Category: Economics for Business: Ch 30

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Cyprus: one crisis ends; another begins

After a week of turmoil in Cyprus (see the News item Ochi, ochi, ochi) a deal has been struck between Cyprus, the EU and the IMF over a €10bn bailout for the island’s banking system. But while the deal may bring the immediate crisis to an end, the Cypriot economy could face years of austerity and depression. And there remain questions over whether the deal sends the wrong message to depositors in banks in other eurozone countries whose banking systems are under pressure.

Unlike the original EU proposal, the deal will not impose a levy on deposits under €100,000, much to the relief of small and medium depositors. But individuals and businesses with deposits over €100,000 in the two main troubled banks (Laiki and the Bank of Cyprus) will face losses that could be as high as 40%. The precise size will become clear in the coming days.

The troubled second largest bank, Laiki (Popular) Bank, will be split into a ‘good’ and a ‘bad’ bank. The assets and liabilities of the good part will be taken over by the largest bank, the Bank of Cyprus. Thus people’s accounts under €100,000 will be moved from one to the other. The ‘bad’ part will include deposits over €100,000 and bonds. Holders of these could lose a substantial proportion of their value.

Many businesses will be hard hit and may be forced to close. This could have serious adverse multiplier effects on the economy. These effects will be aggravated by the fiscal austerity measures which are also part of the deal. The measures are also likely to discourage further inward investment, again pushing the economy further into recession.

And then there are the broader effects on the eurozone. The direct effect of a decline in the Cypriot economy would be tiny; the Cypriot economy accounts for a mere 0.2% of eurozone GDP. Also the effect on small savers in other eurozone countries is also likely to be limited, as people will probably be reassured that savings under €100,000 have remained protected, even in an economy as troubled as Cyprus.

But some commentators argue that the effect on large depositors in other troubled eurozone countries, such as Portugal, Spain, Greece and Italy, could be much more serious. Would people with large balances in these countries prefer to move their money to, say, Germany, or even out of the eurozone altogether? There is clearly disagreement over this last point as you will see from the articles below.

Webcasts and Podcasts

Cyprus agrees bailout with eurozone ministers The Guardian (25/3/13)
Cyprus bailout: Deal reached in Eurogroup talks BBC News (25/3/13)
‘Disaster avoided’ as Cyprus agrees EU bailout deal Euronews (25/3/13)
Cyprus saved from bankruptcy Channel 4 News on YouTube, Faisal Islam (25/3/13)
What are the implications of the Cyprus deal? BBC Radio 4 Today Programme, Stephanie Flanders (25/3/13)
Cyprus bailout deal: Russia riled but Germany relieved BBC News, Steve Rosenberg in Moscow and Stephen Evans in Berlin (25/3/13)
Cyprus bailout deal ‘durable’ says IMF chief BBC News, Christine Lagarde (25/3/13)
Cyprus Bailout Deal Raises Questions: Lombardi Bloomberg, Domenico Lombardi (25/3/13)
Minister Michalis Sarris: Cyprus paying ‘tremendous cost’ BBC Radio 4 Today Programme, Michalis Sarris (26/3/13)

Articles

Last-minute Cyprus deal to close bank, force losses Reuters, Jan Strupczewski and Annika Breidthardt (25/3/13)
Cyprus strikes last-minute EU bailout deal The Guardian, Ian Traynor (25/3/13)
‘There is no future here in Cyprus’ The Telegraph, Nick Squires (25/3/13)
Back from the brink: EU ministers approve €10bn bailout deal at 11th-hour to save Cyprus Independent, Charlotte McDonald-Gibson and Majid Mohamed (25/3/13)
Cyprus bailout: Deal reached in Eurogroup talks BBC News (25/3/13)
Q&A: Cyprus deal BBC News (25/3/13)
The rescue of Cyprus won’t feel like one to its people BBC News, Robert Peston (25/3/13)
Lessons of Cyprus BBC News, Stephanie Flanders (25/3/13)
Cyprus bailout: Dijsselbloem remarks alarm markets BBC News (25/3/13)
Cyprus saved – but at what cost? The Guardian, Helena Smith (25/3/13)
Cyprus bail-out: savers will be raided to save euro in future crisis, says eurozone chief The Telegraph, Bruno Waterfield (25/3/13)
Cyprus’s banks have been tamed – are Malta and Luxembourg next? The Guardian, Ian Traynor (25/3/13)
Lehman lessons weigh on Cyprus talks but 1920s slump must not be ignored The Guardian, Larry Elliott (24/3/13)

