On 28 November 2010, a deal was reached between the Irish government, the ECB, the IMF and other individual governments to bail out Ireland. The deal involved an €85bn package to bail out the collapsing Irish banks. Not all of the money went directly to the banks and the Irish government did set aside some of the loan. However, some of this money will now be required by four key lenders in Ireland, after a stress test by a group of independent experts found that the Republic of Ireland’s banks need another €24bn (that’s £21.2bn) to survive the continuing financial crisis. Allied Irish Banks require €13.5bn, Bank of Ireland €5.2bn, Irish Life €4bn and EBS a meager €1.5bn. The governor of the central bank, Professor Patrick Honohan said:
‘The new requirements are needed to restore market confidence, and ensure banks have enough capital to meet even the markets’ darkest estimates.’
The stress test focused on an assumption of a ‘cumulative collapse’ in property prices by 62%, together with rising unemployment. Following this, the Irish Finance Minister announced the government’s intention to take a majority stake in all of the major lenders. The Irish banks have been told they need to reduce the net loans on their balance sheets by some €71bn (£63bn) by the end of 2013. This process of deleveraging is likely to generate further losses, as many loans and assets will be sold for less than their true value. The causes of this ongoing financial crisis can still be traced back to the weakness within the Irish economy and more specifically to mortgage accounts being in arrears following the property market bubble that burst. A key question will be whether this second bail-out is sufficient to restore much needed confidence in the economy and particularly in the banking sector. The articles below consider this ongoing crisis.
Irish hope it is second time lucky for bail-out Telegraph, Harry Wilson (1/4/11)
Irish Bank needs extra €24bn euros to survive BBC News (31/3/11)
Ireland forced into new £21bn bailout by debt crisis Guardian, Larry Elliott and Jill Treanor (31/3/11)
The hole in Ireland’s banks is £21bn BBC News Blogs: Peston’s Picks, Robert Peston (31/3/11)
ECB has given Ireland serious commitment Reuters (1/4/11)
Ireland banking crisis: is the worst really over? Guardian: Ireland Business Blog, Lisa O’Carroll (1/4/11)
Ireland: a dead cert for default Guardian, Larry Elliott (1/4/11)
Timeline: Ireland’s string of bank bailouts Reuters (31/3/11)
Questions
- What is the process of deleveraging? Why is likely to lead to more losses for Ireland’s banks?
- What are the causes of the financial crisis in Ireland? How do they differ from financial crises around the world?
- What are the arguments for and against bailing out the Irish banks?
- Will this second bailout halt the possible contagion to other Eurozone and EU members?
- If this second bailout proves insufficient, should there be further intervention in the Irish economy?
In March 2009, the Bank of England’s base rate was slashed to 0.5% in a bid to boost aggregate demand and stimulate the UK economy. Since then it has remained at the same level. Interest rates are used by the Bank of England, which aims to keep inflation at the 2% target within a 1% gap either side. However, inflation has been above 3% for some 15 months and the latest figures for February 2011 show that inflation is rising. In January, it was 4%, but data for February calculates an inflation rate of 4.4% – significantly above the Bank of England’s target rate of 2% and above the forecast rate for the month.
One of the causes of such high inflation is the price of fuel, food and clothing. No-one can have failed to notice that petrol prices are higher than ever and this is one of the factors contributing to an increase in the level of prices throughout the economy. Clothing and footwear costs, which rose by 3.6% after the January sales have also contributed to this rising figure and will put increasing pressure on the MPC to raise interest rates in the not so distant future.
In the February 2011 meeting of the Monetary Policy Committee, interest rates were kept at 0.5%, despite markets pricing the chance of a rate rise at 20%. The negative growth experienced in the final quarter of 2010 is likely to have influenced this decision, but will the inflation data we’re now seeing influence the next meeting of the MPC. This undoubtedly puts pressure on the central bank to increase interest rates to try to get inflation back on target. The cost? It could put the recovery in jeopardy and create the possibility of a double-dip recession. There is a conflict here and whatever happens to interest rates, some groups will say it’s the wrong decision. As David Kern said:
“The MPC must be careful before it takes action that may threaten the fragile recovery, particularly in the face of a tough austerity plan.”
