Both the financial and goods markets are heavily influenced by sentiment. And such sentiment tends to be self-reinforcing. If consumers and investors are pessimistic, they will not spend and not invest. The economy declines and this further worsens sentiment and further discourages consumption and investment. Banks become less willing to lend and stock markets fall. The falling stock markets discourage people from buying shares and so share prices fall further. The despondency becomes irrational and greatly exaggerates economic fundamentals.
This same irrationality applies in a boom. Here it becomes irrational exuberance. A boom encourages confidence and stimulates consumer spending and investment. This further stimulates the boom via the multiplier and accelerator and further inspires confidence. Banks are more willing to lend, which further feeds the expansion. Stock markets soar and destabilising speculation further pushes up share prices. There is a stock market bubble.
But bubbles burst. The question is whether the current global stock market boom, with share prices reaching record levels, represents a bubble. One indicator is the price/earnings (PE) ratio of shares. This is the ratio of share prices to earnings per share. Currently the ratio for the US index, S&P 500, is just over 26. This compares with a mean over the past 147 years of 15.64. The current ratio is the third highest after the peaks of the early 2000s and 2008/9.
An alternative measure of the PE ratio is the Shiller PE ratio (see also). This is named after Robert Shiller, who wrote the book Irrational Exuberance. Unlike conventional PE ratios, which only look at average earnings over the past four quarters, the Shiller PE ratio uses average earnings over the past 10 years. “Because this factors in earnings from the previous ten years, it is less prone to wild swings in any one year.”
The current level of the Shiller PE ratio is 29.14, the third highest on record, this time after the period running up to the Wall Street crash of 1929 and the dot-com bubble of the late 1990s. The mean Shiller PE ratio over the past 147 years is 16.72.
So are we in a period of irrational exuberance? And are stock markets experiencing a bubble that sooner or later will burst? The following articles explore these questions.
Articles
2 Clear Instances of Irrational Exuberance Seeking Alpha, Jeffrey Himelson (12/2/17)
Promised land of Trumpflation-inspired global stimulus has been slow off the mark South China Morning Post, David Brown (20/2/17)
A stock market crash is a way off, but this boom will turn to bust The Guardian, Larry Elliott (16/2/17)
The “boring” bubble is close to bursting – the Unilever bid proves it MoneyWeek, John Stepek (20/2/17)
Questions
- Find out what is meant by Minksy’s ‘financial instability hypothesis’ and a ‘Minsky moment’. How might they explain irrational exuberance and the sudden turning point from a boom to a bust?
- Is it really irrational to buy shares with a very high PE ratio if everyone else is doing so?
- Why are people currently exuberant?
- What might cause the current exuberance to end?
- How does irrational exuberance affect the size of the multiplier?
- How might the behaviour of banks and other financial institutions contribute towards a boom fuelled by irrational exuberance?
- Compare the usefulness of a standard PE ratio with the Shiller PE ratio.
- Other than high PE ratios, what else might suggest that stock markets are overvalued?
- Why might a company’s PE ratio differ from its price/dividends ratio (see)? Which is a better measure of whether or not a share is overvalued?
Economic forecasting came in for much criticism at the time of the financial crisis and credit crunch. Few economists had predicted the crisis and its consequences. Even Queen Elizabeth II, on a visit to the London School of Economics in November 2008, asked why economists had got it so wrong. Similar criticisms have emerged since the Brexit vote, with economic forecasters being accused of being excessively pessimistic about the outcome.
The accuracy of economic forecasts was one of the topics discussed by Andy Haldane, Chief Economist at the Bank of England. Speaking at the Institute for Government in London, he compared economic forecasting to weather forecasting (see section from 15’20” in the webcast):
“Remember that? Michael Fish getting up: ‘There’s no hurricane coming but it will be very windy in Spain.’ Very similar to the sort of reports central banks – naming no names – issued pre-crisis, ‘There is no hurricane coming but it might be very windy in the sub-prime sector.” (18’40”)
The problem with the standard economic models which were used for forecasting is that they were essentially equilibrium models which work reasonably well in ‘normal’ times. But when there is a large shock to the economic system, they work much less well. First, the shocks themselves are hard to predict. For example, the sub-prime crisis in 2007/8 was not foreseen by most economists.
