Category: Essentials of Economics: Ch 10

Would you like to be a millionaire? Of course you would – who wouldn’t, right? Actually the answer to this question may be more complicated than you might think (see for instance Sgroi et al (2017) on the economics of happiness: see linked article below), but, generally speaking, most people would answer positively to this question.

What if I told you, however, that you could become a millionaire (actually, scratch that – think big – make that “trillionaire”) overnight and be deeply unhappy about it? If you don’t believe me see what happened to Zimbabwe 10 years ago, when irresponsible money printing and fiscal easing drove the country’s economy to staggering hyperinflation (see the blogs A remnant of hyperinflation in Zimbabwe and Fancy a hundred trillion dollar note?. At the peak of the crisis, prices were increasing by a factor of 130 each year. I have in my office a 100 trillion Zimbabwean dollar note (see below) which I show in my lectures when I talk about hyperinflation to my first year Economics for Business students (if you are one of them, make sure not to miss it next February at UEA!). How much is this 100 trillion note worth? Nothing (except, may be, for collectors). It has been withdrawn from circulation as it ended up not even being worth the cost of the paper on which it was printed.

The Zimbabwean economy managed to pull itself out of this spiral of economic death, partly by informally replacing its hyperinflationary currency with the US greenback, and partly by keeping its fiscal spending under control and reverting to more sane economic policy making. That lasted until 2013, after which the government launched a Zimbabwean digital currency (known as “Zollar”) that had a nominal value set equal to a US dollar; and forced its exporters to exchange their greenbacks for Zollars. It then started spending these USD to finance a very ambitious and unsustainable programme of fiscal expansion.

The Economist published yesterday a story that shows the results of this policy – wild price increases and empty supermarket shelves are both back. According to the newspaper’s report:

At a supermarket in Harare, Zimbabwe’s capital, the finance minister is staring aghast at a pack of nappies. ‘This is absolutely ridiculous!’, exclaims Mthuli Ncube. ‘$49!’ A manager says it cost $23 two weeks ago, before pointing out other eye-watering items such as $20 Coco Pops. […] Over the past two weeks zollars have been trading at as little as 17 cents to the dollar. The devaluation has led to a surge in prices—and not just in imported goods like nappies. Football fans attending the Zimbabwe v Democratic Republic of Congo game on October 16th were shocked to learn that ticket prices had doubled on match day.

How long will it take for the 100 trillion Zollar to make its appearance again? We shall find out. I am sure Zimbabweans will be less than thrilled!

Articles and Report

Videos

Questions

  1. Using an AS/AD diagram, explain the concept of hyperinflation. How can irresponsible fiscal policy-making lead to hyperinflation?
  2. What are the effects of hyperinflation on the people who live in the affected countries? Search the web for examples and case studies, and use them to support your answer.
  3. Once it has started, what policies can be used to fight hyperinflation? Use examples to support your answer.
  4. How does speculation affect hyperinflation?

Ten years ago, the financial crisis deepened and stock markets around the world plummeted. The trigger was the collapse of Lehman Brothers, the fourth-largest US investment bank. It filed for bankruptcy on September 15, 2008. This was not the first bank failure around that time. In 2007, Northern Rock in the UK (Aug/Sept 2007) had collapsed and so too had Bear Stearns in the USA (Mar 2008).

Initially there was some hope that the US government would bail out Lehmans. But when Congress rejected the Bank Bailout Bill on September 29, the US stock market fell sharply, with the Dow Jones falling by 7% the same day. This was mirrored in other countries: the FTSE 100 fell by 15%.

At the core of the problem was excessive lending by banks with too little capital. What is more, much of the capital was of poor quality. Many of the banks held securitised assets containing ‘sub-prime mortgage debt’. The assets, known as collateralised debt obligations (CDOs), were bundles of other assets, including mortgages. US homeowners had been lent money based on the assumption that their houses would increase in value. When house prices fell, homeowners were left in a position of negative equity – owing more than the value of their house. With many people forced to sell their houses, prices fell further. Mortgage debt held by banks could not be redeemed: it was ‘sub-prime’ or ‘toxic debt’.