Perhaps the Budget will provide us with some more information about how the government intends to cut the hole in public finances, ensure that the economy does not fall back into recession and keep inflation under control.
UK inflation revives talk of early interest rate rise Reuters, David Milliken and Christina Fincher (22/3/11)
How to inflation-proof your savings Telegraph, Emma Simon (22/3/11)
UK inflation rate rises to 4.4% in February BBC News (22/3/11)
Interest rates: What the economists say Guardian (10/2/11)
Q&A: Impact of rising inflation Guardian, Phillip Inman (22/3/11)
Inflation soars to over double target rate Sky News, Hazel Baker (22/3/11)
Inflation and public borrowing add to budget 2011 headaches Guardian, Larry Elliott (22/3/11)
Inflation cutting savers’ options BBC News, Kevin Peachey (22/3/11)
Inflation: What the economists say Guardian (22/3/11)
Questions
- Is inflation likely to continue going up? What might stop the rise?
- Why are interest rates such an important tool of monetary policy?
- What is the relationship between interest rates and inflation?
- What are the costs of high inflation? Does anyone benefit?
- Who would gain and who would lose if interest rates are increased in the next MPC meeting?
- Which factors have contributed towards rising inflation in the UK? Is it cost-push or demand-pull inflation?
- Why does this pose a dilemma for the government in terms of public finances and the recession?
We’ve had numerous examples in recent years of the economic turmoil that natural disasters can have and unfortunately, we have another to add to the list: the Japanese earthquake and tsunami. As Japan tries to take stock of the damage and loss of life, the economic consequences of this disaster will also need considering. The previous Kobe earthquake cost the economy an estimated 2% of GDP, but this did hit a key industrial area. The economic consequences of the 2011 earthquake were originally not thought to be as bad, but the economy will undoubtedly suffer.
The Japanese economy, like the UK, shrank in the final quarter of 2010, but was expected to return to growth. The devastation of the earthquake and tsunami is now likely to delay this economic recovery. Many car companies are based in Japan and are expected to take some of the biggest hits. Nomura analysts suggested that annual operating profits of companies such as Toyota, Nissan and Honda would be dented by between 3% and 8%. You only have to look at some of the footage of the disaster to see why this is expected. Supply chains will undoubtedly be disrupted, many of whom are located in the exclusion zone and financial markets across the world have fallen, as the possibility of a nuclear disaster threatens. As Louise Armistead writes:
‘By lunchtime in Britain £32bn had been knocked off the value of the FTSE-100 dropped, which fell by more than 3pc in early trading but recovered later to close down 1.38pc at 5,695.28. Germany’s DAX plunged 3.19pc, recovering from a 4.8pc fall, and France’s CAC ended the day 3.9pc lower, while on Wall Street, the Dow Jones Industrial Index dropped 2pc shortly after opening.’
A key question will be whether Japanese reconstruction will push the economy out of its deflationary spiral or make it even worse.
GDP measures the value of output produced within the domestic economy, but it is by no means an accurate measure of a country’s standard of living. Whilst it will take into account new construction that will be required to rebuild the economy, it doesn’t take into account the initial destruction of it. As output and growth are expected to fall in the immediate aftermath, we may see a boost to growth, as reconstruction begins.
The problem of scarcity is becoming more and more apparent to many survivors, as they begin to run short of basic necessities, which has led to various rationing mechanisms being introduced. Despite the devastating conditions which survivors now find themselves in, when supplies are delivered, the efficiency of Japan is still very evident. As noted by BBC Radio 4 coverage, as soon as the supplies arrived, a line was in place to unload the van in minutes. Teams have been set up to help everyone get through the tragedy. Even in the most devastating of times, Japanese efficiency still shines through and undoubtedly this will be a massive aid in the huge re-construction projects that we will see over the coming months and even years. Analysts say that there will be short term pain, but that the investment in construction will boost the economy later in the year.