Then there is the effect of the shocks. Large shocks are much harder to model as they can trigger strong reactions by consumers and firms, and governments too. These reactions are often hugely affected by sentiment. Bouts of pessimism or even panic can grip markets, as happened in late 2008 with the collapse of Lehman Brothers. Markets can tumble way beyond what would be expected by a calm adjustment to a shock.
It can work the other way too. Economists generally predicted that the Brexit vote would lead to a fall in GDP. However, despite a large depreciation of sterling, consumer sentiment held up better than was expected and the economy kept growing.
But is it fair to compare economic forecasting with weather forecasting? Weather forecasting is concerned with natural phenomena and only seeks to forecast with any accuracy a few days ahead. Economic forecasting, if used correctly, highlights the drivers of economic change, such as government policy or the Brexit vote, and their likely consequences, other things being equal. Given that economies are constantly being affected by economic shocks, including government or central bank actions, it is impossible to forecast the state of the macroeconomy with any accuracy.
This does not mean that forecasting is useless, as it can highlight the likely effects of policies and take into account the latest surveys of, say, consumer and business confidence. It can also give the most likely central forecast of the economy and the likely probabilities of variance from this central forecast. This is why many forecasts use ‘fan charts’: see, for example, Bank of England forecasts.
What economic forecasts cannot do is to predict the precise state of the economy in the future. However, they can be refined to take into account more realistic modelling, including the modelling of human behaviour, and more accurate data, including survey data. But, however refined they become, they can only ever give likely values for various economic variables or likely effects of policy measures.
Webcast
Andy Haldane in Conversation Institute for Government (5/1/17)
Articles
‘Michael Fish’ Comments From Andy Haldane Pounced Upon By Brexit Supporters Huffington Post, Chris York (6/1/17)
Crash was economists’ ‘Michael Fish’ moment, says Andy Haldane BBC News (6/1/17)
The Bank’s ‘Michael Fish’ moment BBC News, Kamal Ahmed (6/1/17)
Bank of England’s Haldane admits crisis in economic forecasting Financial Times, Chris Giles (6/1/17)
Chief economist of Bank of England admits errors in Brexit forecasting BBC News, Phillip Inman (5/1/17)
Economists have completely failed us. They’re no better than Mystic Meg The Guardian, Simon Jenkins (6/1/17)
Five things economists can do to regain trust The Guardian, Katie Allen and Phillip Inman (6/1/17)
Andy Haldane: Bank of England has not changed view on negative impact of Brexit Independent, Ben Chu (5/1/17)
Big data could help economists avoid any more embarrassing Michael Fish moments Independent, Hamish McRae (7/1/17)
Questions
- In what ways does economic forecasting differ from weather forecasting?
- How might economic forecasting be improved?
- To what extent were the warnings of the Bank of England made before the Brexit vote justified? Did such warnings take into account actions that the Bank of England was likely to take?
- How is the UK economy likely to perform over the coming months? What assumptions are you making here?
- Brexit hasn’t happened yet. Why is it extremely difficult to forecast today what the effects of actually leaving the EU will be on the UK economy once it has happened?
- If economic forecasting is difficult and often inaccurate, should it be abandoned?
- The Bank of England is forecasting that inflation will rise in the coming months. Discuss reasons why this forecast is likely to prove correct and reasons why it may prove incorrect.
- How could economic forecasters take the possibility of a Trump victory into account when making forecasts six months ago of the state of the global economy a year or two ahead?
- How might the use of big data transform economic forecasting?
The linked article below from The Economist looks at whether the election of Donald Trump, the effects of the Brexit vote and policies being pursued elsewhere in the world mark a new macroeconomic era. We may be about to witness rising inflation and the end of the era of tight fiscal policy and loose monetary policy. We might see a return of a more Keynesian approach to macreconomic policy.
According to the article, since the financial crisis of 2008, we have been witnessing economies stuck in a liquidity trap. In such cases, there is little scope for further reductions in interest rates. And increases in money supply, in the form of quantitative easing, tend to be held in idle balances, rather than being spent on goods and services. The idle balances take the form of increased bank reserves to rebuild their capital base and increased purchases of assets such as shares and property.