Questions

  1. Explain what is meant by ‘moral hazard’. What moral hazards are implicit in the deal that has been struck with Cyprus?
  2. How does the size of the banking system in Cyprus as a proportion of GDP differ from that in other troubled eurozone countries? How does this affect the ‘contagion’ argument?
  3. Does the experience of Iceland and its troubled banks suggest that the Cypriot problem has nothing to do with its being in the eurozone?
  4. What options are open to the Cypriot government to stimulate the economy and prevent a severe recession? How realistic are these options (if any)?
  5. What are the likely implications of the deal for the economic relationships (as opposed to the political ones) between Cyprus and Russia and between the eurozone and Russia?
  6. Are there any similarities in the relationships between the weak and strong eurozone countries today and those between Germany and other countries in the 1920s and 30s?
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The growing Bank of England inflation remit

The Bank of England was granted independence to set interest rates back in 1997. This is known as instrument independence. However, the remit is set by the government and so it does not have goal independence. Amongst the policy announcements on Budget day (Wed 20 March), the government detailed amendments to the Bank’s remit. In particular, the remit now more explicitly acknowledges that, in exceptional circumstances, the Bank might need to pay more attention to output variability.

Despite the amendments to its remit, the Bank of England continues to have a forward-looking operational inflation rate target of 2 per cent (with a range of tolerance of up to 1 percentage point). The MPC therefore sets the Bank Rate, i.e. the rate at which it engages in short-term lending to financial institutions, to affect general interest rates in the economy. In turn, the level of interest rates is assumed to affect the level of aggregate demand and, hence, the rate of demand-pull inflation as well as inflation rate expectations.

A key economic benefit of delegating interest rate decisions to the Monetary Policy Committee (MPC) is thought to be lower inflation rate expectations. By granting the Bank of England operational or instrument independence, inflation announcements have a credibility that they would not if monetary policy was under the control of elected politicians. So why change the inflation rate remit?

The government remains of the view that inflation rate targeting has served the UK well, despite inflation being persistently above target for the past three years (see chart: click here for a PowerPoint). However, it has sought to clarify how the Bank of England might be expected to behave in exceptional circumstances when the economy is buffeted by shocks and disturbances, such as those that it has faced following the financial crisis of the late 2000s. The government argues that in such circumstances the output volatility that could result by ensuring that inflation remains on target could be undesirable. Therefore, the MPC should give consideration to the volatility of output that targeting inflation would cause in such exceptional circumstances.

The amended remit says that in setting monetary policy the MPC should communicate to the public the trade-offs that are inherent in meeting its forward-looking inflation rate target. Therefore, during exceptional times, the Bank may communicate that the volatility of output resulting from returning inflation to target would be so large that it is prepared to keep monetary policy looser than it otherwise would. This could mean indicating a time-frame over which it would be expected to keep interest rates lower than otherwise. By communicating this, it would in effect be looking to affect peoples’ expectations and, importantly, their behaviour. The prospect of prolonged low interest rates, such as those currently being experienced, might encourage greater expenditure, especially as a result of lower borrowing costs – though of course this is not guaranteed!

The Governor will continue to write an open letter to the Chancellor of the Exchequer if inflation moves away from the target by more than 1 percentage point in either direction. However, in a change to the previous remit, this will be done in conjunction with the minutes of the MPC meeting that follow the publication of the official inflation figures by the Office for National Statistics. By publishing the letter alongside the minutes, it gives the MPC more time to consider its strategy and to give due consideration to the trade-offs in returning inflation to the target. If inflation remains more than 1 percentage point above or below the target the Governor will need to write a further letter after three months. This letter would be alongside the minutes of the third subsequent meeting of the MPC.

Some commentators argue that the amended remit is merely a reflection of the current reality. In other words, the remit is being rewritten in a way which reflects how the MPC is currently making its interest rate decisions. Others are concerned that what was a simple and clear objective is now not the case and that this may have implications for the credibility of monetary policy. Whatever the rights and wrongs, Wednesday’s announcement was an important development in the history of central bank independence in the UK.

Documents
Remit for the Monetary Policy Committee Bank of England, March 2013
Governor Response to the remit for the Monetary Policy Committee Bank of England , March 2013

Articles

Bank of England handed new remit in Osbourne’s budget Guardian, Josephine Moulds (20/3/13)
Budget: Changing the Bank of England Remit Sky News, Ed Conway (20/3/13)
Budget 2013: Bank of England’s monetary policy remit changed Telegraph, Angela Monaghan (20/3/13)
King warns against ‘major change’ to Bank’s remit ITV News (15/3/13)
Chancellor adjusts Bank of England inflation remit Financial Times, Nick Reeve (20/3/13)
Budget 2013: Bank of England gets new orders BBC News (20/3/13)

Questions

  1. Why would monetary policy be expected to be more credible under an independent central bank?
  2. How might a lack of credibility over monetary policy affect the economy’s rate of inflation?
  3. Outline the advantages and disadvantages of the changes to the Bank of England’s remit.
  4. Central bank independence constrains discretion over monetary policy. Should governments constrain their discretion over fiscal policy? What are the advantages and disadvantages?
  5. Explain how the MPC tries to affect the rate of inflation through changes in the Bank Rate?
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The political dynamite of calm economic reflection

In a carefully argued article in the New Statesman, the UK Business Secretary, Vince Cable, considers the slow recovery in the economy and whether additional measures should be adopted. He sums up the current state of the economy as follows:

The British economy is still operating at levels around or below those before the 2008 financial crisis and roughly 15 per cent below an albeit unsustainable pre-crisis trend. There was next to no growth during 2012 and the prospect for 2013 is of very modest recovery.