Response to the crisis

The outcome of the financial crash was a series of bailouts of banks around the world. Banks cut back on lending and the world headed for a major recession.

Initially, the response of governments and central banks was to stimulate their economies through fiscal and monetary policies. Government spending was increased; taxes were cut; interest rates were cut to near zero. By 2010, the global economy seemed to be pulling out of recession.

However, the expansionary fiscal policy, plus the bailing out of banks, had led to large public-sector deficits and growing public-sector debt. Although a return of economic growth would help to increase revenues, many governments felt that the size of the public-sector deficits was too large to rely on economic growth.

As a result, many governments embarked on a period of austerity – tight fiscal policy, involving cutting government expenditure and raising taxes. Although this might slowly bring the deficit down, it slowed down growth and caused major hardships for people who relied on benefits and who saw their benefits cut. It also led to a cut in public services.

Expanding the economy was left to central banks, which kept monetary policy very loose. Rock-bottom interest rates were then accompanied by quantitative easing. This was the expansion of the money supply by central-bank purchases of assets, largely government bonds. A massive amount of extra liquidity was pumped into economies. But with confidence still low, much of this ended up in other asset purchases, such as stocks and shares, rather than being spent on goods and services. The effect was a limited stimulation of the economy, but a surge in stock market prices.

With wages rising slowly, or even falling in real terms, and with credit easy to obtain at record low interest rates, so consumer debt increased.

Lessons

So have the lessons of the financial crash been learned? Would we ever have a repeat of 2007–9?

On the positive side, financial regulators are more aware of the dangers of under capitalisation. Banks’ capital requirements have increased, overseen by the Bank for International Settlements. Under its Basel II and then Basel III regulations (see link below), banks are required to hold much more capital (‘capital buffers’). Some countries’ regulators (normally the central bank), depending on their specific conditions, exceed these the Basel requirements.

But substantial risks remain and many of the lessons have not been learnt from the financial crisis and its aftermath.

There has been a large expansion of household debt, fuelled by low interest rates. This constrains central banks’ ability to raise interest rates without causing financial distress to people with large debts. It also makes it more likely that there will be a Minsky moment, when a trigger, such as a trade war (e.g. between the USA and China), causes banks to curb lending and consumers to rein in debt. This can then lead to a fall in aggregate demand and a recession.

Total debt of the private and public sectors now amounts to $164 trillion, or 225% of world GDP – 12 percentage points higher than in 2009.

China poses a considerable risk, as well as being a driver of global growth. China has very high levels of consumer debt and many of its banks are undercapitalised. It has already experienced one stock market crash. From mid-June 2015, there was a three-week fall in share prices, knocking about 30% off their value. Previously the Chinese stock market had soared, with many people borrowing to buy shares. But this was a classic bubble, with share prices reflecting exuberance, not economic fundamentals.

Although Chinese government purchases of shares and tighter regulation helped to stabilise the market, it is possible that there may be another crash, especially if the trade war with the USA escalates even further. The Chinese stock market has already lost 20% of its value this year.

Then there is the problem with shadow banking. This is the provision of loans by non-bank financial institutions, such as insurance companies or hedge funds. As the International Business Times article linked below states:

A mind-boggling study from the US last year, for example, found that the market share of shadow banking in residential mortgages had rocketed from 15% in 2007 to 38% in 2015. This also represents a staggering 75% of all loans to low-income borrowers and risky borrowers. China’s shadow banking is another major concern, amounting to US$15 trillion, or about 130% of GDP. Meanwhile, fears are mounting that many shadow banks around the world are relaxing their underwriting standards.

Another issue is whether emerging markets can sustain their continued growth, or whether troubles in the more vulnerable emerging-market economies could trigger contagion across the more exposed parts of the developing world and possibly across the whole global economy. The recent crises in Turkey and Argentina may be a portent of this.

