The UK government announced on 14 October 2024 in a ministerial statement that it intended to raise the threshold for the ring-fencing (separation) of retail and investment banking activities of large UK-based banks. These banks are known as ‘systemically important financial institutions (SIFIs)’, which are currently defined as those with more than £25bn of core retail deposits. Under the new regulations, the threshold would rise from £25bn to £35bn.
Ring-fencing is the separation of one set of banking services from another. This separation can be geographical or functional. The UK adopted the latter approach, where ring-fencing is the separation of core retail banking services, such as taking deposits, making payments and granting loans to small and medium-sized enterprises (SMEs) from investment banking and international operations. The intention of ring-fencing was to prevent contagion – to protect essential retail banking services from the risks involved in investment banking activities.
Reducing regulation to increase competition
Raising the limit is intended to facilitate greater competition in the retail banking sector. In recent years, US banks, such as JP Morgan and Goldman Sachs, have been expanding their depositor base in the UK under their respective brands – Chase UK and Marcus.
These relatively small UK subsidiaries were not ring-fenced from their wider investment banking operations as their retail deposits were under (but not far under) the £25bn limit. However, this restricted their ability to increase market share further without bearing the additional regulatory burden associated with ring-fencing that much larger incumbents face. Raising the threshold would allow them to expand to the higher limit without the regulatory burden.
The proposals are part of a broader package of reforms aimed at reducing the regulatory burden on UK-based banks. The hope is that this will stimulate greater lending to SMEs to boost investment and productivity.
The proposals also include a new ‘secondary’ threshold. This will exempt banks providing primarily retail banking services from the rules governing the provision of investment banking accounts. This exemption will apply as long as their investment banking is less than 10% of their tier 1 capital. (Tier 1 capital is currently the buffer which banks are required to retain in case of a crisis.) The changes were the outcome of a review conducted in 2022 but had not been implemented by the previous government.
The announcement has sparked a debate about ring-fencing, with some commentators calling for it to be removed altogether. Therefore, it is timely to revisit the rationale for ring-fencing. This blog examines what ring-fencing is and why it was introduced, and explains the associated economic costs and benefits.
Why was ring-fencing introduced?
Ring-fencing was recommended by the Independent Commission on Banking (ICB) in 2011 (see link below) and implemented through the Financial Services (Banking Reform) Act of 2013. The proposed separation of core retail banking services from investment banking were intended to address issues in banks which arose during the global financial crisis and which required substantial taxpayer bailouts. (See the 2011 blog, Taking the gambling out of high street banking (update).)
Following deregulation and liberalisation of financial services in the 1980s, many UK banks had extended their operations so that they combined domestic retail operations with substantial investment and international operations. The intention was to open up all dimensions of financial services to greater competition and allow banks to exploit economies of scope between retail and investment banking.
However, the risks associated with these services are very different but, in the period before the financial crisis, were provided alongside one another within banking groups.
One significant risk which was not fully recognised at the time was contagion – problems in one dimension of a bank’s activity could severely compromise its ability to provide services in other areas. This is what happened during the financial crisis. Many of the UK banks’ investment operations had made significant investments in off-balance sheet securitised debt instruments – CDOs being the most famous example. (See the 2018 blog, Lehman Brothers: have we learned the lessons 10 years on?.)
When that market crashed in 2007, several UK-based banks incurred significant losses, as did other banks around the world. Given their thin equity buffers and the inability to borrow due to a credit crunch, such banks found it impossible to bear these losses.
The UK government had to step in to save these institutions from failing. If it had not, there would have been significant economic and social costs associated with their inability to provide core retail banking functions. (See the 2017 blog, Ten years on.)
The Independent Commission proposed that ‘the risks inevitably associated with banking have to sit somewhere, and it should not be with taxpayers. Nor do ordinary depositors have the incentive (given deposit insurance to guard against runs) or the practical ability to monitor or bear those risks’ (p.9). Unstructured banks, with no separation of retail from investment activities, increase the potential for both of these stakeholder groups to bear the risks of investment banking.
Structural separation of retail and investment banking addresses this problem. First, separation should make it easier and less costly to resolve problems for banks that get into trouble, avoiding the need for taxpayer bailouts. Second, structural separation should help to insulate retail banking from external financial shocks, ensuring that customer deposits and essential banking services are protected.
