Category: Economics: Ch 22

Posted on

The UK government’ fiscal stance

In this blog we show how we can apply fiscal metrics to assess the UK government’s fiscal stance. This captures the extent to which fiscal policy contributes to the level of economic activity in the economy.

Changes in the fiscal stance can then be used to estimate the extent to which discretionary fiscal policy measures represent a tightening or loosening of policy. We can measure the size and direction of fiscal impulses arising from changes in the government’s budgetary position.

Such an analysis is timely given the Autumn Budget presented by Rachel Reeves on 30 October 2024. This was the first Labour budget in 14 years and the first ever to be presented by a female Chancellor of the Exchequer.

We conclude by considering the forecast profile of expenditures and revenues for the next few years and the new fiscal rules announced by the Chancellor.

The fiscal stance

At its most simple, the fiscal stance measures the extent to which fiscal policy increases or decreases demand, thereby influencing growth and inflation (see Box 1.F, page 28, Autumn Budget 2024: see link below).

The fiscal stance is commonly estimated by measures of pubic-sector borrowing. To understand this, we can refer to the circular flow of income model. In this model, excesses of government spending (an injection) over taxation receipts (a withdrawal or leakage) represent a net injection into the circular flow and hence positively affect the level of aggregate demand for national output, all other things being equal.

A commonly used measure of borrowing in assessing the fiscal stance of the is the primary deficit. Unlike public-sector net borrowing, which is simply the excess of the sector’s spending over its receipts (largely taxation), the primary deficit subtracts net interest costs. It therefore excludes the interest payments on outstanding public-sector debts (and interest income earned on financial assets). The primary deficit can therefore be written as public-sector borrowing less net interest payments.

As discussed in our blog Fiscal impulses in November 2023, the primary deficit captures whether the public sector is able to afford its present fiscal choices by abstracting from debt-serving costs that reflect past fiscal choices. In this way, the primary deficit is a preferable measure to net borrowing both in assessing the impact on economic activity, i.e. the fiscal stance, and in assessing whether today’s fiscal choices will require government to issue additional debt.

Chart 1 shows public-sector net borrowing and the primary balance as shares of GDP for the UK since financial year 1975/76 (click here for a PowerPoint). The data are from the latest Public Finances Databank published by the Office for Budget Responsibility, published on the day of the Autumn Budget in October (see Data links below).

Over the period 1975/6 to 2023/24, public-sector net borrowing and the primary deficit had averaged 3.8% and 1.3% of GDP respectively. In the financial year 2023/24, they were 4.5% and 1.5% (they had been as high as 15.1% and 14.1% in 2020/21 as a result of COVID support measures). In 2024/25 net borrowing and the primary deficit are forecast to be 4.5% and 1.6% respectively. By 2027/28, while net borrowing is forecast to be 2.3% of GDP, there is forecast to be a primary surplus of 0.7% of GDP.

The Autumn Budget lays out plans for higher tax revenues to contribute two-thirds of the overall reduction in the primary deficit over the forecast period (up to 2029/30), while spending decisions contribute the remaining third.

The largest tax-raising measure is an increase in the employer rate of National Insurance Contributions (NICs) by 1.2 percentage points to 15% from April 2025. This will be levied on employee wages above a Secondary Threshold of £5000, reduced from £9100, which will increase in line with CPI inflation each year from April 2028. (See John’s blog, Raising the minimum wage: its effects on poverty and employment, for an analysis on the effects of this change.) This measure, allowing for other changes to the operation of employer NICs, is expected to raise £122 billion over the forecast period. This amounts to over two-thirds of the additional tax take from the taxation measures taken in the Budget.

Chart 2 shows both net borrowing and the primary deficit after being cyclically-adjusted (click here for a PowerPoint). This process adjusts these fiscal indicators to account for those parts of spending and taxation that are affected by the position of the economy in the business cycle. These are those parts that act as automatic stabilisers helping, as the name suggests, to stabilise the economy.