Then there is a risk of a cyber-attack by a rogue government or criminals on key financial insitutions, such as central banks or major international banks. Despite investing large amounts of money in cyber-security, financial institutions worry about their vulnerability to an attack.

Any of these triggers could cause a crisis of confidence, which, in turn, could lead to a fall in stock markets, a fall in aggregate demand and a recession.

Finally there is the question of the deep and prolonged crisis in capitalism itself – a crisis that manifests itself, not in a sudden recession, but in a long-term stagnation of the living standards of the poor and ‘just about managing’. Average real weekly earnings in many countries today are still below those in 2008, before the crash. In Great Britain, real weekly earnings in July 2018 were still some 6% lower than in early 2008.

Articles

Information and data

Questions

  1. Explain the major causes of the financial market crash in 2008.
  2. Would it have been a good idea to have continued with expansionary fiscal policy beyond 2009?
  3. Summarise the Basel III banking regulations.
  4. How could quantitative easing have been differently designed so as to have injected more money into the real sector of the economy?
  5. What are the main threats to the global economy at the current time? Are any of these a ‘hangover’ from the 2007–8 financial crisis?
  6. What is meant by ‘shadow banking’ and how might this be a threat to the future stability of the global economy?
  7. Find data on household debt in two developed countries from 2000 to the present day. Chart the figures. Explain the pattern that emerges and discuss whether there are any dangers for the two economies from the levels of debt.

How much do you know about cryptocurrencies? Even if you don’t know much you are very likely to have heard about the most popular member of the family: Bitcoin. Bitcoin (BTC) has been around for some time now (see the blog Bubbling Bitcoin). It was first released in 2009 by its inventor (the mysterious Satoshi Nakamoto, whose real identity still remains unknown), and since then it has gradually increased in popularity.

According to the Bitcoin Market Journal (a specialised blog, commenting on trends in digital currencies – primarily Bitcoin), there are currently about 29 million digital wallets holding at least 0.001 BTC, although some individual users may own multiple wallets.

Although BTC is the most popular digital currency (and the first one to become widely recognisable), it is certainly not the only one. There are currently more than 400 recognisable cryptocurrencies traded in special digital exchanges (twice this number if you count smaller, less successful ones) with a total capitalisation of $700 billion at its peak (January 3, 2018) – although since then the market has lost a significant part of this value (but it’s still worth 100s of billion of US dollars).

If you have heard about Bitcoin before, chances are you first searched for it sometime between December 2017 and January 2018; that is when the value of Bitcoin soared to $20 000 a piece. A search on Google Trends (a Google utility that shows how many people have searched over a period of time for a certain term – in this case “Bitcoin”) shows this very clearly.

So what do people do with Bitcoin and other cryptocurrencies? The truth is that the majority of users use them for speculative purposes: they buy and sell them, in the hope of making a profit. Due to its extreme volatility (it is very common for the price of the larger cryptocurrencies to fluctuate by 10–20% daily) and the unregulated nature of the cryptocurrency market, it is hardly surprising that most users treat them as very high-risk commodity. This is also why digital currencies tend to attract attention (and new users) when their price soars.

However, cryptocurrencies are not only used for speculation. They can also be used to facilitate transactions. Indeed, according to Wikipedia, there are currently more than 100 000 merchants accepting BTC as a form of payment (online or offline with wallet readers). Financial technology (‘Fintech’) is catching up with this market and some new companies try to compete with the traditional payment networks (Mastercard, Visa and others) by launching plastic cards linked with crypto-wallets (primarily Bitcoin).

Santander bank has expressed an interest in exploring this market further. It is certain that if the market for cryptocurrencies keeps growing at this pace, there will be a lot more challenger fintech firms launching new products that will make it easier to use digital currencies in everyday life.

Cryptocurrencies, therefore, are likely to have a significant impact on the way we pay for our transactions. They can be used to lower transaction costs (e.g. by simplifying the process of sending money abroad), speed up the processing of payments, facilitate microfinancing and transactions in some of the poorest places on earth – where the closest bank may be 50 miles away or further from where people live).