Problems of ring-fencing
Ring-fencing has been subject to criticism, however, which has led to calls for it to be scrapped.
It must be noted that most of the criticism comes from banks themselves. They state that it required significant operational restructuring by UK banks subject to the regulatory framework which was complex and costly.
In addition, segregating activities can lead to inefficiencies, as banks may not be able to take full advantage of economies of scope between investment and retail banking. Furthermore, ring-fencing could lead to a misallocation of capital, where resources are trapped in one part of the bank and cannot be used to invest in other areas, potentially increasing the risks of the specific areas.
Assessing the new proposals
It is argued that the increased threshold proposed by the authorities may put UK institutions at a competitive disadvantage to outside entrants that are building market share from a low base. Smaller entrants do not have to engage in the costly restructuring that the larger UK incumbents have. They can exploit scope economies and capital mobility within their international businesses to cross-subsidise their retail services in the UK which incumbents with larger deposit-bases are not able to.
However, the UK market for retail banking has significant barriers to entry. Following the acquisition of Virgin Money by Nationwide, only six banking groups in the UK meet the current threshold (Barclays, HSBC, Lloyds Banking Group, NatWest Group, Santander UK and TSB). Indeed, all of those have deposits well above the proposed £35bn threshold. Consequently, raising the threshold should not add significant compliance and efficiency costs, while the potential benefits of greater competition for depositors and SMEs could be a substantial boost to investment and productivity. Furthermore, if the new US entrants do suffer problems, it will not be UK taxpayers who will be liable.
Have we been here before?
In many ways, ring-fencing is a throwback to a previous age of regulation.
One of the most famous Acts of Congress relating to finance and financial markets in the USA is the Glass-Steagall Act of 1933. The Act was passed in the aftermath of the 1929 Wall Street crash and the onset of the Great Depression in the USA. That witnessed significant bank failures across the country and problems were traced back to significant losses made by banks in their lending to investors during the speculative frenzy that preceded the stock market crash of 1929.
To prevent a repeat of the contagion and ensure financial stability, Glass-Steagall legislated to separate retail banks and investment banks.
In the UK, such separation had long existed due to the historical restrictions placed on investment banks operating in the City of London. In the late 20th century, the arguments for separation became outweighed by arguments for the liberalisation of markets to improve efficiency and competition in financial services. Banking was increasingly deregulated and separation disappeared as retail banks increasingly engaged in investment activities.
That cycle of deregulation reached its nadir in 2007 with the international financial crisis. The need to bail out banks made it clear that the supposed synergies between investment and retail banking were no compensation for the high costs of contagion in the financial system.
Regulators must be wary of calls for the removal of ring-fencing. Sir John Vickers (chairman of the independent commission on banking) highlighted the need to protect depositors, and more importantly taxpayers, from risks in banking. It is the banks that should bear the risks and manage them accordingly. Ultimately, it is up to the banks to do that better.
Articles
Bank annual reports
Access these annual reports to check the deposit base of these UK banks:
Information
Report
- Final Report: Recommendations
The Independent Commission on Banking, Sir John Vickers (Chair), Clare Spottiswoode, Martin Taylor, Bill Winters and Martin Wolf (September 2011)
Questions
- How did the structure of UK banks cause contagion risk in the period before the global financial crisis?
- How does ring-fencing aim to address this and protect depositors and taxpayers?
- Use the links to the annual reports of the covered banks to assess the extent of deposits held by the institutions in 2023. How far above the proposed buffer do the banks sit?
- Use your answer to 3) and economic concepts to analyse the impact on competition in the UK market for retail deposits of raising the threshold.
- What are the risks for financial stability of raising the threshold?
The market for crude oil is usually a volatile one. Indeed, in the last few months, the market has seen prices rise and fall due to various supply and demand influences. Crude oil is coined the ‘King of Commodities’ due to the impact it has on consumers, producers and both the micro and macro economy. The price of crude oil affects everything from the cost of producing plastics, transportation, and food at the supermarket.
This makes the market for crude oil an economic powerhouse which is closely watched by businesses, traders, and governments. To gain a full understanding of the movements in this market, it is important to identify how demand and supply affect the price of crude oil.
