Category: Economics for Business: Ch 04

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Stopping the Game? Big traders vs. the swarm

Bubbles

Speculation in markets can lead to wild swings in prices as exuberance drives up prices and
pessimism leads to price crashes. When the rise in price exceeds underlying fundamentals, such as profit, the result is a bubble. And bubbles burst.

There have been many examples of bubbles throughout history. One of the most famous is that of tulips in the 17th century. As Box 2.4 in Essential Economics for Business (6th edition) explains:

Between November 1636 and February 1637, there was a 20-fold increase in the price of tulip bulbs, such that a skilled worker’s annual salary would not even cover the price of one bulb. Some were even worth more than a luxury home! But, only three months later, their price had fallen by 99 per cent. Some traders refused to pay the high price and others began to sell their tulips. Prices began falling. This dampened demand (as tulips were seen to be a poor investment) and encouraged more people to sell their tulips. Soon the price was in freefall, with everyone selling. The bubble had burst .

Another example was the South Sea Bubble of 1720. Here, shares in the South Sea Company, given a monopoly by the British government to trade with South America, increased by 900% before collapsing through a lack of trade.

Another, more recent, example is that of Poseidon. This was an Australian nickel mining company which announced in September 1969 that it had discovered a large seam of nickel at Mount Windarra, WA. What followed was a bubble. The share price rose from $0.80 in mid-1969 to a peak of $280 in February 1970 and then crashed to just a few dollars.

Other examples are the Dotcom bubble of the 1990s, the US housing bubble of the mid-2000s and BitCoin, which has seen more than one bubble.

Bubbles always burst eventually. If you buy at a low price and sell at the peak, you can make a lot of money. But many will get their fingers burnt. Those who come late into the market may pay a high price and, if they are slow to sell, can then make a large loss.

GameStop shares – an unlikely candidate for a bubble

The most recent example of a bubble is GameStop. This is a chain of shops in the USA selling games, consoles and other electronic items. During the pandemic it has struggled, as games consumers have turned to online sellers of consoles and online games. It has been forced to close a number of stores. In July 2020, its share price was around $4. With the general recovery in stock markets, this drifted upwards to just under $20 by 12 January 2021.

Then the bubble began.

Hedge fund shorting

Believing that the GameStop shares were now overvalued and likely to fall, many hedge funds started shorting the shares. Shorting (or ‘short selling’) is where investors borrow shares for a fee and immediately sell them on at the current price, agreeing to return them to the lender on a specified day in the near future (the ‘expiration date’). But as the investors have sold the shares they borrowed, they must now buy them at the current price on or before the expiration date so they can return them to the lenders. If the price falls between the two dates, the investors will gain. For example, if you borrow shares and immediately sell them at a current price of £5 and then by the expiration date the price has fallen to $2 and you buy them back at that price to return them to the lender, you make a £3 profit.

But this is a risky strategy. If the price rises between the two dates, investors will lose – as events were to prove.

The swarm of small investors

Enter the ‘armchair investor’. During lockdown, small-scale amateur investing in shares has become a popular activity, with people seeking to make easy gains from the comfort of their own homes. This has been facilitated by online trading platforms such as Robinhood and Trading212. These are easy and cheap, or even free, to use.

What is more, many users of these sites were also collaborating on social media platforms, such as Reddit. They were encouraging each other to buy shares in GameStop and some other companies. In fact, many of these small investors were seeing it as a battle with large-scale institutional investors, such as hedge funds – a David vs. Goliath battle.

With swarms of small investors buying GameStop, its share price surged. From $20 on 12 January, it doubled in price within two days and had reached $77 by 25 January. The frenzy on Reddit then really gathered pace. The share price peaked at $468 early on 28 January. It then fell to $126 less than two hours later, only to rise again to $354 at the beginning of the next day.

Many large investors who had shorted GameStop shares made big losses. Analytics firm Ortex estimated that hedge funds lost a total of $12.5 billion in January. Many small investors, however, who bought early and sold at the peak made huge gains. Other small investors who got the timing wrong made large losses.

