A constant feature of the UK economy (and of many other Western economies) has been record low interest rates. Since March 2009, Bank Rate has stood at 0.5%. Interest rates have traditionally been used to keep inflation on target, but more recently their objective has been to stimulate growth. However, have these low interest rates had a negative effect on the business environment?
Interest rates are a powerful tool of monetary policy and by affecting many of the components of aggregate demand, economic growth can be stimulated. This low-interest rate environment is an effective tool to stimulate consumer spending, as it keeps borrowing costs low and in particular can keep mortgage repayments down. However, this policy has been criticised for the harm it has been doing to savers – after all, money in the bank will not earn an individual any money with interest rates at 0.5%! Furthermore, there is now a concern that such low interest rates have led to ‘zombie companies’ and they are restricting the growth potential and recovery of the economy.
A report by the Adam Smith Institute suggests that these ‘zombie companies’ have emerged in part by the low-interest environment and are continuing to absorb resources, which could otherwise be re-allocated to companies with more potential, productivity and a greater contribution to the economic recovery. During a recession, there will undoubtedly be many business closures, as aggregate demand falls, sales and profits decline until eventually the business becomes unviable and loans cannot be repaid. Given the depth and duration of the recent recessionary period, the number of business closures should have been very large. However, the total number appears to be relatively low – around 2% or 100,000 and the report suggests that the low interest rates have helped to ‘protect’ them.
Low interest rates have enabled businesses to meet their debt repayments more easily and with some banks being unwilling to admit to ‘bad loans’, businesses have benefited from loans being extended or ‘rolled over’. This has enabled them to survive for longer and as the report suggests, may be preventing a full recovery. The report’s author, Tom Papworth said:
Low interest rates and bank forbearance represent a vast and badly targeted attempt to avoid dealing with the recession. Rather than solving our current crisis, they risk dooming the UK to a decade of stagnation … We tend to see zombies as slow-moving and faintly laughable works of fiction. Economically, zombies are quite real and hugely damaging, and governments and entrepreneurs cannot simply walk away.
The problem they create is that resources are invested into these companies – labour, capital, innovation. This creates an opportunity cost – the resources may be more productive if invested into new companies, with greater productive potential. The criticism is that the competitiveness of the economy is being undermined by the continued presence of such companies and that this in turn is holding the UK economy back. Perhaps the interest rate rise that may happen this time next year may be what is needed to encourage the re-allocation of capital. However, a 0.5 percentage point rise in interest rates would hardly be the end of the world for some of these companies. Perhaps a more focused approach looking at restructuring is the key to their survival and the allocation of resources to their most productive use. The following articles and the report itself consider the case of the trading dead.
Report
The Trading Dead The Adam Smith Institute, Tom Papworth November 2013
Articles
Zombie firms threaten UK’s economic recovery, says thinktank The Guardian, Gyyn Topam (18/11/13)
Zombie companies ‘probably have no long term future’ BBC News (18/11/13)
Rate rise set to put stake through heart of zombie companies Financial Times, Brian Groom (14/11/13)
Why we can still save the zombie firms hindering the UK economic rival City A.M., Henry Jackson (18/11/13)
Breathing new life into zombies The Telegraph, Rachel Bridge (9/11/13)
Questions
- Which components of aggregate demand are affected (and how) by low interest rates?
- Why do low interest rates offer ‘protection’ to vulnerable businesses?
- How is the reallocation of resources relevant in the case of zombie companies?
- If interest rates were to increase, how would this affect the debts of vulnerable businesses? Would a small rate irse be sufficient and effective?
- What suggestions does the report give for zombie companies to survive and become more productive?
- Is there evidence of zombie companies in other parts of the world?
UK Supermarkets: a prime example of an oligopoly. This industry is highly competitive and over the past decade, but particularly since the onset of the credit crunch, price wars have been a constant feature of this market. You could barely watch a full programme on commercial TV without seeing one of the big supermarkets advertising that their prices were lower than everyone else’s! So, despite oligopoly being towards the ‘least competitive’ end of the market structure spectrum, this is an example of just how competitive the market can actually be.
