Paul Volcker was Chair of the US Federal Reserve from 1979 to 1987. He was also Chair of the Economic Recovery Advisory Board under President Barack Obama from February 2009 to January 2011. In the webcast and articles below, he reflects on the current state of the world financial system – from regulation, to the euro crisis, to world imbalances, to the system of floating exchange rates.
He argues that global financial systems are vulnerable to breakdowns. What is needed is reform to the system, and for that there needs to be consensus by politicians, regulators and central banks.
But, in the absence of international consensus on some key points, reform will be greatly weakened, if not aborted. The freedom of money, financial markets and people to move – and thus to escape regulation and taxation – might be an acceptable, even constructive, brake on excessive official intervention, but not if a deregulatory race to the bottom prevents adoption of needed ethical and prudential standards.
Perhaps most important is a coherent, consistent approach to dealing with the imminent failure of “systemically important” institutions. Taxpayers and governments alike are tired of bailing out creditors for fear of the destructive contagious effects of failure – even as bailouts encourage excessive risk-taking.
According to Volcker, countries must be prepared to surrender some sovereignty. Policies must be co-ordinated internationally and there must be stronger regulation by international bodies, such as the IMF and stronger concerted action by global organisations, such as the G20.
Left to their own devices, in an era of floating exchange rates, countries may pursue policies that exacerbate global imbalances.
Not so long ago, we were comforted by theorising that floating exchange rates would mediate international adjustments in a timely and orderly way. But, in the real world, many countries, particularly but not limited to small, open economies, simply find it impractical or undesirable to permit their currency to float.
We are left with the certainty, however awkward, that active participation in an open world economy requires some surrender of economic sovereignty. Or, to put the point more positively, it requires a willingness to co-ordinate policies more effectively.
Webcast
Volcker Urges Global Monetary System Overhaul BloombergBusinessweek (31/5/12)
Articles
Is global financial reform possible? Guardian, Paul Volcker (6/6/12)
Volcker Urges Global Financial System Overhaul After Crisis BloombergBusinessweek, Robyn Meredith and Shamim Adam (31/5/12)
Questions
- What reforms, according to Volcker, need to be implemented in order for the euro to function effectively without crises?
- What can the USA do to ease the euro crisis?
- What are Volcker’s views on the regulation of the US banking system?
- How are incentive structures in banks related to speculative activities?
- Should banks be allowed to fail?
- What financial imbalances exist between countries?
- What international monetary reforms are required?
- What light can game theory shed on the difficulty of achieving global policy co-ordination?
- Is an international system of floating exchange rates appropriate given the size of international financial flows?
Figures released by the Bank of England show that M4 fell by 5.0% in the year to March 2012. This record fall comes despite over £320 billion of assets purchased by the Bank under its quantitative easing programme. These are funded by the creation of reserves in the Bank of England. (See the Bank of England site for details of the timing and amounts of QE.)
Because of the considerable injection of new money into the banking system, notes and coin plus banks’ reserve balances in the Bank of England rose by 44.9%. So how is it that this measure of narrow money has increased massively and yet M4 has fallen?
One problem with using figures for changes in M4 to gauge economic activity is that they include intra-financial sector transactions – transactions between ‘other financial corporations’ (OFCs). Such transactions do not impact on the real economy. For this reason, the Bank of England prefers to focus on a measure that excludes these transactions between OFCs, a measure known as ‘M4 excluding intermediate OFCs’. This measure rose by 2.7% in the year to March 2012. Although this was positive, it was still weak.
So why does quantitative easing seem to be having such a small effect on bank lending? The following articles look at the issue.
Articles
Record collapse in UK money supply blamed on banks The Telegraph, Philip Aldrick (2/5/12)
UK March mortgage approvals rise unexpectedly London South East (2/5/12)
UK March Net Consumer Lending +GBP1.4 Billion NASDAQ, Jason Douglas and Nicholas Winning (2/5/12)
M4 Hits Record Low; Non-Residents Sell Gilts Market News International (2/5/12)
Data
Bankstats (Monetary & Financial Statistics) – March 2012 Bank of England (2/5/12): see Tables A1.1.1, A2.1.1 and A2.2.3
Questions
- How does quantitative easing impact on the narrow measure of money: notes, coin and banks’ reserve balances in the Bank of England?
- How might an increase in narrow money lead to an increase in broad money (such as M4)?
- How is it that notes, coin and banks’ reserve balances rose so rapidly in the year to March 2012, while M4 fell and even M4 excluding OFCs rose only slightly?
- Does this suggest that money supply is endogenous? Explain.