What influences the demand and supply of crude oil?
The law of demand and supply states that if demand increases, prices will rise, and if supply increases, prices will fall. This is exactly what happens in the market for crude oil. The consumer side of the market consists of various companies and hundreds of millions of people. The producer side of the market is made up of oil-producing countries. Collectively, both consumers and producers influence the market price.
However, the demand and supply of crude oil, and therefore the price, is also affected by global economic conditions and geopolitical tensions. What happens in the world impacts the price of oil, especially since a large proportion of the world’s biggest oil producers are in politically unstable areas.
Over the past five years, global events have had a major impact on the price of oil. The economic conditions created by the impact of the COVID pandemic saw prices plummet from around $55 per barrel just before the pandemic in February 2020 to around $15 per barrel in April 2020. By mid-2021 they had recovered to around $75 per barrel. Then, in the aftermath of Russia’s invasion of Ukraine in February 2022, the price surged to reach $133 in June 2022. More recently, geopolitical tensions in the Middle East and concerns about China’s economic outlook have intensified concerns about the future direction of the market. (Click here for a PowerPoint of the chart.)
Geopolitical tensions
In the first week of October 2024, the price of crude oil rose by almost 10% to around $78 per barrel as the conflict in the Middle East intensified. It unfortunately comes at a time when many countries are starting to recover from the rise in oil prices caused by the pandemic and the war in Ukraine. Any increase in prices will affect the price that consumers pay to fill up their vehicles with fuel, just when prices of diesel and petrol had reached their lowest level for three years.
The Governor of the Bank of England, Andrew Bailey, has said that the Bank is monitoring developments in the Middle East ‘extremely closely’, as the conflict has the potential to have serious impacts in the UK. The Bank of England will therefore be watching for any movement in oil prices that could fuel inflation.
The main concerns stem from further escalation in the conflict between Israel and the Iran-backed armed group, Hezbollah, in Lebanon. If Israel decides to attack Iran’s oil sector, this is likely to cause a sharp rise in the price of oil. Iran is the world’s seventh largest oil exporter and exports over half of its production to China. If the oilfields of a medium-sized supplier, like Iran, were attacked, this could threaten general inflation in the UK, which could in turn influence any decision by the Bank of England to lower interest rates next month.
Supply deficits
This week (2nd week of October 2024) saw the price of crude oil surge above $81 per barrel to hit its highest level since August. This rise means that prices increased by 12% in a week. However, this surge in price also means that prices rose by almost 21% between the start September and the start of October alone. Yet it was only in early September when crude oil hit a year-to-date low, highlighting the volatility in the market.
As the Middle-East war enters a new and more energy-related phase, the loss of Iranian oil would leave the market in a supply deficit. The law of supply implies that such a deficit would lead to an increase in prices. This also comes at a time when the US Strategic Petroleum Reserve has also been depleted, causing further concerns about global oil supply.
However, the biggest and most significant impact would be a disruption to flows through the Strait of Hormuz. This is a relatively narrow channel at the east end of the Persian Gulf through which a huge amount of oil tanker traffic passes – about a third of total seaborne-traded oil. It is therefore known as the world’s most important oil transit chokepoint. The risk that escalation could block the Strait of Hormuz could technically see a halt in about a fifth of the world’s oil supply. This would include exports from big Gulf producers, including Saudi Arabia, UAE, Kuwait and Iraq. In a worst-case scenario of a full closure of the Strait, a barrel of oil could very quickly rise to well above $100.
Disruption to shipments would also lead to higher gas prices and therefore lead to a rise in household gas and electricity bills. As with oil, gas prices filter down supply chains, affecting the cost of virtually all goods, resulting in a further rise in the cost of living. With energy bills in the UK having already risen by 10% for this winter, an escalation to the conflict could see prices rise further still.
China’s economic outlook
Despite the concern for the future supply of oil, there is also a need to consider how the demand for oil could impact price changes in the market. The price of oil declined on 14 October 2024 in light of concerns over China’s struggling economy. As China is the world’s largest importer of crude oil, there are emerging fears about the potential limits on fuel demand. This fall in price reversed increases made the previous week as investors become concerned about worsening deflationary pressures in China.