Even if people did believe that monetary policy would work to boost aggregate demand and result in higher inflation, then they would also believe that any such boost would be temporary as central banks would then have to tighten monetary policy to keep inflation within the target they had been set. This would limit spending increases, keeping the economy in the liquidity trap.
With a liquidity trap, fiscal policy is likely to be much more effective than monetary policy in boosting aggregate demand. However, its scope to pull an economy out of recession and create sustained higher growth depends on the extent to which governments, and markets, can tolerate higher budget deficits and growing debt. With governments seeking to claw down deficits and ultimately debt, this severely limits the potential for using fiscal policy.
With the election of Donald Trump, we might be entering a new era of fiscal policy. He has promised large-scale infrastructure spending and tax cuts. Although he has also promised to reduce the deficit, he is implying that this will only occur when the economy is growing more rapidly and hence tax revenues are increasing.
Is Donald Trump a Keynesian? Or are such promises merely part of campaigning – promises that will be watered down when he takes office in January? We shall have to wait and see whether we are about to enter a new era of macroeconomic policy – an era that has been increasingly advocated by international bodies, such as the IMF and the OECD (see the blog post, OECD goes public).
Article
Slumponomics: Trump and the political economy of liquidity traps The Economist (10/11/16)
Questions
- Explain what is meant by ‘the liquidity trap’.
- Why is monetary policy relatively ineffective in a liquidity trap? Use a diagram to support your argument.
- Why is fiscal policy (in the absence of public-sector deficit targets) relatively effective in a liquidity trap? Again, use a diagram to support your argument.
- Examine how the Japanese government attempted to escape the liquidity trap? (Search this site for ‘Abenomics’.)
- In what ways may the depreciation of the pound since the Brexit vote help the UK to escape the liquidity trap?
- Could a different form of quantitative easing, known as ‘helicopter money’, whereby government or private spending is financed directly by new money, allow countries to escape the liquidity trap? (Search this site for ‘helicopter money’.)
- Why may a political upheaval be necessary for a country to escape the liquidity trap?
In a recent blog, Falling sterling – bad for some; good for others, we looked at the depreciation of sterling following the Brexit vote. We saw how it will have beneficial effects for some, such as exporters, and adverse effects for others, such as consumers having to pay a higher price for imports and foreign holidays. The article linked below examines these effects in more depth.
Just how much the quantity of exports will increase depends on two main things. The first is the amount by which the foreign currency price falls. This depends on what exporters choose to do. Say the pound falls from €1.30 to €1.18. Do exporters who had previously sold a product selling in the UK for £100 and in the eurozone for €130, now reduce the euro price to €118? Or do they put it down by less – say, to €125, thereby earning £105.93 (£(125/1.18)). Their sales would increase by less, but their profit margin would rise.
The second is the foreign currency price elasticity of demand for exports in the foreign markets. The more elastic it is, the more exports will rise for any given euro price reduction.
It is similar with imports. How much the sales of these fall depends again on two main things. The first is the amount by which the importing companies are prepared to raise sterling prices. Again assume that the pound falls from €1.30 to €1.18 – in other words, the euro rises from 76.92p (£1/1.3) to 84.75p (£1/1.18). What happens to the price of an import to the UK from the eurozone whose euro price is €100? Does the importer raise the price from £76.92 to £84.75, or by less than that, being prepared to accept a smaller profit margin?
The second is the sterling price elasticity of demand for imports in the UK. The more elastic it is, the more imports will fall and, probably, the more the importer will be prepared to limit the sterling price increase.
The article also looks at the effect on aggregate demand. As we saw in the previous blog, a depreciation boosts aggregate demand by increasing exports and curbing imports. The effects of this rise in aggregate demand depends on the degree of slack in the economy and the extent, therefore, that (a) exporters and those producing import substitutes can respond in terms of high production and employment and (b) other sectors can produce more as multiplier effects play out.