- How does requiring banks to rebuild their capital base impact on the relationship between narrow and broad money?
On 2 May 2012, Sir Mervyn King, Governor of the Bank of England, gave the BBC Today Prgramme’s public lecture. In it, he reflected on the causes and aftermath of the banking crisis of 2007/8.
He said that the main cause of the banking crisis was the risky behaviour of the banks themselves – behaviour that they had been allowed to get away with becuase regulation was too light. The cause was not one of inappropriate fiscal and monetary policy.
According to Dr King, there had been no classical macroeconomic boom and bust. True there had been a bust, but there was no preceding boom. Economic growth had not been unsustainable in the sense of being persistently above the potential rate. In other words, the output gap had been close to zero. As Mervyn King puts it
Let me start by pointing out what did not go wrong. In the five years before the onset of the crisis, across the industrialised world growth was steady and both unemployment and inflation were low and stable. Whether in this country, the United States or Europe, there was no unsustainable boom like that seen in the 1980s; this was a bust without a boom.
In terms of monetary policy, inflation had been on track and interest rates were not too low. And as for fiscal policy, government borrowing had been within the Golden Rule, whereby, over the cycle, the goverment borrowed only to invest and kept a current budget balance. Indeed, the period of the late 1990s and early to mid 2000s had become known as the Great Moderation.
So what went wrong? Again in the words of Dr King:
In a nutshell, our banking and financial system overextended itself. That left it fragile and vulnerable to a sudden loss of confidence.
The most obvious symptom was that banks were lending too much. Strikingly, most of that increase in lending wasn’t to families or businesses, but to other parts of the financial system. To finance this, banks were borrowing large amounts themselves. And this was their Achilles’ heel. By the end of 2006, some banks had borrowed as much as £50 for every pound provided by their own shareholders. So even a small piece of bad news about the value of its assets would wipe out much of a bank’s capital, and leave depositors scurrying for the door. What made the situation worse was that the fortunes of banks had become closely tied together through transactions in complex and obscure financial instruments. So it was difficult to know which banks were safe and which weren’t. The result was an increasingly fragile banking system.
But doesn’t his imply that regulation of the banking system had failed? And if so why? And have things now been fixed – so that banks will no longer run the risk of failure? Dr King addresses this issue and others in his speech and also in his interview the next day for the Today Programme, also linked to below.
Podcasts
The Today Programme Lecture BBC Radio 4, Sir Mervyn King (2/5/12) (Transcript of speech)
Also on YouTube at Governor’s Today Programme lecture, 2 May 2012
Sir Mervyn King: The full interview BBC Today Programme, Sir Mervyn King talks to Evan Davis (3/5/12)
Sir Mervyn King analysis ‘verging on delusional’ BBC Today Programme, Dylan Grice and Ngaire Woods (3/5/12)
Articles
Sir Mervyn King rejects criticism for crisis BBC News (3/5/12)
The boom and bust of Mervyn King BBC News, Robert Peston (3/5/12)
Sir Mervyn King admits BoE failed over financial crisis The Telegraph, Philip Aldrick (3/5/12)
Sir Mervyn King admits: we did too little to warn of economic crisis Guardian, Larry Elliott (2/5/12)
King Says BOE Will Risk Unpopularity to Prevent Crises Bloomberg, Jennifer Ryan and Scott Hamilton (3/5/12)
Data
Economic Outlook Annex Tables OECD (See Annex Tables 1, 10, 14, 18, 27, 28, 32, 33, 61 and 62)
Statistical Interactive Database Bank of England (See for example, A Money and Lending: counterparts to changes in M4, alternative presentation > Seasonally adjusted > Public sector contribution > PSNCR)
Questions
- Why was the period of the late 1990s and early to mid 2000s described as the Great Moderation?
- Chart the size of the output gap, the rate of inflation and public-sector deficits as a percentage of GDP in the UK and other major economies from 1995 to 2007. Is this evidence of the Great Moderation?
- To what extent would evidence of house prices, consumer debt, bank lending and the balance of trade deficit suggest that there was indeed a boom from the mid 1990s to 2007?
- What, according to Dr King were the main causes of the credit crunch?
- What, with hindsight, should the Bank of England have done differently?
- What UK body was responsible for regulating banks in the run up to the credit crunch? Why might its regulation be described as ‘light touch’?
- In what sense was there a moral hazard in central banks being willing to bail out banks?
- What banking reforms have taken place or will take place in the near future? Will they address the problems identified by Dr King and prevent another banking crisis ever occurring again?
