooth income’ and that this is something which is increasingly important with more people having erratic incomes as the gig-economy continues to grow. However, he notes that credit provision needs to be “sustainable”.

BBC Interview

Financial regulator warns of growing debt among young people BBC News (16/10/17)

Articles

Young people are borrowing to cover basic living costs, warns City watchdog Guardian, Julia Kollewe (16/10/17)
Britain’s debt time​bomb: FCA urges action over £200bn crisis Guardian, Phillip Inman and Jill Treanor (18/9/17)
FCA warning that young are borrowing to eat shames Britain Independent, James Moore (16/7/17)
Young people are ‘borrowing to cover basic living costs’ and increasing numbers are going bankrupt, warns financial watchdog Daily Mail, Kate Ferguson (6/10/17)
More and more young people are falling into debt – but it’s not their fault Metro, Alex Simpson (20/10/17)

Data

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

Questions

  1. What does it mean if people are financially distressed?
  2. What do you think Mr Bailey means by ‘sustainable credit’?
  3. In what ways might levels of debt impact on the macroeconomy?
  4. How does credit help to smooth spending patterns? Why might this be more important with the growth in the gig-economy?
  5. What is meant by inter-generational fairness?
  6. Of what relevance are changing patterns in wealth and debt to inter-generational fairness? What factors might be driving these patterns?
  7. What sort of credit is unsecured credit? How does it differ from secured credit?
  8. Are there measures that policymakers can take to reduce the likelihood that flows of credit become too excessive?

An economy that becomes dependent on credit can, in turn, become acutely volatile. Too much credit and there exists the potential for financial distress which can result in an economic slowdown as people cut back on spending. Too little credit and the growth in aggregate demand is subdued. Some argue that this is what now faces a financialised economy like the UK. Even it this overstates the significance of credit, there is no doubt that UK credit data is keenly followed by economists and policymakers.

Recent rates of credit accumulation by individuals have raised concern. In July 2014 the Prudential Regulation Authority (PRA) of the Bank of England issued a statement voicing its concern that the growth in consumer credit, also known as unsecured lending, was stretching the financial well-being of individuals and that the resilience of lenders’ consumer credit portfolios was therefore reducing.

Chart 1 illustrates the scale of the flows of both consumer credit (unsecured lending) and mortgages (secured credit) from banks and building societies to individuals. It shows the amount of credit net of repayments lent over the last 12 months. In the 12 months to July 2017 the net accumulation of consumer credit was £18.2 billion while that of secured borrowing was £40.8 billion. Although the 12-month level of consumer credit accumulation was down from its recent peak of £19.2 billion in November 2016, total net lending (including secured lending) to individuals of £59.0 billion was its highest since September 2008. (Click here to download a PowerPoint of the chart).

To help put in context the size of flows of net lending Chart 2 shows the annual flows of consumer credit and secured debt as percentages of GDP. In this case each observation measures net lending over the past four quarters as a percentage of annual GDP. The latest observation is for 2017 Q2 and shows that the annual net flow of consumer credit was equivalent to 0.94 per cent of GDP while that for secured borrowing was 1.78 per cent of GDP. While the flows of consumer credit and secured borrowing as shares of national income have eased a little from their values in the second half of last year, they have not eased significantly. (Click here to download a PowerPoint of the chart).

Despite the recent strength of borrowing, levels are nothing like those seen in the mid 2000s. Nonetheless, we need to see the current accumulation of debt in the context of two important factors: debt already accumulated and the future macroeconomic environment. Chart 3 gives some insight to the first of these two by looking at stocks of debt outstanding as shares of GDP. The total debt-to-GDP ratio peaked 90 percent in 2009 before relatively slower growth in credit accumulation saw the ratio fall back. The ratio has now been at or around the 78 per cent level consistently for the past two or so years. (Click here to download a PowerPoint of the chart).

The ratio of the stock of consumer debt to GDP peaked in 2008 at 13.3 per cent. It too fell back reaching 9.05 per cent in the middle of 2014. Since that time the ratio has been rising and by the end of the second quarter of this year was 10.1 per cent. The PRA appears not only to be concerned by this but also the likely unwinding of what it describes as the ‘current benign macroeconomic environment and historically low arrears rates’.

Going forward, we might expect to see ever closer scrutiny not only of the aggregate indicators referred to here but of an array of credit indicators. The PRA statement, for example, refers to the number of , ‘0% interest credit card offers’, falling interest rates on unsecured personal loans and the growth of motor finance loans. The hope is that we can avoid the costs of financial distress that so starkly affected the economy in the late 2000s and that continue to cast a shadow over today’s economic prospects.