The process of cyclical adjustment leads to estimates of receipts and expenditures as if the economy were operating at its potential output level and hence with no output gap. The act of cyclically adjusting the primary deficit, which is our preferred measure of the fiscal stance, allows us to assess better the public sector’s fiscal stance.

Over the period from 1975/6 up to and including 2023/24, the cyclically-adjusted primary deficit (CAPD) averaged 1.1% of potential GDP. In 2024/25 the CAPD is forecast to be 1.5% of potential GDP. It then moves to a surplus of 0.5% by 2027/28. It therefore mirrors the path of the unadjusted primary deficit.

Measuring the fiscal impulse

To assess even more clearly the extent to which the fiscal stance is changing, we can use the cyclically-adjusted primary deficit to measure a fiscal impulse. This captures the magnitude of change in discretionary fiscal policy.

The term should not be confused with fiscal multipliers which measure the impact of fiscal changes on outcomes, such as real GDP and employment. Instead, we are interested in the size of the impulse that the economy is being subject to. Specifically, we are measuring discretionary fiscal policy changes that result in structural changes in the government budget and which, therefore, allow an assessment of how much, if at all, a country’s fiscal stance has tightened or loosened.

The size of the fiscal impulse is measured by the year-on-year percentage point change in the cyclically-adjusted public-sector primary deficit (CAPD) as a percentage of potential GDP. A larger deficit or a smaller surplus indicates a fiscal loosening. This is consistent with a positive fiscal impulse. On the other hand, a smaller deficit or a larger surplus indicates a fiscal tightening. This is consistent with a negative fiscal impulse.

Chart 3 shows the magnitude of UK fiscal impulses since the mid-1970s (Click here for a PowerPoint file). The scale of the fiscal interventions in response to the COVID-19 pandemic, which included the COVID-19 Business Interruption Loan Scheme (CBILS) and Job Retention Scheme (‘furlough’), stand out sharply. In 2020 the CAPD to potential output ratio rose from 1.7 to 14.4%. This represents a positive fiscal impulse of 12.4% of GDP.

This was followed in 2021 by a tightening of the fiscal stance, with a negative fiscal impulse of 10.1% of GDP as the CAPD to potential output fell back to 4.0%. Subsequent tightening was tempered by policy measures to limit the impact on the private sector of the cost-of-living crisis, including the Energy Price Guarantee and Energy Bills Support Scheme.

For comparison, the fiscal response to the global financial crisis from 2007 to 2009 saw a cumulative positive fiscal impulse of 5.6% of GDP. While smaller in comparison to the discretionary fiscal responses to the COVID-19 pandemic, it nonetheless represented a sizeable loosening of the fiscal stance.

Chart 4 focuses on the implied fiscal impulse for the forecast period up to 2029/30 (click here for a PowerPoint). The period is notable for a negative fiscal impulse each year. Across the period as a whole, this there is a cumulative negative fiscal impulse of 2.6% of GDP. Most of the ‘heavy-lifting’ of the fiscal consolidation occurs in the three financial years from 2025/26 during which there is a cumulative negative impulse of 2.0% of GDP.

Looking forward

To conclude, we consider the implications for the projected profiles of public-sector spending, receipts and liabilities over the forecast period up to 2029/30.

Chart 5 plots data since the mid-1950s (click here for a PowerPoint). It shows the size of total public-sector spending (also known as ‘total managed expenditures’), taxation receipts (sometimes referred as the ‘tax burden’) and total public-sector receipts as shares of GDP. This last one includes additional receipts, such as interest payments on financial assets and income generated by public corporations, as well as taxation receipts.