And it was not just GameStop. Social media were buzzing with suggestions about buying shares in other poorly performing companies that large-scale institutional investors were shorting. Another target was silver and silver mines. At one point, silver prices rose by more than 10% on 1 February. However, money invested in silver is huge relative to GameStop and hence small investors were unlikely to shift prices by anything like as much as GameStop shares.

Amidst this turmoil, the US Securities and Exchange Commission (SEC) issued a statement on 29 January. It warned that it was working closely with other regulators and the US stock exchange ‘to ensure that regulated entities uphold their obligations to protect investors and to identify and pursue potential wrongdoing’. It remains to be seen, however, what it can do to curb the concerted activities of small investors. Perhaps, only the experience of bubbles bursting and the severe losses that can result will make small investors think twice about backing failing companies. Some Davids may beat Goliath; others will be defeated.

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Data

Questions

  1. Distinguish between stabilising and destabilising speculation.
  2. Use a demand and supply diagram to illustrate destabilising speculation.
  3. Explain how short selling contributed to the financial crisis of 2007/8 (see Box 2.7 in Economics (10th edition) or Box 3.4 in Essentials of Economics (8th edition)).
  4. Why won’t shares such as GameStop go on rising rapidly in price for ever? What limits the rise?
  5. Find out some other shares that have been trending among small investors. Why were these specific shares targeted?
  6. How has quantitative easing impacted on stock markets? What might be the effect of a winding down of QE or even the use of quantitative tightening?
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The future for oil prices: a case of supply and demand

In its latest Commodity Special Feature (pages 43 to 53 of the October 2020 World Economic Outlook), the IMF examines the future of oil and other commodity prices. With the collapse in oil demand during the early stages of the coronavirus pandemic, oil prices plummeted. Brent crude fell from around $60 per barrel in late January to below $20 in April.

However, oil prices then rose somewhat and have typically been between $40 and $45 per barrel since June 2020 – still more than 35% lower than at the beginning of the year (see chart below: click here for a PowerPoint). This rise was caused by a slight recovery in demand but largely by supply reductions. These were the result partly of limits agreed by OPEC+ (OPEC, Russia and some other non-OPEC oil producing countries) and partly of reduced drilling in the USA and the closure of many shale oil wells which the lower prices had made unprofitable.

The IMF considers the future for oil prices and concludes that prices will remain subdued. It forecasts that petroleum spot prices will average $47 per barrel in 2021, up only slightly from the $42 average it predicts for 2020.

On the supply side it predicts that ‘stronger oil production growth in several non-OPEC+ countries, a faster normalization of Libya’s oil production, and a breakdown of the OPEC+ agreement’ will push up supply and push down prices. Even if the OPEC+ agreement holds, the members are set to ease their production cut by nearly 25% at the start of 2021. This rise in supply will be offset to some extent by possibly ‘excessive cuts in oil and gas upstream investments and further bankruptcies in the energy sector’.

On the demand side, the speed of the recovery from the pandemic will be a major determinant. If the second wave is long-lasting and deep, with a vaccine available to all still some way off, oil demand could remain subdued for many months. This will be compounded by the accelerating shift to renewable energy and electric vehicles and by government policies to reduce CO2 emissions.

Report

Articles

Oil price data

Questions

  1. Describe a scenario in which oil prices rebound significantly over the coming months. Illustrate your answer with a supply and demand diagram.
  2. Describe a scenario in which oil prices fall over the coming months. Again, illustrate your answer with a supply and demand diagram.
  3. How are the price elasticities of demand and supply relevant to the size of any oil price change?
  4. Project forward 10 years and predict whether oil prices will be higher or lower than now. What are the major determinants of supply and demand in your prediction?
  5. What are oil futures? What determines oil future prices?
  6. How does speculation affect oil prices?
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Supply and demand: the housing market

For the majority of people, a house (or flat) is the most valuable thing they will ever own.