With household incomes being squeezed, in particular by another oligopolistic industry (energy) and with the ‘middle market’ being pinched by higher-end retailers and budget retailers, the supermarket sector is facing uncertain times. Asda’s sales growth has continued to slow and in response, the giant supermarket chain will be launching a £1 billion price-cutting campaign. Tesco is the market leader, but Sainsbury’s and Asda have been battling over the second spot. One of Asda’s selling points is its low prices. Perhaps not as low as Aldi and Lidl, but this new pricing strategy will aim to bring its prices further below Tesco, Sainsbury’s and Morrisons and
close the gap with the two big discount supermarkets. As Andy Clarke, Asda’s Chief Executive, said:
We regard ourselves as the UK’s leading value retailer and it is against this backdrop that I have today set out our strategic priorities which will improve, extend and expand the business over the next five years.
So, what will be the impact of lower prices? It appears as though Asda is marketing itself towards the budget end of the pricing spectrum, perhaps aiming to become fiercer competitors with Aldi and Lidl and let Tesco and Sainsbury’s do battle with the higher-end retailers, such as Waitrose and Marks and Spencer. Lower prices should cause a substitution effects towards Asda’s products, as many of them will have relatively price elastic demand. If the other supermarkets don’t respond, this should lead to sales growth. However, the key to an oligopoly is interdependence: the actions of one firm will affect all other firms in the market. The implications then, are that Tesco may react to this pricing strategy by engaging in its own price cuts, especially as the Christmas period approaches. The characteristic of interdependence was evident in the aftermath of Asda’s announcement when shares in Tesco and Morrisons both fell, showing how the markets were responding.
Of course, there are many other factors that affect a consumer’s decision as to whether to shop at Asda, Tesco or any other big supermarket. In the area where I live, we have a Tesco and a Morrisons (a few years ago, we had neither!). I don’t shop at Asda, as the nearest branch is over 30 miles away – even if prices were significantly lower, it would be more expensive to get there and back and a lot less convenient. For others, it may be loyalty and not just of the ‘I’ve shopped there all my life’ kind! For some, clubcard vouchers from Tesco may be preferred to Asda’s offerings and thus tiny price differences between the supermarkets may have little effect on a consumer’s decision as to where to shop. Many products at supermarkets are relatively cheap and thus as the proportion of our income that we spend on these goods is pretty low, any change in price doesn’t cause much of an effect on our demand.
It’s not just a pricing strategy where money is being invested by Asda. More investment will be going into their online services and more stores will be created, kin particular in London and the South East where their presence is low, but demand appears to be high. Improving ‘product quality, style and design’ will also be on the agenda, all with the aim of boosting sales growth and securing its position as the second largest retailer in the sector, perhaps with a long term aim of one day overtaking Tesco. The following articles consider the supermarket battleground.
Supermarket battle heats up as Asda announces £1bn price-cutting plan The Telegraph, Graham Ruddick (14/11/13)
Sainsbury’s profits make it second biggest supermarket BBC News (13/11/13)
Asda to launch £1bn price-cut plan AOL, Press Association (15/11/13)
Asda takes fight to rivals with £1bn investment plan The Guardian, Angela Monaghan (14/11/13)
UK’s Asda promises £1 billion investment in price cuts Reuters (14/11/13)
Asda makes bid to woo shoppers with vow of five-year £1billion price war after it was overtaken in market share by Sainsbury’s Mail Online, Sean Poulter (15/11/13)
Sainsbury’s overtakes Asda on demand for its premium lines Independent, Simon Neville (14/11/13)
Asda to put £1bn into lowering prices over five years The Grocer, Thomas Hobbs (14/11/13)
Wal-Mart posts $3.7bn quarterly income BBC News (14/11/13)
Questions
- What are the key characteristics of an oligopoly?
- What is meant by a price war? Who benefits?
- How important is the concept of price elasticity of demand when deciding whether or not to cut the price of a range of products?
- Why is the proportion of income spent on a good a key determinant of the elasticity of demand of a product?
- How can market share be calculated?
- Many suggest that the ‘middle market’ of the supermarket sector is slowly disappearing. Why is this?
- How effective will Asda’s price cutting strategy be? Which factors will determine its effectiveness?