Australia was one of the few economies that seemed to be somewhat insulated from the 2008/09 recession and credit crunch. However, with the UK now back in recession and global economic conditions worsening in much of Europe, Australia has now joined the list of countries that are experiencing economic conditions that are ‘weaker than forecast’.
Today’s world involves economies that are increasingly interdependent, hence the spread of the world economic slowdown. As such, with weak global demand, Australia has started to feel the effects, with demand for its goods and raw materials falling. This has led Australia’s central bank – the Reserve Bank of Australia – to cut its key interest rate (the ‘cash rate’) by more than expected. The rate had been at 4.25% and it was widely believed that a 0.25 percentage point cut would occur. However, the central bank cut the cash rate rate to 3.75% to counter the weakening conditions. The Reserve Bank said:
“This decision is based on information received over the past few months that suggests that economic conditions have been somewhat weaker than expected, while inflation has moderated …Growth in the world economy slowed in the second half of 2011, and is likely to continue at a below-trend pace this year.”
Banks’ interest rates have been falling in Australia for the past few months and this latest cut will do much to help financially squeezed households. Data show that Australian house sales have fallen, as have house prices, and retail sales have fared little better.
Lower interest rates are often a tool used to steer inflation and the Australian central bank may not have been as willing to cut rates had the inflation rate not come down in recent months. Keeping consumer prices under control remains a top priority for the central bank and so it will be interesting to see the impact that these rate cuts will have on the Australian economy.
Articles
Australia cenbank surprises with aggressive half point rate cut Reuters, Wayne Cole (1/5/12)
Australia cuts rates by than forecast to 3.75% BBC News (1/5/12)
Banks unlikely to pass on full rate cut The Australian, Wall Street Journal, Peter Trute (1/5/12)
Australia cuts rate to support economy Financial Times, Neil Hume (1/5/12)
Australia slashes interest rates by 0.5pc to boost economy The Telegraph (1/5/12)
Australia cuts interest rates as economy slows Guardian, Phillip Inman (1/5/12)
Banks must pass on rate cut: businesses Sydney Morning Herald, Ehssan Veiszadeh (1/5/12)
Bond prices rally after rate cut Sydney Morning Herald (1/5/12)
Surplus remains appropriate: Swan Sydney Morning Herald, Colin Brinsden (1/5/12)
Webcasts
Reserve Bank of Australia Cuts Rates by 50 Basis Points to 3.75% CNBC video, Lauren Rosborough (1/5/12)
Further `Modest’ RBA Easing Possible, ANZ Says Bloomberg, Tony Morriss (1/5/12)
Australia’s central bank shifts focus to growth BBC News, Duncan Kennedy (1/5/12)
Questions
- Which factors will a central bank consider when setting interest rates?
- Explain the components of aggregate demand that will be affected by a lower rate of interest.
- Using diagrams to illustrate the process, explain both the interest-rate and the exchange-rate transmission mechanisms of the fall in interest rates.
- How are interest rates used to target inflation?
- How will lower rates of interest help the Australian economy recover from weakening global economic conditions?
- Why are Australia’s banks unlikely to pass on the full rate cut to consumers?
- Why did bond prices rise and the Australian dollar depreciate after the rate cut? Why does this suggest that a 0.5% cut was greater than anticpated by markets?
A crucial determinant of the economy’s short-term prospects is the appetite of households for spending. This is because household spending makes up roughly two-thirds of the total demand for firms’ goods and services or two-thirds of what economists refer to as aggregate demand. So what are the latest forecasts for consumer spending? We briefly consider the forecasts of the Office for Budget Responsibility for consumer spending and, in doing so, update an earlier bog Gloomy prospects for spending in 2012?
In its March 2012 Economic and Fiscal Outlook the Office for Budget Responsibility presents it forecasts for economic growth and household spending. The following table summarises these forecasts.
OBR Forecasts (annual real percentage change)
|
2012 |
2013 |
2014 |
2015 |
2016 |
| GDP |
0.8 |
2.0 |
2.7 |
3.0 |
3.0 |
| Consumption |
0.5 |
1.3 |
2.3 |
3.0 |
3.0 |
| Disposable income |
–0.2 |
0.5 |
1.9 |
2.4 |
2.5 |
Paul Volcker was Chair of the US Federal Reserve from 1979 to 1987. He was also Chair of the Economic Recovery Advisory Board under President Barack Obama from February 2009 to January 2011. In the webcast and articles below, he reflects on the current state of the world financial system – from regulation, to the euro crisis, to world imbalances, to the system of floating exchange rates.