It is important to understand the role that house prices play in the economy and how much of an impact they have.

The Bank of England monitors changes in the housing market to assess the risks to the financial system and the wider economy. The housing market employs large numbers of people in construction, sales, furniture and fittings, and accounts for a sizeable percentage of the value of GDP. The market is closely linked to consumer spending and therefore is a crucially important sector of the economy.

The concepts of supply and demand can be applied to understand house price changes and the impacts on the economy.

What is the housing market?

The housing market brings together different stakeholders, such as homeowners who are selling their properties, people seeking to buy a property, renters, investors who buy and sell properties solely for investment purposes, contractors, renovators and estate agents, who act as facilitators in the process of buying or selling a property.

In the UK, two-thirds of households own the property in which they live, and the remaining third of households are renters, split fairly equally between private and social renting. We can thus divide people into:

  • Homeowners – either outright owners or with a mortgage;
  • Private renters – people renting from private landlords;
  • Social renters – people renting from local authorities and housing associations.

There are many determinants of demand and supply in the housing market, many of which are related to demographic factors. Such factors include the size of the market, rate of marriages, divorces, and deaths. However, factors such as income, availability of credit, interest rates and consumer preferences are also important.

Why is the housing market important for the economy?

Changes in the housing market are always given such importance due to the relationship house prices have with consumer spending. Changes in house prices and the number of sales affect how much money people have to spend. Given that household spending accounts for two-thirds of Britain’s total economic activity, any changes in consumption is likely to have a major impact on the wider economy. Observing the housing market helps us to assess the overall demand for goods and services.

When house prices increase, those consumers who own their own homes have now become better off as their houses are worth more. This ‘wealth effect’ increases the confidence of homeowners, which in turn increases consumption. Some of these homeowners will decide to acquire additional borrowing against the value of their home. The borrowing is then spent in the economy on goods and services, thereby increasing aggregate demand and GDP.

However, when house prices decline, homeowners lose confidence as their home is now worth less than before. This becomes a major issue if prices have decreased enough to make their house worth less than the remainder of the unpaid mortgage – known as ‘negative equity’. Homeowners will therefore reduce their consumption and will be less likely to undertake any new borrowing.

The vast majority of homeowners will have taken out a mortgage in order to purchase their home. Mortgages are the largest source of debt for households in the UK. More than 70% of household borrowing is mortgage debt. Half of all homeowners who live in the house they own are still paying off their mortgage. Therefore, households might suddenly hold back on their spending during times of uncertainty because they start to worry about repaying their debts. This has a knock-on effect on the rest of economy, and a small problem can suddenly become a big one.

In addition to affecting overall household spending, the buying and selling of houses also affects the economy directly. Housing investment is a small but unpredictable part of total output in the economy. There are two different ways in which the buying and selling of houses impacts GDP.

The first is when a new build is purchased. This directly contributes to GDP through the investment in the land to build the house on, the purchase of materials and the creation of jobs. Once the homeowners move in they also contribute to the local economy: i.e. shopping at local shops.

The second is when an existing home is bought or sold. The purchase of an existing home does not have the same impact on GDP. However, it does still contribute to GDP: i.e. from estate agents’ and solicitors’ fees and removal costs to the purchase of new furniture.

Why house prices change: demand and supply

Demand: the demand for housing can be defined as the quantity of properties that homebuyers are willing and able to buy at a given price in a given time period. Factors affecting the demand for housing include:

  • Real incomes: If real incomes increase the demand for housing increases due to a rise in the standard of living.
  • The cost of a mortgage: If there is a rise in interest rates in the economy, mortgage interest rates are likely to rise too. This makes the cost of financing a loan more expensive and therefore will see a decline in demand.
  • Availability of credit: The more lending banks and building societies are willing to provide, the more people will borrow and spend on housing and hence the higher house prices will be.
  • Economic growth: When the economy is in the recovery and boom stages of the business cycle, wages rise. This will increase the demand for houses.
  • Population: When the population increases or if there is an increase in single-person households, demand for housing increases.
  • Employment/unemployment: The higher the level of unemployment in an economy, the less people will able to afford housing.
  • Confidence: If consumers feel optimistic about the future state of the economy, they will be more likely to go ahead with purchasing a house, thereby increasing demand. House prices tend to rise if people expect to be richer in the future.