Japanese earthquake: Markets shed £1trillion amid nuclear fears Telegraph, Louise Armistead (16/3/11)
Panic over Japan triggers market turmoil Independent, Nikhil Kumar (16/3/11)
Japan quake: Economy ‘to rebound’ after short term pain BBC News (14/3/11)
Japan disaster: The cost of a crisis Guardian (16/3/11)
Global stock markets tumble in ‘perfect storm’ amid fears of nuclear disaster Mail Online, Hugo Duncan (16/3/11)
Japan’s earthquake will cause a global financial aftershock Guardian, Peter Hadfield (15/3/11)
Economists’ estimate of Japan quake impact Reuters (16/3/11)
Fukishima factor adds pressure to economic fallout from Japan’s crisis Guardian, Larry Elliott (15/3/11)
Questions
- What is the likely impact on Japan’s GDP?
- Why is the potential disruption to the supply chain important for a firm?
- How and why will this catastrophe affect global financial markets?
- What are some of the main problems of using GDP as a measurement for growth? Think about the impact on GDP of Japan’s destruction and their future re-construction.
- What types of production methods etc have Japan implemented to allow them to become so efficient in production?
- What are the arguments to suggest that this disaster might help the Japanese economy recover from its deflationary spiral? What are the arguments to suggest that it might make it worse?
- What are some other examples of natural disasters or human errors that have also had economic consequences?
In a statement to the House of Commons on 9 February 2011, the Chancellor announced that banks would extend their new lending to SMEs (Small and Medium-Sized Enterprises) from £179 billion in 2010 to £190 billion in 2011. An important question is the extent to which this initiative, which forms part of a series of initiatives in conjunction with the banking sector known as Project Merlin, will impact on economic activity.
Let’s begin by thinking about the role that credit plays in an economy. Firstly, it serves a short-term role by enabling individuals and firms to ‘bridge the gap’ between their income and their spending. Secondly, it can, depending on the size and terms of the credit, help to fund longer-term investments. In the case of firms, for instance, it can help to fund capital projects such as an expansion of premises or the installation of new equipment or production processes.
The extension of credit is the main source of growth in the money supply. If the credit which is extended by financial institutions is spent it increases economic activity. The size of the increase in economic activity will depend on how many times the credit is passed on from one firm or individual to the next. In other words, it depends on the velocity of circulation of money – often referred to simply as V. If the initial credit funds a series of purchases and the recipients of these monies, i.e. those from whom the purchases are made, then use their increased deposits to fund purchases themselves, the expansion could be sizeable.
There is every indication that the additional credit for SMEs will be welcome and it seems reasonable to assume that this will positively impact on spending. But, by how much is not entirely clear. This is what fascinates me about macroeconomics, but, perhaps understandably, may well frustrate others! Once the payments for the purchases made using the newly available credit become new deposits, how will these recipients respond? Will other credit-constrained firms use this liquidity to engage in purchases themselves? But, what if these recipients use the monies to increase or rebuild their own financial wealth? In this last scenario – a pessimistic scenario – the velocity of circulation will increase relatively little and economic activity little too.
The corporate sector, of course, does not exist in isolation of other sectors of the economy and, in particular, of the household sector. As some of the income from the expanded credit flows to them in the form of factor payments (i.e. wages and profits) – though by how much is itself debtable – how will they respond? Again will credit-constrained households look to spend? Alternatively, will they hold on to these liquid balances perhaps using them as buffer-stock savings? This is not an unrealistic possibility given the leverage of households and the need to rebuild wealth, especially so in times of incredible economic uncertainty? But, who knows!
So while Merlin may have waved his wand, the full extent of its impact, though probably positive, is far from clear. Time will tell. Isn’t macroeconomics wonderful!
HM Treasury Press Release
Government welcomes banks’ statement on lending by 15% more to SMEs, and on pay and support for regional growth, HM Treasury, 9 February 2011
Statement to the House of Commons by the Chancellor
Statement on banking by the Chancellor of the Exchequer 9 February 2011
Articles
Banks sign lending and bonus deal BBC News (9/2/11)
Banks agree Project Merlin lending and bonus deal BBC News (9/2/11)
Osborne’s plans arrive too late for the economy Independent, Sean O’Grady (11/2/11)
Project Merlin ‘could weaken UK banks’ Telegraph, Harry Wilson (11/2/11)
Nothing wizard about Project Merlin Guardian UK, Nils Pratley (7/2/11)
Softball: Britain’s banks make peace with the government – for now The Economist (10/2/11)
Smaller firms insist banks must change their attitude The Herald (11/2/11)
Questions
- Detail the various roles that financial institutions play in a modern-day economy.