But there is a dark side to these products. They have been linked to tax-evasion for instance, as many people who trade digital currencies fail to declare capital gains to national tax authorities. They can be used to overcome capital controls and other restrictions imposed by national governments (the case of Greece comes to mind as a recent example).

They have also been blamed for facilitating illegal trading activities, such as in drugs and weapons, due to the anonymity that some of these coins are thought to offer to their users – although quite often they are much easier to trace than their users believe.

Cryptocurrencies do have the potential to change the way we live. They also have the potential to become the biggest Ponzi scheme in the history of mankind.

Over the next few months, I will write a number of blogs to explore the literature on the economics of cryptocurrencies, and discuss some of the major challenges that needs to be overcome if this technology is to become mainstream.

Articles and information

Questions

  1. How much do you know about Bitcoin and other cryptocurrencies? When did you first find out about them and what triggered your interest?
  2. Would you be willing to accept payment in BTC? Why yes? Why no?
  3. Identify five ways in which the use of cryptocurrencies can benefit or damage the global economy.

On 8 February, the Bank of England issued a statement that was seen by many as a warning for earlier and speedier than previously anticipated increases in the UK base rate. Mark Carney, the governor of the Bank of England, referred in his statement to ‘recent forecasts’ which make it more likely that ‘monetary policy would need to be tightened somewhat earlier and by a somewhat greater extent over the forecast period than anticipated at the time of the November report’.

A similar picture emerges on the other side of the Atlantic. With labour markets continuing to deliver spectacularly high rates of employment (the highest in the last 17 years), there are also now signs that wages are on an upward trajectory. According to a recent report from the US Bureau of Labor Statistics, US wage growth has been stronger than expected, with average hourly earnings rising by 2.9 percent – the strongest growth since 2009.

These statements have coincided with a week of sharp corrections and turbulence in the world’s largest capital markets, as investors become increasingly conscious of the threat of rising inflation – and the possibility of tighter monetary policy.

The Dow Jones plunged from an all-time high of 26,186 points on 1 February to 23,860 a week later – losing more than 10 per cent of its value in just five trading sessions (suffering a 4.62 percentag fall on 5 February alone – the worst one-day point fall since 2011). European and Asian markets followed suit, with the FTSE-100, DAX and NIKKEI all suffering heavy losses in excess of 5 per cent over the same period.

But why should higher inflationary expectations fuel a sell-off in global capital markets? After all, what firm wouldn’t like to sell its commodities at a higher price? Well, that’s not entirely true. Investors know that further increases in inflation are likely to be met by central banks hiking interest rates. This is because central banks are unlikely to be willing or able to allow inflation rates to rise much above their target levels.

The Bank of England, for instance, sets itself an inflation target of 2%. The actual ongoing rate of inflation reported in the latest quarterly Inflation Report is 3% (50 per cent higher than the target rate).

Any increase in interest rates is likely to have a direct impact on both the demand and the supply side of the economy.

Consumers (the demand side) would see their cost of borrowing increase. This could put pressure on households that have accumulated large amounts of debt since the beginning of the recession and could result in lower consumer spending.

Firms (the supply side) are just as likely to suffer higher borrowing costs, but also higher operational costs due to rising wages – both of which could put pressure on profit margins.

It now seems more likely that we are coming towards the end of the post-2008 era – a period that saw the cost of money being driven down to unprecedentedly low rates as the world’s largest economies dealt with the aftermath of the Great Recession.

For some, this is not all bad news – as it takes us a step closer towards a more historically ‘normal’ equilibrium. It remains to be seen how smooth such a transition will be and to what extent the high-leveraged world economy will manage to keep its current pace, despite the increasingly hawkish stance in monetary policy by the world’s biggest central banks.