Any reduced demand from China could indicate an oversupply of crude oil and therefore potential price declines. Official data from China reveal a sharp year-on-year drop in the producer price index of 2.8% – the fastest decline in six months. These disappointing results have stirred uncertainty about the Chinese government’s economic stimulus plans. Prices could fall further if there are continuing doubts about the government’s ability to implement effective fiscal measures to promote consumer spending and, in turn, economic growth.
As a result of the 2% price fall in oil prices on 14 October, OPEC (the Organization of the Petroleum Exporting Countries) has lowered its 2024 and 2025 global oil demand growth. This negative news outweighed market concerns over the possibility that an Israeli response to Iran’s missile attack could disrupt oil production.
What is the future for oil prices?
It is expected that the market for oil will remain a volatile one. Indeed, the current uncertainties around the globe only highlight this. It is never a simple task to predict what will happen in a market that is influenced by so many global factors, and the current global landscape only adds to the complexity.
There’s a wide spectrum of predictions about what could come next in the market for crude oil. Given the changes in the first two weeks of October alone, supply and demand factors from separate parts of the globe have made the future of oil prices particularly uncertain. Callum Macpherson, head of commodities at Investec, stated in early October that ‘there is really no way of telling where we will be this time next week’ (see the first BBC News article linked below).
Despite the predominately negative outlook, this is all based on potential scenarios. Caroline Bain, chief commodities economist at Capital Economics suggests that if the ‘worst-case scenario’ of further escalation in the Middle East conflict does not materialise, oil prices are likely to ‘ease back quite quickly’. Even if Iran’s supplies were disrupted, China could turn to Russia for its oil. Bain says that there is ‘more than enough capacity’ globally to cover the gap if Iranian production is lost. However, this does then raise the question of where the loyalty of Saudi Arabia, the world’s second largest oil producer, lies and whether it will increase or restrict further production.
What is certain is that the market for crude oil will continue to be a market that is closely observed. It doesn’t take much change in global activity for prices to move. Therefore, in the current political and macroeconomic environment, the coming weeks and months will be critical in determining oil prices and, in turn, their economic effects.
Articles
- How worried should I be about rising oil prices?
BBC News, Michael Race (4/10/24)
- Interest rates could fall more quickly, hints Bank
BBC News, Dearbail Jordan (3/10/24)
- Oil Prices Eye $100 A Barrel As War Risk Premium Returns
FX Empire, Phil Carr (8/10/24)
- Crude oil futures reverse previous gains following disappointing economic data from China
London Loves Business, Hamza Zraimek (14/10/24)
- Oil falls 2% as OPEC cuts oil demand growth view, China concerns
Reuters, Arathy Somasekhar (14/10/24)
- Could war in the Gulf push oil to $100 a barrel?
The Economist (7/10/24)
- The Commodities Feed: Oil remains volatile
ING Think, Ewa Manthey and Warren Patterson (8/10/24)
- Who and what is driving oil price volatility
FT Alphaville, George Steer (9/10/24)
- Brent crude surges above $80 as conflict and storm spark supply fears
Financial Times, Rafe Uddin and Jamie Smyth (7/10/24)
Questions
- Use a demand and supply diagram to illustrate what has happened to oil prices in the main two scenarios:
(a) Conflict in the Middle East;
(b) Concerns about China’s economic performance.
- How are the price elasticities of demand and supply relevant to the size of any oil price change?
- What policy options do the governments have to deal with the potential of increasing energy prices?
- What are oil futures? What determines oil future prices?
- How does speculation affect oil prices?
We continue to live through incredibly turbulent times. In the past decade or so we have experienced a global financial crisis, a global health emergency, seen the UK’s departure from the European Union, and witnessed increasing levels of geopolitical tension and conflict. Add to this the effects from the climate emergency and it easy to see why the issue of economic uncertainty is so important when thinking about a country’s economic prospects.
In this blog we consider how we can capture this uncertainty through a World Uncertainty Index and the ways by which economic uncertainty impacts on the macroeconomic environment.