- Do the activities of banks carry with them any risks? How might such risks be reduced?
- What is meant by the velocity of circulation or the velocity of money?
- What factors do you think could affect the velocity of money?
- How does credit creation affect the growth of the money supply?
- What do you understand by individuals or firms being credit-constrained?
- What factors are likely to affect how credit-constrained an individual household is?
- What do you think might be meant by buffer-stock saving? What might affect the size of the buffer-stock held by a household?
In March 2009, the Bank of England’s base rate was slashed to 0.5% in a bid to boost aggregate demand and stimulate the UK economy. And there it has remained for almost 2 years and as yet, no change is in sight. In the February 2011 meeting of the Monetary Policy Committee (who are responsible for setting interest rates to keep inflation on target), the decision was to keep interest rates at 0.5% rather than raise them to tackle high and rising UK inflation. Those in favour of keeping interest rates at this record low argue that any increase could damage the UK’s ability to recover and may lead to the dreaded double-dip recession. This is of particular concern given the economy’s performance in the last quarter of 2010.
However, one group that will certainly not be happy is the savers. With instant-access savings accounts paying on average just 0.84% before tax and with inflation at 3.7%, savers aren’t just not gaining much interest, but are actually seeing the value of their money in real terms fall. Howard Archer of HIS Global Insight said:
“For now, we retain our view that the Bank of England will hold off from raising interest rates until the latter months of the year. Even if interest rates do rise in the near term, the likelihood is still that they will rise only gradually and remain very low compared to past norms.
Monetary policy will need to stay loose for an extended period to offset the impact of the major, sustained fiscal squeeze. Consequently, we retain the view that interest rates will only rise to 2pc by the end of 2012.”
Following some speculation that the Bank of England may succumb to the pressure of inflation and hike up interest rates (markets had priced in a 20% chance of a rate rise), sterling did take a hit, but after the decision to keep rates at 0.5%, sterling recovered against the dollar. There is a belief amongst some traders that rates will rise in May, but others believe rates may remain at 0.5% until much later in 2011, as the country aims to avoid plunging back into recession. Of 49 economists that responsed to a poll by Reuters, three quarters of them said that rates would rise by the end of 2011, with median forecasts predicting a rise around November. This is certainly a space to watch, as it has implications for everyone in the UK and for many in countries around the world.
BOE leaves bank rate unchanged at 0.5% at Feb meeting Automated Trader (10/2/11)
Economists predict interest rates will rise in November Telegraph, Szu Ping Chan (11/2/11)
UK May rate hike view holds firm after BOE Reuters, Kirsten Donovan (10/2/11)
Interest rates: What the economists say Guardian (10/2/11)
Fixed rate mortgages becoming more expensive BBC News (10/2/11)
Bank rate: savers’ celebrations on hold Telegraph, Richard Evans (10/2/11)
Inflation fears turn up heat ahead of bank rate decision City AM, Julian Harris (10/2/11)
Sterling takes BOE in its stride, higher rate talk aids Reuters, Anirban Nag (10/2/11)
Bank of England holds interest rates of 0.5% Telegraph, Emma Rowley (10/2/11)
Questions
- Why are interest rates such an important tool of monetary policy? Think about which variables of aggregate demand will be affected by the Bank of England’s decision.
- What is the relationship between interest rates and inflation?
- What explanation is there for the fall in the value of sterling following speculation that interest rates may rise? Why did sterling recover after the Bank of England’s decision?
- How has the recent speculation affected fixed rate mortgages?
- What does the Telegraph article about “savers’ celebrations on hold” mean about the ‘real value’ of money and savings?
- What are (a) the arguments for keeping interest rates at 0.5% and (b) the arguments for raising interest rates? Who wins and loses in each case?
- Are there any other government policies that could be used to combat inflation, without creating the possibility of a double-dip recession? Why haven’t they been used?