Supply: The supply of housing can be defined as the flow of properties available at a given price in a given time period. The supply of housing includes both new-build homes and existing properties. Factors affecting the supply for housing include:

  • Costs of production: The higher the cost of production, the fewer houses are built, reducing the supply of housese coming to the market. Example of costs include: labour costs, land for development and building materials.
  • Government policy: If the government increases taxation and/or reduces subsidies for new house developments, there will be fewer new houses built.
  • Number of construction companies: Depending on their objectives, the more construction companies there are, the more likely there is to be an increase in the supply of housing. The construction industry accounts for around 7% of UK GDP.
  • Technology and innovation: With improved technology and innovation in the construction industry, houses become cheaper and easier to build, thus increasing the supply.
  • Government spending on building new social housing: The government has the ability to influence the supply of housing by increasing spending on new social housing.

Price elasticity of supply

The supply of new housing in the short run is price inelastic. The main reason for this is the time it takes to build a new home. The production of a house can take many months, from the planning process to the project’s completion. Supply also relies on access to a skilled labour force and the availability of certain construction materials.

Because of the inelastic supply, any changes in demand are likely to have a significant effect on price. This is illustrated by the diagram, which shows a larger proportionate increase in price than quantity when demand increases from D1 to D2.

The current UK housing market

Despite the current economic climate and the effects of the lockdown restrictions on consumers, house prices have increased, and sales have now resumed. Rightmove, which advertises 95% of homes for sale, states that the housing market has seen its busiest month in more than 10 years in July. During the summer, the housing market usually sees a lull in activity. However, since the easing of lockdown, there has been a flurry of activity from buyers and sellers. Since July 2019, house prices have increased by 1.7%, according to the Nationwide Building Society.

London estate agency, Hamptons, states that homeowners are now bringing forward their moving plans as the experience of lockdown has encouraged them to seek more space. The mortgage market is also very favourable right now in terms of interest rates, and rental demand is continuing to surge across the UK.

The increase in activity in the market has also been helped by the announcement of a stamp duty ‘holiday’ until March 2021. This sees the threshold above which stamp duty is paid rising from £125 000 to £500 000. Estate agency, Savills, has also seen an increase in the number of new buyers registering with its service, more than double the number registered in July 2019. It is thought that, along with the tax savings from stamp duty, people’s experiences in lockdown have made them evaluate their current living space and reconsider their housing needs.

However, given the that the economy is experiencing its deepest recession on record, there is concern about just how long the market can resist the economic forces pulling prices down.

Historically, a drop in house prices has been both a cause and a consequence of economic recessions. During the 2008 financial crisis, house prices fell by about 30%. As previously mentioned, for the majority of people, a house is the most valuable thing they will ever own and therefore consumers are extremely interested in its value. Consumer confidence is one of the key factors affecting the demand for housing. If consumers feel pessimistic about the future state of the economy, they will be less likely to go ahead with purchasing a house, thereby decreasing demand. Britain’s Office for Budget Responsibility, the country’s fiscal watchdog, forecasts that during this downturn prices will fall 5% this year and 11% in 2021.

Various government schemes put in place to help during lockdown are starting to come to an end. The main one – the furlough scheme, which replaced 80% of eligible workers’ incomes – comes to an end in October. It is forecast that labour market conditions will weaken significantly in the quarters ahead, with unemployment predicted to rise for the rest of the year. If these predictions materialise, it would likely dampen housing activity once again.

