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.
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.
- The Lehman Brothers Crash And The Chaos That Followed – Everything You Need To Know
HuffPost, Isabel Togoh (15/9/18)
- Ten years after the crash: have the lessons of Lehman been learned?
The Guardian, Yanis Varoufakis, Ann Pettifor, Mark Littlewood, David Blanchflower, Olli Rehn, Nicky Morgan and Micah White (14/9/18)
- Financial crisis 10 years on: Who are the winners and losers?
Independent, Kate Hughes (14/9/18)
- Investment winners and losers 10 years after the crash
Financial Times, Kate Beioley (14/9/18)
- Nine Lessons From the Global Financial Crisis
Bloomberg, Mohamed A. El-Erian (13/9/18)
- Lehman — why we need a change of mindset
Deutsche Welle, Thomas Straubhaar (14/9/18)
- ‘The world is sleepwalking into a financial crisis’ – Gordon Brown
The Guardian, Larry Elliott (12/9/18)
- Economists warn of new financial crisis on anniversary of 2008 crash
Channel 4 news, Helia Ebrahimi (15/9/18)
- Financial crisis 2008: Five biggest risks of a new crash
International Business Times, Nafis Alam (14/9/18)
- Carney warns against complacency on 10th anniversary of financial crisis
BBC News, Kamal Ahmed (12/9/18)
- A cyberattack could trigger the next financial crisis, new report says
CNBC, Bob Pisani (13/9/18)
Information and data
- Explain the major causes of the financial market crash in 2008.
- Would it have been a good idea to have continued with expansionary fiscal policy beyond 2009?
- Summarise the Basel III banking regulations.
- How could quantitative easing have been differently designed so as to have injected more money into the real sector of the economy?
- 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?
- What is meant by ‘shadow banking’ and how might this be a threat to the future stability of the global economy?
- 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.
The last two weeks have been quite busy for macroeconomists, HM Treasury staff and statisticians in the UK. The Chancellor of the Exchequer, Mr Phillip Hammond, delivered his (fairly upbeat) Spring Budget Statement on 13 March, highlighting among other things the ‘stellar performance’ of UK labour markets. According to a Treasury Press Release:
Employment has increased by 3 million since 2010, which is the equivalent of 1,000 people finding work every day. The unemployment rate is close to a 40-year low. There is also a joint record number of women in work – 15.1 million. The OBR predict there will be over 500,000 more people in work by 2022.
To put these figures in perspective, according to recent ONS estimates, in January 2018 the rate of UK unemployment was 4.3 per cent – down from 4.4 per cent in December 2017. This is the lowest it has been since 1975. This is of course good news: a thriving labour market is a prerequisite for a healthy economy and a good sign that the UK is on track to full recovery from its 2008 woes.
The Bank of England welcomed the news with a mixture of optimism and relief, and signalled that the time for the next interest rate hike is nigh: most likely at the next MPC meeting in May.
But what is the practical implication of all this for UK consumers and workers?
For workers it means it’s a ‘sellers’ market’: as more people get into employment, it becomes increasingly difficult for certain sectors to fill new vacancies. This is pushing nominal wages up. Indeed, UK wages increased on average by 2.6 per cent year-to-year.
In real terms, however, wage growth has not been high enough to outpace inflation: real wages have fallen by 0.2 per cent compared to last year. Britain has received a pay rise, but not high enough to compensate for rising prices. To quote Matt Hughes, a senior ONS statistician:
Employment and unemployment levels were both up on the quarter, with the employment rate returning to its joint highest ever. ‘Economically inactive’ people — those who are neither working nor looking for a job — fell by their largest amount in almost five and a half years, however. Total earnings growth continues to nudge upwards in cash terms. However, earnings are still failing to outpace inflation.
An increase in interest rates is likely to put further pressure on indebted households. Even more so as it coincides with the end of the five-year grace period since the launch of the 2013 Help-to-Buy scheme, which means that many new homeowners who come to the end of their five year fixed rate deals, will soon find themselves paying more for their mortgage, while also starting to pay interest on their Help-to-buy government loan.
Will wages grow fast enough in 2018 to outpace inflation (and despite Brexit, which is now only 12 months away)? We shall see.