PRA Statement

PRA Statement on Consumer Credit PRA, Bank of England (4/7/14)

Articles

Bank of England demands consumer credit vigilance; construction growth slows – as it happened Guardian (4/7/14)
Bank of England warns more defences may be needed against consumer credit Telegraph (24/7/17)
Beware the bubble: Bank of England clamps down on credit Telegraph, Tim Wallace (1/7/17)
Bank of England raises capital requirements on UK lenders amid concerns about excessive consumer borrowing Independent, Ben Chu (27/6/17)
Bank of England tightens mortgage borrowing rules amid fears of debt boom Express, Lana Clements (27/6/17)
Rise in personal loans dangerous, Bank of England official says BBC News (25/7/17)
Bank of England takes action over bad loans BBC News (27/6/17)

Data

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

Questions

  1. What does it mean if people are financially distressed? What responses might people take in response to this distress?
  2. How can financial distress affect the economy’s growth path?
  3. How would you measure the financial well-being of an individual? What about the financial well-being of firms?
  4. What role mights banks play in affecting levels of financial distress in the economy?
  5. What does it mean if credit conditions are pro-cyclical?
  6. Why might banks’ lending be pro-cyclical?
  7. Are there measures that policymakers can take to reduce the likelihood that flows of credit become too excessive?
  8. Why do some economists refer to the economic downturn of the late 2000s as a balance sheet recession? How likely is another balance sheet recession in the short term? What about in the longer term?

According to a new report, Time for Change published by the Institute for Public Policy Research (IPPR), ‘The British economic model needs fundamental reform.’

It is no longer generating rising earnings for a majority of the population, and young people today are set to be poorer than their parents. Beneath its headlines figures, the economy is suffering from deep and longstanding weaknesses, which make it unfit to face the challenges of the 2020s.

The report by the IPPR’s Commission on Economic Justice is an interim one, with the final report due in the latter part of next year. The commission was set up in 2016 and includes business leaders, such as the heads of John Lewis and Siemens, the TUC General Secretary, the Archbishop of Canterbury and other leading figures.

Commenting on the interim report, Justin Welby, the Archbishop of Canterbury said

Our economic model is broken. Britain stands at a watershed moment where we need to make fundamental choices about the sort of economy we need. We are failing those who will grow up into a world where the gap between the richest and poorest parts of the country is significant and destabilising

The report found that wages have stagnated for the majority of the population since the financial crisis of 2007/8. Wage income has fallen as a proportion of national income, while the proportions going to income from profits and property have risen. Young people are poorer than previous generations of young people.

Despite low unemployment, many people are on zero-hour contracts, part-time contracts or employed on a casual basis. For many, their jobs are insecure and they have no bargaining power.

The UK for many years has had a lower rate of investment that other developed economies and productivity, in terms of output per hour, is the lowest of its major competitors. Productivity in Germany is 36% higher than in the UK; in France and the USA it is 29% higher. Although there are some internationally competitive UK firms with high productivity, the country has:

a longer ‘tail’ of low-productivity businesses, in which weak management and poor use of skills leads to ‘bad jobs’ and low wages.

There are many other challenges, including an ageing population, uncertainties from Brexit, a large current account deficit, increased competition from abroad and growth once more in private-sector debt, which means that consumption may cease to be the main driver of economic growth as people seek to curb their borrowing.

The report is also critical of fiscal policy, which with record low interest rates could have been used to finance infrastructure projects as well as supporting public services.

The report recommends three approaches:

The first is institutional reform to support investment.

The second is making the economy more competitive through a coherent industrial strategy, reform of the financial sector to support long-term investment, reform of corporate governance to promote business success and tackling the market dominance of companies such as Amazon and Google.

The third is to bring greater social justice and equality through encouraging more secure and better-paid jobs, strengthening trades unions and reforming the tax system to make it fairer and smarter.

Not surprisingly the government has defended its record of reducing debt, presiding over falling unemployment and reduced inequality as measured by a reduced Gini coefficient. However, there has only been a modest fall in the Gini coefficient, from 0.333 in 2009/10 to 0.315 in 2016/7, and this has largely been the result of the very rich seeing a decline in income from assets.

Articles

Britain’s economy is broken and failing to tackle inequality, says major new report Independent, Ben Chu (6/9/17)
UK’s economic model is broken, says Archbishop of Canterbury The Guardian, Phillip Inman (5/9/17)
Tax wealth or see the UK tear itself apart, Cable will warn Bloomberg, Alex Morales and Thomas Penny (6/9/17)
Archbishop of Canterbury calls for radical economic reform BBC News (5/9/17)
Archbishop warns economy is “broken” as report reveals longest period of wage stagnation for 150 years Huffington Post, Rachel Wearmouth (6/9/17)
Britain’s economy is broken. We desperately need new ideas The Guardian, Tom Kibasi (4/6/17)
Carney: Britain is in the ‘first lost decade since the 1860s’, Business Insider, Oscar Williams-Grut (6/12/16)
Our broken economy, in one simple chart New York Times, David Leonhardt (7/8/16)

Report

Time for Change: A new Vision for the British Economy IPPR Commission on Economic Justice (6/9/17)

Questions

  1. Why have wages for the majority of the UK population stagnated for the past 10 years?
  2. Why is productivity in the UK lower than in most other developed economies?
  3. Is it possible for poor people to become poorer and yet for the Gini coefficient to fall?
  4. What institutional reforms would you suggest to encourage greater investment?
  5. Explain the possible advantages and disadvantages of abandoning ‘austerity policy’ and adopting a more expansionist fiscal stance?
  6. Does it matter that Amazon and Google are dominant players in their respective markets? Explain.