Finally, the article looks at the effect of the depreciation of sterling on asset prices. UK assets will be worth less in foreign currency terms; foreign assets will be worth more in sterling. Just how much the prices of internationally traded assets, such as shares and some property, will change depends, again, on their price elasticities of demand. In terms of assets, there has been a gain to UK balance sheets from the depreciation. As Roger Bootle says:
Whereas the overwhelming majority of the UK’s liabilities to foreigners are denominated in sterling, the overwhelming bulk of our assets abroad are denominated in foreign currency. So the lower pound has raised the sterling value of our overseas assets while leaving the sterling value of our liabilities more or less unchanged.
Article
How a lower pound will help us to escape cloud cuckoo land, The Telegraph, Roger Bootle (31/7/16)
Questions
- What determines the amount that exporters from the UK adjust the foreign currency price of their exports following a depreciation of sterling?
- What determines the amount by which importers to the UK adjust the sterling price of their products following a depreciation of sterling?
- What determines the amount by which sterling will depreciate over the coming months?
- Distinguish between stabilising and destabilising speculation? How does this apply to exchange rates and what determines the likelihood of there being destabilising speculation against sterling exchange rates?
- How is UK inflation likely to be affected by a depreciation of sterling?
- Why does Roger Bootle believe that the UK has been living in ‘cloud cuckoo land’ with respect to exchange rates?
- Why has the UK managed to sustain a large current account deficit over so many years?
In this post we focus on three aspects of poverty around the world. The first is the definition of poverty. Is it an absolute or a relative concept? Does its definition change as the world develops. The second is the extent of poverty. Is the problem getting worse as inequality deepens, or are the numbers (absolutely or proportionately) getting smaller despite increased inequality? The third is policy to tackle the problem. What can be done and is being done? What answers are being given by policymakers in different parts of the world?
As far as the measurement of poverty is concerned, the simplest distinction is between absolute and relative poverty. Absolute poverty could be measured as income below a certain real level deemed necessary to achieve a particular standard of living. This could be specified in terms of sufficient income to have adequate food, shelter, clothing and leisure time, and adequate access to healthcare, clean water, sanitation, education, etc. An obvious problem here is what is considered ‘adequate’, as this is partly culturally determined and will also depend on physical and geographical features, such as climate.
The World Bank defines extreme absolute poverty as living on under $1.90 per day in purchasing-power parity terms. However, even after adjusting for purchasing power, what is considered the poverty threshold differs enormously from country to country. As the Wikipedia entry states:
Each nation has its own threshold for absolute poverty line; in the United States, for example, the absolute poverty line was US$15.15 per day in 2010 (US$22,000 per year for a family of four), while in India it was US$1.0 per day and in China the absolute poverty line was US$0.55 per day, each on PPP basis in 2010.
Relative poverty is normally taken to mean when a person’s income falls below a certain percentage of the mean or median. Thus in richer countries, for a given percentage, the poverty threshold would be at a higher absolute income. 
In the EU, people in relative poverty are defined as those with disposable income (after monetary benefits) less than 60% of the median.
Both approaches focus on consumption. Other approaches include social and cultural exclusion as dimensions of poverty.
What is clear is that poverty has a number of definitions. One problem with this is that politicians can focus on whatever definition suits them. Thus in the UK, with relatively high levels of employment, but often at low wages and only part-time employment, the Conservative government has redefined poverty as where no-one in a family is in work. Yet many working families have very low levels of income, considerably below 60% of the median.
The second aspect of poverty is its extent and whether it is growing. According to the United Nations, globally ‘extreme poverty rates have been cut by more than half since 1990. While this is a remarkable achievement, one in five people in developing regions still live on less than $1.25 a day, and there are millions more who make little more than this daily amount, plus many people risk slipping back into poverty.’
Despite this progress, in many countries extreme poverty is increasing. And in others, although the number in extreme poverty may be declining, it is still high and inequality is increasing so that more people are living only just above the extreme poverty line. The articles look at dimensions of poverty in different countries.
For example, the first The Conversation article argues that the financial crisis of 2008–09 led to a substantial increase in poverty across the European continent.
The impoverishment of Greece, Italy, Cyprus, Spain and Portugal has been so severe that these southern European countries, taken together, had higher levels of poverty and deprivation than many of the former Communist nations that joined the European Union in 2004.