Unsurprisingly there is vigorous debate as to what has gone wrong. And also what has gone right; unemployment has fallen as a result of a million (net) new jobs in the private sector and there is vigorous growth of new enterprises. Optimistic official growth forecasts and prophets of mass unemployment have both been confounded.

He argues that supply-side policies involving “a major and sustained commitment to skills, innovation and infrastructure investment” are essential if more rapid long-term growth is to be achieved. This is relatively uncontroversial.

But he also considers the claim that austerity has kept the economy from recovering and whether policies to tackle the negative output gap should be adopted, even if this means a short-term increase in government borrowing.

But crude Keynesian policies of expanding aggregate demand are both difficult to implement and may not take into account the particular circumstance of the current extended recession – or depression – in the UK and in many eurozone countries. World aggregate demand, however, is not deficient. In fact it is expanding quite rapidly, and with the sterling exchange rate index some 20% lower than before the financial crisis, this should give plenty of opportunity for UK exporters.

Yet expanding UK aggregate demand is proving difficult to achieve. Consumers, worried about falling real wages and large debts accumulated in the years of expansion, are reluctant to increase consumption and take on more debts, despite low interest rates. In the light of dampened consumer demand, firms are reluctant to invest. This makes monetary policy particularly ineffective, especially when banks have become more risk averse and wish to hold higher reserves, and indeed are under pressure to do so.

So what can be done? He argues that there is “some scope for more demand to boost output, particularly if the stimulus is targeted on supply bottlenecks such as infrastructure and skills.” In other words, he advocates policies that will simultaneously increase both aggregate demand and aggregate supply. Monetary policy, involving negative real interest rates and quantitative easing, has helped to prevent a larger fall in real aggregate demand and a deeper dive into recession, but the dampened demand for money and the desire by banks to build their reserves has meant a massive fall in the money multiplier. Perhaps monetary policy needs to be more aggressive still (see the blog post, Doves from above), but this may not be sufficient.

Which brings Dr Cable to the political dynamite! He advocates an increase in public investment on infrastructure (schools and colleges, hospitals, road and rail projects and housing, and considers whether this should be financed, not by switching government expenditure away from current spending, but by borrowing more.

Such a strategy does not undermine the central objective of reducing the structural deficit, and may assist it by reviving growth. It may complicate the secondary objective of reducing government debt relative to GDP because it entails more state borrowing; but in a weak economy, more public investment increases the numerator and the denominator.

He raises the question of whether the balance of risks has changed: away from the risk of increased short-term borrowing causing a collapse of confidence to the risk of lack of growth causing a deterioration in public finances and this causing a fall in confidence. As we saw in the blog post Moody Blues, the lack of growth has already caused one ratings agency (Moody’s) to downgrade the UK’s credit rating. The other two major agencies, Standard & Poor’s and Fitch may well follow suit.

The day after Dr Cable’s article was published, David Cameron gave a speech saying that the government would stick to its plan of deficit reduction. Not surprisingly commentators interpreted this as a split in the Coalition. Carefully argued economics from Dr Cable it might have been, but political analysts have seen it as a hand grenade, as you will see from some of the articles below.

When the facts change, should I change my mind? New Statesman, Vince Cable (6/3/13)
Keynes would be on our side New Statesman, Vince Cable (12/1/11)
Exclusive: Vince Cable calls on Osborne to change direction New Statesman, George Eaton (67/3/13)
Vince Cable: Borrowing may not be as bad as slow growth BBC News (7/3/13)
Vince Cable makes direct challenge to Cameron over economic programme The Guardian, Nicholas Watt (7/3/13)
Vince Cable Says George Osborne Must Change Course And Borrow More To Revive Growth Huffington Post, Ned Simons (6/3/13)
David Cameron and Vince Cable at war over route to recovery Independent, Andrew Grice (6/3/13)
Vince Cable: Borrowing may not be as bad as slow growth BBC News, James Landale (6/3/13)
David Cameron: We will hold firm on economy BBC News (7/3/13)
David Cameron: We will hold firm on economy BBC News (7/3/13)
Clegg Backs Cable Over Controversial Economy Comments LBC Radio, Nick Clegg (7/3/13)
It’s plain what George Osborne needs to do – so just get on and do it The Telegraph, Jeremy Warner (6/3/13)
Vince Cable’s plan B: a “matter of judgement” BBC News, Stephanie Flanders (7/3/13)
George Osborne needs to turn on the spending taps The Guardian, Phillip Inman (12/3/13)