Data, Reports and Analysis
- What is monetary policy, and how is it used to fine tune the economy?
- What is the effect of an increase in interest rates on aggregate demand?
- How optimistic (or pessimistic) are you about the UK’s economic outlook in 2018? Explain your reasoning.
In three interesting articles, linked below, the authors consider the state of economies since the financial crisis of 2007–8 and whether governments have the right tools to tackle future economic shocks.
There have been some successes over the past 10 years, in particular keeping inflation close to central bank targets despite considerable shocks (see the Vox article). Also unemployment has fallen in most countries and to very low levels in some, including the UK.
But economic growth has generally remained well below the levels prior to the financial crisis, with low productivity growth being the main culprit. Indeed, many people have seen no growth at all in their real incomes over the past 10 years, with low unemployment being bought at the cost of a growth in zero-hour contracts and work in the gig economy. And what economic growth we have seen has been largely the result of taking up slack through unprecedentedly loose monetary policy.
Fiscal policy, except in the period directly following the financial crisis, has generally been tight as governments have sought to reduce their deficits and slow down the growth in their debt.
But what will happen if economies once more slow? Or, worse still, what will happen if there is another global recession? Do countries have the policies to tackle the problem this time round?
Quantitative easing could be used again, but many economists believe that it will have more limited scope if confined to the purchase of assets in the secondary market. Also, there is little scope for reducing interest rates, which, despite some modest rises in the USA, remain at close to zero in most developed countries.
One possibility is a combination of monetary and fiscal policy, where new money is used to finance government expenditure on infrastructure, such as road and rail, broadband, green energy, hospitals and schools and colleges. This would avoid the need for governments to borrow on open markets as the spending would be financed by new government securities purchased directly by the central bank.
An objection to such ‘people’s quantitative easing‘, as it has been dubbed, is that it would effectively end the independence of central banks. This independence has been credited by many with giving central banks credibility in controlling inflation. Would inflationary expectations rise with people’s quantitative easing and, with it, actual inflation? A lot would depend on the extent to which this QE could still be conducted within a framework of targeting inflation and whether people’s expectations of inflation could be managed jointly by the government and central bank.
How should recessions be fought when interest rates are low? The Economist. Free exchange (21/10/17)
The economy is failing. We need to think radically about how to fix it The Guardian, Liam Byrne (25/10/17)
Elusive inflation and the Great Recession Vox, David Miles, Ugo Panizza, Ricardo Reis, Ángel Ubide (25/10/17)
Economics since the crisis Vox on YouTube. Charles Goodhart (11/10/17)
Is the system broken? Vox on YouTube, Anat Admati (12/10/17)
Signs of a crisis Vox on YouTube, Christian Thimann (19/10/17)
Policy stances since 2007 Vox on YouTube, Paul Krugman (29/10/17)
Did policymakers get it right? Vox on YouTube, Paul Krugman (4/10/17)
- Why, during the next recession, will the “zero lower bound” (ZLB) on interest rates almost certainly bite again?
- Why would the scope for QE, as conducted up to now, be more limited in the future if a recession were to occur?
- Why have central banks appeared to have been so successful in keeping inflation close to target despite negative and positive demand- and supply-side shocks?
- Why are the pressures on government expenditure likely to increase in the coming years?
- How would a temporary price-level target help to tackle a recession when the economy next bumps into the ZLB? What would limit its success?
- Is it appropriate for central banks to stick to an inflation target in times when there is an adverse supply-side shock resulting in cost-push inflation?
- Why might monetary policy conducted in a framework of inflation targeting tend to lessen the impact of a fiscal stimulus?
- What are the arguments for and against relaxing central bank independence and pursuing a co-ordinated fiscal and monetary policy?
- What are the arguments for and against using helicopter money to boost private expenditure during a future recession where interest rates are already near the ZLB?
- What are the arguments for and against using ‘people’s QE’?
The latest edition of the IMF’s Fiscal Monitor, ‘Tackling Inequality’ challenges conventional wisdom that policies to reduce inequality will also reduce economic growth.