World Uncertainty Index
Hites Ahir, Nicholas Bloom and Davide Furceri have constructed a measure of uncertainty known as the World Uncertainty Index (WUI). This tracks uncertainty around the world using the process of ‘text mining’ the country reports produced by the Economist Intelligence Unit. The words searched for are ‘uncertain’, ‘uncertainty’ and ‘uncertainties’ and a tally is recorded based on the number of times they occur per 1000 words of text. To produce the index this figure is then multiplied up by 100 000. A higher number therefore indicates a greater level of uncertainty. For more information on the construction of the index see the 2022 article by Ahir, Bloom and Furceri linked below.
Figure 1 (click here for a PowerPoint) shows the WUI both globally and in the UK quarterly since 1991. The global index covers 143 countries and is presented as both a simple average and a GDP weighted average. The UK WUI is also shown. This is a three-quarter weighted average, the authors’ preferred measure for individual countries, where increasing weights of 0.1, 0.3 and 0.6 are used for the three most recent quarters.
From Figure 1 we can see how the level of uncertainty has been particularly volatile over the past decade or more. Events such as the sovereign debt crisis in parts of Europe in the early 2010s, the Brexit referendum in 2016, the COVID-pandemic in 2020–21 and the invasion of Ukraine in 2022 all played their part in affecting uncertainty domestically and internationally.
Uncertainty, risk-aversion and aggregate demand
Now the question turns to how uncertainty affects economies. One way of addressing this is to think about ways in which uncertainty affects the choices that people and businesses make. In doing so, we could think about the impact of uncertainty on components of aggregate demand, such as household consumption and investment, or capital expenditures by firms.
As Figure 2 shows (click here for a PowerPoint), investment is particularly volatile, and much more so than household spending. Some of this can be attributed to the ‘lumpiness’ of investment decisions since these expenditures tend to be characterised by indivisibility and irreversibility. This means that they are often relatively costly to finance and are ‘all or nothing’ decisions. In the context of uncertainty, it can make sense therefore for firms to wait for news that makes the future clearer. In this sense, we can think of uncertainty rather like a fog that firms are peering through. The thicker the fog, the more uncertain the future and the more cautious firms are likely to be.
The greater caution that many firms are likely to adopt in more uncertain times is consistent with the property of risk-aversion that we often attribute to a range of economic agents. When applied to household spending decisions, risk-aversion is often used to explain why households are willing to hold a buffer stock of savings to self-insure against unforeseen events and their future financial outcomes being worse than expected. Hence, in more uncertain times households are likely to want to increase this buffer further.
The theory of buffer-stock saving was popularised by Christopher Carroll in 1992 (see link below). It implies that in the presence of uncertainty, people are prepared to consume less today in order to increase levels of saving, pay off existing debts, or borrow less relative to that in the absence of uncertainty. The extent of the buffer of financial wealth that people want to hold will depend on their own appetite for risk, the level of uncertainty, and the moderating effect from their own impatience and, hence, present bias for consuming today.
Risk aversion is consistent with the property of diminishing marginal utility of income or consumption. In other words, as people’s total spending volumes increase, their levels of utility or satisfaction increase but at an increasingly slower rate. It is this which explains why individuals are willing to engage with the financial system to reallocate their expected life-time earnings and have a smoother consumption profile than would otherwise be the case from their fluctuating incomes.
Yet diminishing marginal utility not only explains consumption smoothing, but also why people are willing to engage with the financial system to have financial buffers as self-insurance. It explains why people save more or borrow less today than suggested by our base-line consumption smoothing model. It is the result of people’s greater dislike (and loss of utility) from their financial affairs being worse than expected than their like (and additional utility) from them being better than expected. This tendency is only likely to increase the more uncertain times are. The result is that uncertainty tends to lower household consumption with perhaps ‘big-ticket items’, such as cars, furniture, and expensive electronic goods, being particularly sensitive to uncertainty.
Uncertainty and confidence
Uncertainty does not just affect risk; it also affects confidence. Risk and confidence are often considered together, not least because their effects in generating and transmitting shocks can be difficult to disentangle.
We can think of confidence as capturing our mood or sentiment, particularly with respect to future economic developments. Figure 3 plots the Uncertainty Index for the UK alongside the OECD’s composite consumer and business confidence indicators. Values above 100 for the confidence indicators indicate greater confidence about the future economic situation and near-term business environment, while values below 100 indicate pessimism towards the future economic and business environments.