The third aspect is how to tackle the problem of poverty. There are three broad policy approaches.
The first is the use of cash transfers, such as unemployment benefits. The second is providing free or subsidised goods and services, such as healthcare or education. The ability of a country to support the poor in either of these ways depends on its tax base. Also, clearly, it depends on its priorities. There is also the issue of incentives. Do benefits encourage or discourage the recipients from seeking work? This depends on the design of the system. For example, if childcare is subsidised, this may both aid poor parents and also encourage parents responsible for looking after young children to seek work.
The third is to attempt to improve the earning power of the poor. This may in part be by the second approach of improving education, training and health. But it may also involve removing restrictions to employment, say by making various forms of discrimination illegal. It may also involve increasing land rights. In many developing countries land is very unequally distributed; redistribution to the poor can make a substantial contribution to relieving poverty. Another approach is to encourage agencies which supply microfinance for poor people wishing to set up their own small business.
The articles below look at a number of dimensions of poverty: its measurement, its extent and its alleviation. They look at the problem from the perspective of different countries. It is interesting to see to what extent the problems and solutions they identify are country-specific or general.
Articles
Extreme poverty affects 1 in 8 globally Buenos Aires Herald (20/7/16)
How poverty has radically shifted across Europe in the last decade The Conversation, Rod Hick (20/7/16)
The economics of poverty The Tribune of India, S Subramanian (22/7/16)
Poverty Chains and Global Capitalism. Towards a Global Process of Impoverishment Global Research (Canada), Benjamin Selwyn (20/7/16)
Asia’s cost of prosperity The Nation, Karl Wilson (24/7/16)
Private rental sector is the ‘new home of poverty’ in the UK The Guardian, Brian Robson (20/7/16)
Challenges in maintaining progress against global poverty Vox, Martin Ravallion (23/12/15)
California, sixth largest economy in the world, has highest poverty rate in US wsws.org, Marc Wells (22/7/16)
How gross inequality and crushed hopes have fed the rise of Donald Trump The Conversation, Nick Fischer (21/7/16)
Information
Sustainable Development Goals – Goal 1: End poverty in all its forms everywhere United Nations
Children of the Recession: Innocenti Report Card 12 UNICEF, Gonzalo Fanjul (September 2014)
Listings on Poverty Joseph Rowntree Foundation
Poverty The World Bank
Hunger and World Poverty Poverty.com
Questions
- Distinguish between absolute and relative poverty. Give examples of specific measures of each and the extent to which they capture the complex nature of the problem.
- Discuss the appropriateness of the seven measures of poverty used in the first The Conversation article.
- How did the financial crisis affect the proportion of people living in poverty? Explain.
- What is the relationship between poverty and inequality? Does a more unequal society imply that there will be a greater proportion of people living in poverty?
- How has international poverty changed in recent years? What explanations can you give?
- What are the advantages and disadvantages of using income per head as a measure of poverty, whether absolute or relative?
- Why is poverty so high in (a) the USA as a whole; (b) California specifically?
- How does globalisation affect poverty?
- Are adverse environmental consequences an inevitable result of reducing poverty in developing countries?
- Is freer trade likely to increase or decrease poverty? Explain
Both the financial and goods markets are heavily influenced by sentiment. And such sentiment tends to be self-reinforcing. If consumers and investors are pessimistic, they will not spend and not invest. The economy declines and this further worsens sentiment and further discourages consumption and investment. Banks become less willing to lend and stock markets fall. The falling stock markets discourage people from buying shares and so share prices fall further. The despondency becomes irrational and greatly exaggerates economic fundamentals.
But bubbles burst. The question is whether the current global stock market boom, with share prices reaching record levels, represents a bubble. One indicator is the price/earnings (PE) ratio of shares. This is the ratio of share prices to earnings per share. Currently the ratio for the US index, S&P 500, is just over 26. This compares with a mean over the past 147 years of 15.64. The current ratio is the third highest after the peaks of the early 2000s and 2008/9.
The current level of the Shiller PE ratio is 29.14, the third highest on record, this time after the period running up to the Wall Street crash of 1929 and the dot-com bubble of the late 1990s. The mean Shiller PE ratio over the past 147 years is 16.72.