A remarkable event took place in Venezuela on Friday 8th November. Soldiers, on the orders of the president, temporarily occupied a chain of shops run by a leading electrical retailer called Dakar. The shops were forced to cut the prices of their electrical appliances and five managers were arrested and accused of ‘hiking up’ prices.
Unsurprisingly, news of these lower prices spread very quickly and long queues rapidly appeared outside the stores as people hoped to buy plasma televisions, fridges and washing machines at bargain prices. On Sunday 9th November, the president, Nicolas Maduro, gave a televised address in which he condemned the owners of the stores and announced that he was going to ask the National Assembly to grant him extra powers so that he could extend price controls to all consumer goods. He stated that he would next turn his attention to stores selling toys, cars, textiles and shoes.
The use of price controls in Venezuela is not new and dates back to 2003 when they were first introduced by the then president Hugo Chavez. Initially the regulations were imposed on various foods and basic goods. For example, by 2009 maximum prices had been set for cooking oil, white rice, sugar, coffee, flour, margarine, pasta and cheese. Businesses often complained that the maximum prices set by the government were below the costs of production. For example after a maximum price of 2.15 Bolivares was placed on a kilo of rice, producers argued that the cost of producing a kilo of rice was 4.41 Bolivares.
The impact of the maximum prices in Venezuela appears to have been exactly what the theories in the economics textbooks would have predicted – shortages, long queues of people waiting outside shops and a flourishing black market. An article on the shortage of toilet rolls has been discussed in a previous article on this news site: Shortages in Venezuela- what’s the solution? However this has not stopped the Venezuelan government extending the scheme and increasing the number of products that have maximum prices imposed on them. In 2011 Hugo Chavez argued that the policy was required because:
The market has…become a perverse mechanism where big monopolies, the big trans-nationals and the bourgeoise dominate and ransack the people.
Economics textbooks often include some analysis of the impact of price ceilings on a competitive market. The effects on consumer surplus, producer surplus and deadweight welfare are usually discussed. However the potential administrative costs are rarely considered. The Venezuelan case helps to illustrate how in practise these costs could be quite significant.
For example, in April 2012 price controls in Venezuela were extended to a range of 19 products including fruit juice, toilet paper, nappies, soap, detergent, deodorant, toothpaste, baby food, floor polish, mineral water and razor blades. This caused a reduction in prices of between 4% and 25%. However this did not simply mean setting 19 different maximum prices because the goods were all sold in different quantities or different package sizes. For example a tube of toothpaste could be purchased in 4 different sizes – 50ml, 75ml, 100ml and 150 ml. Therefore officials had to set 4 different figures. Nappies were sold in 12 different package sizes ranging from10 nappies/packet to78 nappies/packet. Once again this meant that the administrators had to set 10 different maximum prices just for nappies. In total across the 19 products government officials had to set prices for 616 different individual items!! Companies were given just one month to adjust to the new legislation.
Whenever maximum prices are imposed on a competitive market both frustrated buyers and sellers have an incentive to evade them and trade illegally. Therefore the government established a number of organisations in an attempt to make sure the prices were enforced. One agency is called The National Superintendency of Fair Costs and Prices or Sundecop. Officials from this agency were sent out to 82 retail outlets in April 2012 to try to make sure that firms were sticking to the new regulated prices. They also printed and handed out leaflets to the public informing them of the changes. Another agency is called ‘The Institute for the Defense of People’s Access to Goods and Services’ or ‘Indepabis’. This organisation launched a new strategy in June 2012 in order to monitor compliance. This included the creation of a network called the Friends of Indepabis which would act as an information point for members of the public to report illegal pricing. A new complaints phone line was also introduced.
If president Maduro is granted the power to extend maximum prices to all consumer products, then one can only begin to imagine the extra administrative costs involved with implementing the policy.
Venezuelan president Maduro ‘to expand price controls’ BBC News (11/11/13)
Venezuela sends in troops to force electronics chain to charge ‘fair’ prices NBC News (13/11/13)
Venezuela appliances crackdown spurs uncertainty ABC news (13/11/13)
Venezuela’s government seizes electronic goods shops BBC News (9/11/13)
Venezuelan government sends TROOPS into electronics chain to force them to sell goods at a “fair price” DailyMirror (10/11/13)
Shocher: Price Controls Lead to Shortages in Venezuela Free Advice, Robert Murphy (2/10/13)
Venezuelan Government Action against Overpricing Welcomed by Citizens, Manipulated by Media venezuelanalysis (12/11/13).