Questions

  1. Why has monetary policy proved ineffective in achieving a rapid recovery from recession?
  2. Distinguish between discretionary fiscal policy and automatic fiscal stabilisers.
  3. Why has the existence of automatic fiscal stabilisers meant that the public-sector deficit has been difficult to bring down?
  4. In what ways has the balance of risks in using discretionary fiscal policy changed over the past three years?
  5. In what ways is the depression of the late 2000s/early 2010s (a) similar to and (b) different from the Great Depression of the early 1930s?
  6. In what ways is the structure of public-sector debt in the UK different from that in many countries in the eurozone? Why does this give the government more scope for expansionary fiscal policy?
  7. Why does the Office of Budget Responsibility’s estimates of the tax and government expenditure multipliers suggest that “if fiscal policy is to work in a Keynesian manner, it needs to be targeted carefully, concentrating on capital projects”?
  8. Why did Keynes argue that monetary policy is ineffective at the zero bound (to use Dr Cable’s terminology)? Are we currently at the zero bound? If so what can be done?
  9. Has fiscal tightening more than offset loose monetary policy?
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Doves from above

With many countries struggling to recover from the depression of the past few years, central banks are considering more and more doveish moves to kick-start lending. But with short-term interest rates in the USA, the UK and Japan close to zero, the scope for further cuts are limited. So what can central banks do?

The first thing that can be done is to adopt a higher inflation target or to accept inflation above target – at least for the time being. This could be accompanied by explicitly targeting GDP growth (real or nominal) or unemployment (see the blog from last December, Rethinking central bank targets).

The second option is to increase quantitative easing. Although in a minority at the last MPC meeting, Mervyn King, the current Bank of England Governor, argued for a further £25 billion of asset purchases (bringing the total to £400bn) (see MPC minutes paragraph 39). It is highly likely that the MPC will agree to further QE at its next meeting in March. In Japan, the new governor of the Bank of Japan is expected to include asset purchases as part of the policy of monetary easing.

The third option is for the central bank to provide finance at below-market rates of interest directly to the banking sector specifically for lending: e.g. to small businesses or for house purchase. The Bank of England’s Funding for Lending Scheme is an example and the Bank is considering extending it to other financial institutions.

One other approach, mooted by the Bank of England’s Deputy Governor before the House of Commons Treasury Select Committee, is for negative interest rates paid on Banks’ reserves in the Bank of England. This would, in effect, be a fee levied on banks for keeping money on deposit. The idea would be to encourage banks to lend the money and not to keep excessive liquidity. As you can see from the chart, three rounds of quantitative easing have led to a huge increase in bank’s reserves at the Bank of England. (Click here for a PowerPoint of the chart.)

The following articles consider these various proposals and whether they will work to stimulate lending and thereby aggregate demand and economic recovery.

Central banks: Brave new words The Economist (23/2/13)
Phoney currency wars The Economist (16/2/13)
Analysis: Global central banks will keep taking it easy Reuters, Alan Wheatley (22/2/13)
Quantitative easing: the markets are struggling with a serious drug habi The Guardian, Larry Elliott (24/2/13)
Negative interest rates idea floated by Bank’s Paul Tucker BBC News (26/2/13)
Bank of England mulls negative interest rates Independent, Ben Chu (26/2/13)
BoE floats extending Funding for Lending to non-banks Mortgage Solutions, Adam Williams (26/2/13)
Funding for Lending Scheme failing to get banks lending Left Foot Forward, James Bloodworth (26/2/13)
Mortgage market boosted by lending schemes, says Redrow BBC News (26/2/13)
Widespread quantitative easing risks ‘QE wars’ and stagnation The Guardian, Nouriel Roubini (28/2/13)

Questions

  1. Consider each of the methods outlined above and their chances of success in stimulating aggregate demand.
  2. Go through each of the methods and consider the problems they are likely to create/have created.
  3. How important is it that monetary policy measures affect people’s expectations?
  4. What effects do the measures have on the distribution of income between borrowers and savers?
  5. What are annuities? How are these affected by policies of monetary easing?
  6. How has actual and anticipated Japanese monetary policy affected the exchange rate of the Japanese yen? How is this likely to affect the Japanese economy?
  7. Explain the sub-heading of the final article above, “When several major central banks pursue QE at the same time, it becomes a zero-sum game”. Do you agree?