Video

Dow plunges 1,175 – worst point decline in history CNN Money, Matt Egan (5/2/18)

Articles

Global Markets Shed $5.2 Trillion During the Dow’s Stock Market Correction Fortune, Lucinda Shen (9/2/18)
Bank of England warns of larger rises in interest rates Financial Times, Chris Giles and Gemma Tetlow (8/2/18)
Stocks are now in a correction — here’s what that means Business Insider, Andy Kiersz (8/2/18)
US economy adds 200,000 jobs in January and wages rise at fastest pace since recession Business Insider, Akin Oyedele (2/2/18)

Questions

  1. Using supply and demand diagrams, explain the likely effect of an increase in interest rates to equilibrium prices and output. Is it good news for investors and how do you expect them to react to such hikes? What other factors are likely to influence the direction of the effect?
  2. Do you believe that the current ultra-low interest rates could stay with us for much longer? Explain your reasoning.
  3. What is likely to happen to the exchange rate of the pound against the US dollar, if the Bank of England increases interest rates first?
  4. Why do stock markets often ‘overshoot’ in responding to expected changes in interest rates or other economic variables

The UK is a productivity laggard. Compared to many developed countries over the recent past it has experienced weaker growth in output per worker and output per hour worked. This is detrimental to our longer-term well-being and to peoples’ living standards. An important contributory factor has been the weakness of growth in (non-financial) capital per worker. Recent ONS figures show that UK experienced a decline in capital per worker from 2012 to 2015, which was only ended in 2016.

Non-financial capital assets (also known as fixed assets) are defined as already-produced, durable goods or any non-financial asset used in the production of goods or services. This includes items such as dwellings, buildings, ICT, machinery and transport equipment.

Chart 1 shows the value of net capital assets in the UK since 1995. ‘Net’ figures account for the depreciation of assets and so reflect the market value of the capital stock. At the end of 2016 the net capital stock was estimated at £7.54 trillion (at 2015 prices) compared to £4.94 trillion (at 2015 prices) in 1995, an increase of 53 per cent or about 2.4 per cent per year.

However, as the chart shows, the rate of growth slowed markedly following the financial crisis of the late 2000s, averaging a mere 0.8 per cent per year since 2010. (Click here for a Powerpoint of the chart).

Capital intensity can be measured by the amount of capital per employee. Capital intensity is important because the growth in net capital per employee impacts on productivity. Its growth has an impact on the current effectiveness of capital and labour in production and on the future growth in potential output per employee.

Chart 2 shows that, following the financial crisis, falling employment levels temporarily boosted the growth in net capital per employee. Then, as employment levels recovered and began growing again, the weakness in investment meant that net capital per employee began to fall.

In 2016, as employment growth slowed, the now stronger flows of investment meant that, for the first time since 2011, net capital per employee was finally rising again. (Click here for a PowerPoint of the chart).

The persistent weakness experienced by UK in the growth of capital intensity in the 2010s is a drag on productivity and on supply-side growth. The weakness of UK productivity growth looks like remaining for some time one of the biggest economic challenges facing policymakers. Productivity needs its capital.

Articles

UK business investment on ice until more Brexit progress, warns BCC The Guardian, Richard Partington (11/12/17)
Budget 2017: Can Digital Plug The UK’s Productivity Gap? Hufttington Post, William Newton (27/11/17)
UK productivity estimates must be ‘significantly’ lowered, admits OBR The Guardian, Richard Partington and Phillip Inman (13/12/17)
UK productivity sees further fall BBC News (6/10/17)

Data

Capital stocks, consumption of fixed capital in the UK: 2017 ONS

Questions

  1. How might we measure productivity?
  2. Compose a list of items that are examples of non-financial (or fixed) capital.
  3. How can the growth of non-financial (or fixed) capital affect productivity?
  4. What is meant by capital intensity? Why is this concept important for long-term growth?
  5. What factors might affect the rate of capital accumulation? Are there interventions that governments can make to impact on the rate of capital accumulation?
  6. Discuss the possible reasons why the UK has become a productivity laggard.