Questions
- Explain why a maximum price imposed on a competitive market might generate a shortage. Draw a diagram to illustrate and explain your answer.
- Are there any circumstances when a maximum price would not cause a shortage in a competitive market?
- Analyse the impact of a maximum price on consumer surplus, producer surplus and deadweight welfare loss. Assume the market is competitive and clearly state any other assumptions you have made in your analysis. Comment on the impact of the price ceiling on economic efficiency.
- Illustrate and explain what would happen to consumer surplus and deadweight welfare loss if the available goods for sale were only purchased by the consumers with the lowest willingness to pay.
- Why might a maximum price lead to a flourishing black market?
- The former president, Hugo Chavez, argued that the price regulations were required because “big monopolies… ransack the people”. Using economic theory discuss this statement. Examine the impact of a maximum price on a pure monopoly.
The Consumer Prices index (CPI) measures the rate of inflation and in October, this rate fell to 2.2%, bringing inflation to its lowest level since September 2012. For many, this drop in inflation came as a surprise, but it brings the rate much closer to the Bank of England’s target and thus reduces the pressure on changing interest rates.
The CPI is calculated by calculating the weighted average price of a basket of goods and comparing how this price level changes from one month to the next. Between September and October prices across a range of markets fell, thus bringing inflation to its lowest level in many months. Transport prices fell by their largest amount since mid-2009, in part driven by fuel price cuts at the big supermarkets and this was also accompanied by falls in education costs and food. The Mail Online article linked below gives a breakdown of the sectors where the largest price falls have taken place. One thing that has not yet been included in the data is the impact of the price rises by the energy companies. The impact of his will obviously be to raise energy costs and hence we can expect to see an impact on the CPI in the coming months, once the price rises take effect.
With inflation coming back on target, pressures on the Bank of England to raise interest rates have been reduced. When inflation was above the target rate, there were concerns that the Bank of England would need to raise interest rates to cut aggregate demand and thus bring inflation down.
However, the adverse effect of this would be a potential decline in growth. With inflation falling to 2.2%, this pressure has been removed and hence interest rates can continue to remain at the record low, with the objective of stimulating the economy. Chris Williamson from Markit said:
The easing in the rate of inflation and underlying price pressures will provide greater scope for monetary policy to be kept looser for longer and thereby helping ensure a sustainable upturn in the economy … Lower inflation reduces the risk of the Bank of England having to hike rates earlier than it may otherwise prefer to, allowing policy to focus on stimulating growth rather than warding off rising inflationary pressures.
The lower rate of inflation also has good news for consumers and businesses. Wages remain flat and thus the reduction in the CPI is crucial for consumers, as it improves their purchasing power. As for businesses, a low inflation environment creates more certainty, as inflation tends to be more stable. Businesses are more able to invest with confidence, again benefiting the economy. Any further falls in the CPI would bring inflation back to its target level of 2% and then undoubtedly concerns will turn back to the spectre of deflation, though with the recent announcements in energy price rises, perhaps we’re getting a little ahead of ourselves! Though we only need to look to countries such as Spain and Sweden where prices are falling to realise that it is certainly a possibility. The following articles consider the data and the impact.
UK inflation falls in October: what the economists say The Guardian, Katie Allen (12/11/13)
British inflation hits 13-month low, easing pressure on central bank Reuters, David Milliken and William Schomberg (12/11/13)
UK inflation falls to 2.2% in October BBC News (1211/13)
UK inflation falls to 13-month low: reaction The Telegraph (12/11/13)
Fall in inflation to 2.2% welcome by government The Guardian, Katie Allen (12/11/13)
Inflation falls to lowest level for a year as supermarket petrol price war helps ease the squeeze on family finances Mail Online, Matt Chorley (12/11/13)
Inflation falls to its lowest level for more than a year as consumers benefit from petrol pump price war Independent, John-Paul Ford Rojas (12/11/13)
UK inflation slows to 2.2%, lowest level in a year Bloomberg, Scott Hamilton and Jennifer Ryan (12/11/13)
Are we facing deflation? Let’s not get carried away The Telegraph, Jeremy Warner (12/11/13)
Questions
- How is the CPI calculated?