While some inequality is inevitable in a market-based economic system, excessive inequality can erode social cohesion, lead to political polarization, and ultimately lower economic growth.
The IMF looks at three possible policy alternatives to reduce inequality without damaging economic growth
The first is a rise in personal income tax rates for top earners. Since top rates have been cut in most countries, with the OECD average falling from 62% to 35% over the past 30 years, the IMF maintains that there is considerable scope of raising top rates, with the optimum being around 44%. Evidence suggests that income tax elasticity is low at most countries’ current top rates, meaning that a rise in top income tax rates would only have a small disincentive effect on earnings.
An increased progressiveness of income tax should be backed by sufficient taxes on capital to prevent income being reclassified as capital. Different types of wealth tax, such as inheritance tax, could also be considered. Countries should also reduce the opportunities for tax evasion.
The second policy alternative is a universal basic income for all people. This could be achieved by various means, such as tax credits, child benefits and other cash benefits, or minimum wages plus benefits for the unemployed or non-employed.
The third is better access to health and education, both for their direct effect on reducing inequality and for improving productivity and hence people’s earning potential.
In all three cases, fiscal policy can help through a combination of taxes, benefits and public expenditure on social infrastructure and human capital.
But a major problem with using increased tax rates is international competition, especially with corporation tax rates. Countries are keen to attract international investment by having corporation tax rates lower than their rivals. But, of course, countries cannot all have a lower rate than each other. The attempt to do so simply leads to a general lowering of corporation tax rates (see chart in The Economist article) – to a race to the bottom. The Nash equilibrium rate of such a game is zero!
Raising Taxes on the Rich Won’t Necessarily Curb Growth, IMF Says Bloomberg, Ben Holland and Andrew Mayeda (11/10/17)
The Fiscal Monitor, Introduction IMF (October 2017)
Transcript of the Press Conference on the Release of the October 2017 Fiscal Monitor IMF (12/10/17)
Higher taxes can lower inequality without denting economic growth The Economist, Buttonwood (19/10/17)
Trump says the US has the highest corporate tax rate in the world. He’s wrong. Vox, Zeeshan Aleem (31/8/17)
Reducing inequality need not hurt growth Livemint, Ajit Ranade (18/10/17)
IMF: higher taxes for rich will cut inequality without hitting growth The Guardian, Larry Elliott and Heather Stewart (12/10/17)
IMF Fiscal Monitor
IMF Fiscal Monitor: Tackling Inequality – Landing Page IMF (October 2017)
Opening Remarks of Vitor Gaspar, Director of the Fiscal Affairs Department at a Press Conference Presenting the Fall 2017 Fiscal Monitor: Tackling Inequality IMF (11/10/17)
Fiscal Monitor, Tackling Inequality – Full Text IMF (October 2017)
- Referring to the October 2017 Fiscal Monitor, linked above, what arguments does the IMF use for suggesting that the optimal top rate of income tax is considerably higher than the current OECD average?
- What are the arguments for introducing a universal basic income? Should this depend on people’s circumstances, such as the number of their children, assets, such as savings or property, and housing costs?
- Find out the details of the UK government’s Universal Credit. Does this classify as a universal basic income?
- Why may governments reject the IMF’s policy recommendations to tackle inequality?
- In what sense can better access to health and education be seen as a means of reducing inequality? How is inequality being defined in this case?
- Find out what the UK Labour Party’s policy is on rates of income tax for top earners. Is this consistent with the IMF’s policy recommendations?
- What does the IMF report suggest about the shape of the Laffer curve?
- Explain what is meant by tax elasticity and how it relates to the Laffer curve?
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.
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)
Time for Change: A new Vision for the British Economy IPPR Commission on Economic Justice (6/9/17)
- Why have wages for the majority of the UK population stagnated for the past 10 years?
- Why is productivity in the UK lower than in most other developed economies?
- Is it possible for poor people to become poorer and yet for the Gini coefficient to fall?
- What institutional reforms would you suggest to encourage greater investment?
- Explain the possible advantages and disadvantages of abandoning ‘austerity policy’ and adopting a more expansionist fiscal stance?
- Does it matter that Amazon and Google are dominant players in their respective markets? Explain.