Figure 3 suggests that the relationship between confidence and uncertainty is rather more complex than perhaps is generally understood (click here for a PowerPoint). Haddow, Hare, Hooley and Shakir (see link below) argue that the evidence tends to point to changes in uncertainty affecting confidence, but with less evidence that changes in confidence affect uncertainty.
To illustrate this, consider the global financial crisis of the late 2000s. The argument can be made that the heightened uncertainty about future prospects for households and businesses helped to erode their confidence in the future. The result was that people and businesses revised down their expectations of the future (pessimism). However, although people were more pessimistic about the future, this was more likely to have been the result of uncertainty rather than the cause of further uncertainty.
Conclusion
For economists and policymakers alike, indicators of uncertainty, such as the Ahir, Bloom and Furceri World Uncertainty Index, are invaluable tools in understanding and forecasting behaviour and the likely economic outcomes that follow. Some uncertainty is inevitable, but the persistence of greater uncertainty since the global financial crisis of the late 2000s compares quite starkly with the relatively lower and more stable levels of uncertainty seen from the mid-1990s up to the crisis. Hence the recent frequency and size of changes in uncertainty show how important it to understand how uncertainty effects transmit through economies.
Academic papers
- The World Uncertainty Index
National Bureau of Economic Research, Working Paper 29763, Hites Ahir, Nicholas Bloom and Davide Furceri (February 2022)
- The Buffer-Stock Theory of Saving: Some Macroeconomic Evidence
Brookings Papers on Economic Activity, Christopher D Carroll (Vol 2, 1992)
- Macroeconomic uncertainty: what is it, how can we measure it and why does it matter?
Bank of England Quarterly Bulletin, 2013 Q2, Abigail Haddow, Chris Hare, John Hooley and Tamarah Shakir (13/6/13)
Articles
Data
Questions
- (a) Explain what is meant by the concept of diminishing marginal utility of consumption.
(b) Explain how this concept helps us to understand both consumption smoothing and the motivation to engage in buffer-stock saving.
- Explain the distinction between confidence and uncertainty when analysing macroeconomic shocks.
- Discuss which types of expenditures you think are likely to be most susceptible to uncertainty shocks.
- Discuss how economic uncertainty might affect productivity and the growth of potential output.
- How might the interconnectedness of economies affect the transmission of uncertainty effects through economies?
In the first of a series of updated blogs focusing on the importance of the distinction between nominal and real values we look at the issue of earnings. Here we update the blog Getting Real with Pay written back in February 2019. Then, we noted how the macroeconomic environment since the financial crisis of the late 2000s had continued to affect people’s pay. Specifically, we observed that there had been no growth in real or inflation-adjusted pay. In other words, people were no better off in 2019 than in 2008.
In this updated blog, we consider to what extent the picture has changed five years down the line. While we do not consider the distributional impact on pay, the aggregate picture nonetheless continues to paint a very stark picture, with consequences for living standards and financial wellbeing.
While the distinction between nominal and real values is perhaps best known in relation to GDP and economic growth, the distinction is also applied frequently to analyse the movement of one price relative to prices in general. One example is that of movements in pay (earnings) relative to consumer prices.
Pay reflects the price of labour. The value of our actual pay is our nominal pay. If our pay rises more quickly than consumer prices, then our real pay increases. This means that our purchasing power rises and so the volume of goods and services we can afford increases. On the other hand, if our actual pay rises less quickly than consumer prices then our real pay falls. When real pay falls, purchasing power falls and the volume of goods and services we can afford falls.
Figures from the Office for National Statistics show that in January 2000 regular weekly pay (excluding bonuses and before taxes and other deductions from pay) was £293. By April 2024 this had risen to £640. This is an increase of 118 per cent. Over the same period, the consumer prices index known as the CPIH, which, unlike the better-known CPI, includes owner-occupied housing costs and council tax, rose by 82 per cent. Therefore, the figures are consistent with a rise both in nominal and real pay between January 2000 to April 2024. However, this masks a rather different picture that has emerged since the global financial crisis of the late 2000s.