- Use an AD/AS diagram to illustrate how prices have been brought back down. Is the reduction in inflation due to demand-side or supply-side factors?
- What are the benefits of low inflation?
- The Telegraph article mentions the possibility of deflation. What is deflation and why does it cause such concern?
- Explain why a fall in the rate of inflation eases pressure on the Bank of England.
- How does the rate of inflation affect the cost of living?
- Is a target rate of inflation a good idea?
Nearly two years ago, France lost its triple A credit-rating and the news has only got worse. Unemployment has risen and economic growth in France has remained low and this is one of the reasons why France’s credit rating has been downgraded further from AA+ to AA. A high credit rating doesn’t guarantee market confidence, but it does help to keep the cost of borrowing for the government low. Thus, this downgrading could spell trouble for French borrowing costs.
Standard and Poor’s (S&P), who downgraded the French credit rating, is expecting government debt to rise to 86% of gross domestic product and believes that unemployment will remain above 10% until 2016. While the French government has put various reforms in place to boost the struggling economy, S&P don’t believe they are sufficient and have been very public in criticising the government’s effort. They were quoted as saying:
We believe the French government’s reforms to taxation, as well as to product, services and labour markets, will not substantially raise France’s medium-term growth prospects and that on-going high unemployment is weakening support for further significant fiscal and structural policy measures.
Following the downgrading, the return for those investors purchasing French debt did begin to rise, echoing the theory that the cost of borrowing would rise. 
The yield on French government 10-year bonds increased from 2.158% to 2.389%. The outlook given to France by S&P was ‘stable’, implying that there is a relatively low chance that S&P would change France’s credit-rating again in the next two years.
Many were surprised at the downgrading of France’s credit rating, but this may be the nudge that President Hollande needs to push through extensive labour market reforms with the aim of reducing unemployment and generating growth in the economy. Despite this latest move by S&P, the other credit rating agencies have yet to take similar action. Perhaps they are more convinced by the Finance Minister, Pierre Moscovici who claims that France’s debt is ‘one of the safest and most liquid in the world.’ He commented that:
They are underestimating France’s ability to reform, to pull itself up … During the last 18 months the government has implemented major reforms aimed at improving the French economic situation, restoring its public finances and its competitiveness.
It will take some time for the full impact of this development in France’s economy to become apparent. The cost of borrowing has already risen only time will tell what will happen to market confidence over the coming weeks. However, what is certain is that pressure is already mounting on Francois Hollande. The following articles consider the French economy.
France told to reform labour market after second credit rating downgrade The Guardian, Phillip Inman (8/13/13)
France’s credit rating cut by S&P to AA BBC News (8/11/13)
S&P lowers France rating on reform doubts, markets unfazed Reuters, Nicholas Vinocur (8/11/13)
Hollande approval rating slumps as France downgraded The Telegraph, James Titcomb (8/11/13)
S&P cuts France’s credit rating by one notch to double-A Wall Street Journal, William Horobin (8/11/13)
Five charts that show the state of the French economy The Telegraph (8/11/13)
France rating downgrade heaps pressure on Francois Hollande Financial Times, Michael Stothard (8/11/13)
Questions
- What does a double A rating mean for the French economy?
- Which factors will be considered when a ratings agency decides to change a country’s credit rating?
- France’s unemployment rate is one of the key factors that S&P has considered. Why is France’s unemployment rate so high? Which type(s) of unemployment are increasing?
- Use a diagram to illustrate the unemployment that France is facing.
- If a country does see its credit rating downgraded, what might this mean for government borrowing costs? Explain why this might cause further problems for a country?
- Markets have been ‘unfazed’ by the downgrade. How do you think markets will react to over the coming weeks? Explain your answer.
- What action could the French government take to ensure that S&P is the only ratings agency that downgrades their credit rating?