Conclusion

Fluctuations in house prices and transactions tend to amplify the volatility of the economic cycle. Therefore, it is crucial that we understand what influences such changes. Understanding how supply and demand factors influence the housing market can enable key stakeholders to make better predictions about future activity and plan accordingly. The current market has seen a growth since the easing of restrictions but there is concern that this has been powered by pent-up demand. Therefore, the outlook for house prices is uncertain and the full effects of an economic downturn are yet to be realised.

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Questions

  1. Explain why the supply of housing is inelastic in the short-term.
  2. Given that the elasticity of housing supply in the UK is low, what policies could be introduced to ensure that house building is more responsive to changes in market demand?
  3. If unemployment does increase as predicted, explain what impact this would have on the demand in the housing market and house prices? Use a supply and demand diagram to aid your answer.
  4. Explain how changes in house prices affect the government’s key macroeconomic objectives.
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Stock markets rise despite the recession. Why?

Share prices are determined by demand and supply. The same applies to stock market indices, such as the FTSE 100 and FTSE 250 in the UK and the Dow Jones Industrial Average and the S&P 500 in the USA. After all, the indices are the weighted average prices of the shares included in the index. Generally, when economies are performing well, or are expected to do so, share prices will rise. They are likely to fall in a recession or if a recession is anticipated. A main reason for this is that the dividends paid on shares will reflect the profitability of firms, which tends to rise in times of a buoyant economy.

When it first became clear that Covid-19 would become a pandemic and as countries began locking down, so stock markets plummeted. People anticipated that many businesses would fail and that the likely recession would cause profits of many other surviving firms to decline rapidly. People sold shares.

The first chart shows how the FTSE 100 fell from 7466 in early February 2020 to 5190 in late March, a fall of 30.5%. The Dow Jones fell by 34% over the same period. In both cases the fall was driven not only by the decline in the respective economy over the period, but by speculation that further declines were to come (click here for a PowerPoint of the chart).

But then stock markets started rising again, especially the Dow Jones, despite the fact that the recessions in the UK, the USA and other countries were gathering pace. In the second quarter of 2020, the Dow Jones rose by 23% and yet the US economy declined by 33% – the biggest quarterly decline on record. How could this be explained by supply and demand?

Quantitative easing

In order to boost aggregate demand and reduce the size of the recession, central banks around the world engaged in large-scale quantitative easing. This involves central banks buying government bonds and possibly corporate bonds too with newly created money. The extra money is then used to purchase other assets, such as stocks and shares and property, or physical capital or goods and services. The second chart shows that quantitative easing by the Bank of England increased the Bank’s asset holding from April to July 2020 by 50%, from £469bn to £705bn (click here for a PowerPoint of the chart).

But given the general pessimism about the state of the global economy, employment and personal finances, there was little feed-through into consumption and investment. Instead, most of the extra money was used to buy assets. This gave a huge boost to stock markets. Stock market movements were thus out of line with movements in GDP.

Confidence

Stock market prices do not just reflect the current economic and financial situation, but also what people anticipate the situation to be in the future. As infection and death rates from Covid-19 waned around Europe and in many other countries, so consumer and business confidence rose. This is illustrated in the third chart, which shows industrial, consumer and construction confidence indicators in the EU. As you can see, after falling sharply as the pandemic took hold in early 2020 and countries were locked down, confidence then rose (click here for a PowerPoint of the chart).

But, as infection rates have risen somewhat in many countries and continue to soar in the USA, Brazil, India and some other countries, this confidence may well start to fall again and this could impact on stock markets.

Speculation

A final, but related, cause of recent stock market movements is speculation. If people see share prices falling and believe that they are likely to fall further, then they will sell shares and hold cash or safer assets instead. This will amplify the fall and encourage further speculation. If, however, they see share prices rising and believe that they will continue to do so, they are likely to want to buy shares, hoping to make a gain by buying them relatively cheaply. This will amplify the rise and, again, encourage further speculation.