Chart 1 shows the annual percentage changes in actual (nominal) regular weekly pay and the CPIH since January 2001. Each value is simply the percentage change from 12 months earlier. The period up to June 2008 saw the annual growth of weekly pay outstrip the growth of consumer prices – the blue line in the chart is above the red dashed line. Therefore, the real value of pay rose. However, from June 2008 to August 2014 pay growth consistently fell short of the rate of consumer price inflation – the blue line is below the red dashed line. The result was that average real weekly pay fell. (Click here to download a PowerPoint copy of the chart.)
Chart 2 show the average levels of nominal and real weekly pay. The real series is adjusted for inflation. It is calculated by deflating the nominal pay values by the CPIH. Since the CPIH is a price index whose value averages 100 across 2015, the real pay values are at constant 2015 consumer prices. From the chart, we can see that the real value of weekly pay peaked in April 2008 at £473 at 2015 prices. The subsequent period saw rates of pay increases that were lower than rates of consumer price inflation. This meant that by March 2014 the real value of weekly pay had fallen by 6.3 per cent to £443 at 2015 prices. (Click here to download a PowerPoint copy of the chart.)
Although real (inflation-adjusted) pay recovered a little after 2014, 2017 again saw consumer price inflation rates greater than those of pay inflation (see Chart 1). This meant that at the start of 2018 real earnings were 3.2 per cent lower than their 2008-peak (see Chart 2). Real earnings then began to recover, buoyed by the economic rebound following the relaxation of COVID lockdown measures and increasing staffing pressures. Real earnings finally passed their 2008-peak in August 2020. By April 2021 regular weekly pay reached £491 at 2015 prices which was 3.8 per cent above the pre-global financial crisis peak.
However, the boost to real wages was to be short-lived as inflationary pressures rose markedly. While some of this was attributable to the same pressures that were driving up wages, inflationary pressures were fuelled further by the commodity price shock arising from Russia’s invasion of Ukraine and, in particular, its impact on energy prices. This saw the CPIH inflation rate rise to 9.6 per cent in October 2022 (while the CPI inflation rate peaked in the same month at 11.1 per cent). The result was that real weekly earnings fell by 2.7 per cent between January and October 2022 to stand at £471 at 2015 consumer prices. Consequently, average pay was once again below its pre-global financial crisis level.
Although inflationary pressures have recently weakened and real earnings have begun to recover, real regular weekly earnings in April 20024 (£486 at 2015 prices) were a mere 2.7 per cent higher than back in the first half of 2008. This compares to a nominal increase of around 58 per cent over the same period thereby demonstrating the importance of the distinction between nominal and real values in understanding what developments in pay mean for the purchasing power of households.
Chart 3 reinforces the importance of the nominal-real distinction. It shows nicely the sustained period of real pay deflation (negative rates of pay inflation) that followed the financial crisis, and the significant rates of real pay deflation associated with the recent inflation shock.
The result is that since June 2008 the average annual rate of growth of real regular weekly pay has been 0.1 per cent, despite nominal pay increasing at an annual rate of 2.9 per cent. In contrast, the period from January 2001 to May 2008 saw real regular weekly pay grow at an annual rate of 2.1 per cent with nominal pay growing at an annual rate of 4.0 per cent. (Click here to download a PowerPoint copy of the chart.)
If we think about the growth of nominal earnings, we can identify two important determinants.
The first is the expected rate of inflation. Workers will understandably want wage growth at least to match the growth in prices so as to maintain their purchasing power.
The second factor is the growth in labour productivity. Firms will be more willing to grant pay increases if workers are more productive, since productivity helps to offset pay increases and maintain firms’ profit margins. Consequently, since over time the actual rate of inflation will tend to mirror the expected rate, the growth of real pay is closely related to the growth of labour productivity. This is significant because, as John discusses in his blog The Productivity Puzzle (14 April 2024), labour productivity growth in the UK, as measured by national output per worker hour, has stalled since the global financial crisis.
Understanding the stagnation of real earnings therefore nicely highlights the interconnectedness of economic variables. In this case, it highlights the connections between productivity, levels of investment and people’s purchasing power. It is not surprising, therefore, that the stagnation of both real earnings and productivity growth since the global financial crisis have become two of the most keenly debated macroeconomic issues of recent times. Indeed, it is likely that their behaviour will continue to shape macroeconomic debates and broader conversations around government policy for some time.