If there is a second wave of the pandemic, then stock markets could well fall again, as they could if speculators think that share prices have overshot the levels that reflect the economic and financial situation. But then there may be even further quantitative easing.

There are many uncertainties, both with the pandemic and with governments’ policy responses. These make forecasting stock market movements very difficult. Large gains or large losses could await people speculating on what will happen to share prices.

Articles

Questions

  1. Illustrate the recent movements of stock markets using demand and supply diagrams. Explain your diagrams.
  2. What determines the price elasticity of demand for shares?
  3. Distinguish between stabilising and destabilising speculation. How are the concepts relevant to the recent history of stock market movements?
  4. Explain how quantitative easing works to increase (a) asset prices; (b) aggregate demand.
  5. What is the difference between quantitative easing as currently conducted by central banks and ‘helicopter money‘?
  6. Give some examples of companies whose share prices have risen strongly since March 2020. Explain why these particular shares have done so well.
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Economists and the real world

Economists are often criticised for making inaccurate forecasts and for making false assumptions. Their analysis is frequently dismissed by politicians when it contradicts their own views.

But is this fair? Have economists responded to the realities of the global economy and to the behaviour of people, firms, institutions and government as they respond to economic circumstances? The answer is a qualified yes.

Behavioural economics is increasingly challenging the simple assumption that people are ‘rational’, in the sense that they maximise their self interest by weighing up the marginal costs and benefits of alternatives open to them. And macroeconomic models are evolving to take account of a range of drivers of global growth and the business cycle.

The linked article and podcast below look at the views of 2019 Nobel Prize-winning economist Esther Duflo. She has challenged some of the traditional assumptions of economics about the nature of rationality and what motivates people. But her work is still very much in the tradition of economists. She examines evidence and sees how people respond to incentives and then derives policy implications from the analysis.

Take the case of the mobility of labour. She examines why people who lose their jobs may not always move to a new one if it’s in a different town. Partly this is for financial reasons – moving is costly and housing may be more expensive where the new job is located. Partly, however, it is for reasons of identity. Many people are attached to where they currently live. They may be reluctant to leave family and friends and familiar surroundings and hope that a new job will turn up – even if it means a cut in wages. This is not irrational; it just means that people are driven by more than simply wages.

Duflo is doing what economists typically do – examining behaviour in the light of evidence. In her case, she is revisiting the concept of rationality to take account of evidence on what motivates people and the way they behave.

In the light of workers’ motivation, she considers the implications for the gains from trade. Is free trade policy necessarily desirable if people lose their jobs because of cheap imports from China and other developing countries where labour costs are low?

The answer is not a clear yes or no, as import-competing industries are only part of the story. If protectionist policies are pursued, other countries may retaliate with protectionist policies themselves. In such cases, people working in the export sector may lose their jobs.

She also looks at how people may respond to a rise or cut in tax rates. Again the answer is not clear cut and an examination of empirical evidence is necessary to devise appropriate policy. Not only is there an income and substitution effect from tax changes, but people are motivated to work by factors other than take-home pay. Likewise, firms are encouraged to invest by factors other than the simple post-tax profitability of investment.

Podcast

Article

Questions

  1. In traditional ‘neoclassical’ economics, what is meant by ‘rationality’ in terms of (a) consumer behaviour; (b) producer behaviour?
  2. How might the concept of rationality be expanded to take into account a whole range of factors other than the direct costs and benefits of a decision?
  3. What is meant by bounded rationality?
  4. What would be the effect on workers’ willingness to work more or fewer hours as a result of a cut in the marginal income tax rate if (a) the income effect was greater than the substitution effect; (b) the substitution effect was greater than the income effect? Would your answers to (a) and (b) be the opposite in the case of a rise in the marginal income tax rate?
  5. Give some arguments that you consider to be legitimate for imposing controls on imports in (a) the short run; (b) the long run. How might you counter these arguments from a free-trade perspective?