Articles
Questions
- Using the examples of both GDP and earnings, explain how the distinction between nominal and real relates to the distinction between values and volumes.
- In what circumstances would an increase in actual pay translate into a reduction in real pay?
- In what circumstances would a decrease in actual pay translate into an increase in real pay?
- What factors might explain the reduction in real rates of pay seen in the UK following the financial crisis of 2007–8?
- Of what importance might the growth in real rates of pay be for consumption and aggregate demand?
- Why is the growth of real pay an indicator of financial well-being? What other indicators might be included in measuring financial well-being?
- Assume that you have been asked to undertake a distributional analysis of real earnings since the financial crisis. What might be the focus of your analysis? What information would you therefore need to collect?
The UK Chancellor of the Exchequer, Jeremy Hunt, delivered his Spring Budget on 6 March 2024. In his speech, he announced a cut in national insurance (NI): a tax paid by workers on employment or self-employment income. The main rate of NI for employed workers will be cut from 10% to 8% from 6 April 2024. This follows a cut this January from 12% to 10%. The rate for the self-employed will be cut from 9% to 6% from 6 April. These will be the new marginal rates from the NI-free threshold of £12 750 to the higher threshold of £50 270 (above which the marginal rate is 2% and remains unchanged). Unlike income tax, NI applies only to income from work (employment or self-employment) and does not include pension incomes, rent, interest and dividends.
The cuts will make all employed and self-employed people earning more than £12 750 better off than they would have been without them. For employees on average incomes of £35 000, the two cuts will be worth £900 per year.
But will people end up paying less direct tax (income tax and NI) overall than in previous years? The answer is no because of the issue of fiscal drag (see the blog, Inflation and fiscal drag). Fiscal drag refers to the dampening effect on aggregate demand when higher incomes lead to a higher proportion being paid in tax. It occurs when there is a faster growth in incomes than in tax thresholds. This means that (a) the tax-free allowance accounts for a smaller proportion of people’s incomes and (b) a higher proportion of many people’s incomes will be paid at the higher income tax rate. Fiscal drag is especially acute when thresholds are frozen, when inflation is rapid and when real incomes rise rapidly.
Tax thresholds have been frozen since 2021 and the government plans to keep them frozen until 2028. This is illustrated in the following table.
According to the Institute for Fiscal Studies, the net effect of fiscal drag means that for every £1 given back to employed and self-employed workers by the NI cuts, £1.30 will have been taken away as a result of freezing thresholds between 2021 and 2024. This will rise to £1.90 in 2027/28.
Tax revenues are still set to rise as a percentage of GDP. This is illustrated in the chart. Tax revenues were 33.2% of GDP in 2010/11. By 2022/23 the figure had risen to 36.3%. With neither of the two changes to NI (January 2024 and April 2024), the OBR forecasts that the figure would rise to 37.7% by 2028/29 – the top dashed line in the chart. After the first cut, announced in November, it forecasts a smaller rise to 37.3% – the middle dashed line. After the second cut, announced in the Spring Budget, the OBR cut the forecast figure to 37.1% – the bottom dashed line. (Click here for a PowerPoint of the chart.)
As you can see from the chart, despite the cut in NI rates, the fiscal drag from freezing thresholds means that tax revenue as a percentage of GDP is still set to rise.
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Questions
- Would fiscal drag occur with frozen nominal tax bands if there were zero real growth in incomes? Explain.
- Find out what happened to other taxes, benefits, reliefs and incentives in the 2024 Spring Budget. Assess their macroeconomic effect.
- If the government decides that it wishes to increase tax revenues as a proportion of GDP (for example, to fund increased government expenditure on infrastructure and socially desirable projects and benefits), examine the arguments for increasing personal allowances and tax bands in line with inflation but raising the rates of income tax in order to raise sufficient revenue?
- Distinguish between market-orientated and interventionist supply-side policies? Why do political parties differ in their approaches to supply-side policy?
- What is the Conservative government’s fiscal rule? Is the Spring Budget 2024 consistent with this rule?
- What policies were announced in the Spring Budget 2024 to increase productivity? Why is it difficult to estimate the financial outcome of such policies?