The OBR forecasts that in real terms (i.e. after adjustment for inflation), public-sector spending will increase on average over the period from 2025/26 to 2029/30 by 1.4% per year, but with total receipts due to rise more quickly at 2.5% per year and taxation receipts by 2.8% per year. The implications of this, as discussed in the OBR’s October 1014 Economic and Fiscal Outlook (see link below), are that:

the size of the state is forecast to settle at 44% of GDP by the end of the decade, almost 5 percentage points higher than before the pandemic” while additional tax revenues will “push the tax take to a historic high of 38% of GDP by 2029-30

Finally, the government has committed to two key rules: a stability rule and an investment rule.

The stability rule. This states that the current budget must be in surplus by 2029/30 or, once 2029/30 becomes the third year of the forecast period, it will be in balance or surplus every third year of the rolling forecast period thereafter. The current budget refers to the difference between receipts and expenditures other than capital expenditures. In effect, it captures the ability of government to meet day-to-day spending and is intended to ensure that over the medium term any borrowing is solely for investment. It is important to note that ‘balance’ is defined in a range of between a deficit and surplus of no more than 0.5% of GDP.

The stability rule replaces the borrowing rule of the previous government that public net borrowing, therefore inclusive of investment expenditures, was not to exceed 3% of GDP by the fifth year of the rolling forecast period.

The investment rule. The government is planning to increase investment. In order to do this in a financially sustainable way, the investment rule states that public-sector net financial liabilities (PSNFL) or net financial debt for short, is falling as a share GDP by 2029/30, until 2029/30 becomes the third year of the forecast period. PSNFL should then fall by the third year of the rolling forecast period. PSNFL is a broader measure of the sector’s balance sheet than public-sector net debt (PSND), which was targeted under the previous government and which was required to fall by the fifth year of the rolling forecast period.

The new target, as well as now extending to the Bank of England, ‘nets off’ not just liquid liabilities (i.e. cash in the bank and foreign exchange reserves) but also financial assets such as shares and money owed to it, including expected student loan repayments. While liabilities are broader too, including for example, the local government pension scheme, the impact is expected to reduce the new liabilities target by £236 billion or 8.2 percentage points of GDP in 2024/25. The hope is that both rules can support what the Budget Report labels a ‘step change in investment’.

As Chart 6 shows, public investment as a share of GDP has not exceeded 6% this century and during the 2010s averaged only 4.4% (click here for a PowerPoint). The forecast has it rising above 5% for a time, but easing to 4.8% by end of the period.

This suggests more progress will be needed if the UK is to experience a significant and enduring increase in public investment. Of course, this needs to be set in the context of the wider public finances and is illustrative of the choices facing fiscal policymakers across the globe after the often violent shocks that have rocked economies and impacted on the state of the public finances in recent years.

Articles

Official documents

Data

Questions

  1. Explain what is meant by the following fiscal terms:
    (a) Structural deficit,
    (b) Automatic stabilisers,
    (c) Discretionary fiscal policy,
    (d) Public-sector net borrowing,
    (e) Primary deficit,
    (f) Current budget balance,
    (g) Public-sector net financial liabilities (PSNFL).
  2. Explain the difference between a fiscal impulse and a fiscal multiplier.
  3. In designing fiscal rules what issues might policymakers need to consider?
  4. What are key differences between the fiscal rules of the previous Conservative government and the new Labour government in the UK? What economic arguments would you make for and against the ‘old’ and ‘new’ fiscal rules?
  5. What is meant by the ‘sustainability’ of the public finances? What factors might impact on their sustainability?
Posted on

Raising the minimum wage: its effects on poverty and employment

The first Budget of the new UK Labour government was announced on 30 October 2024. It contained a number of measures that will help to tackle inequality. These include extra spending on health and education. This will benefit households on lower incomes the most as a percentage of net income. Increases in tax, by contrast, will be paid predominantly by those on higher incomes. The Chart opposite (taken from the Budget Report) illustrates this. It shows that the poorest 10% will benefit from the largest percentage gain, while the richest 10% will be the only decile that loses.

But one of the major ways of tackling inequality and poverty was raising the minimum wage. The so-called ‘National Living Wage (NLW)’, paid to those aged 21 and over, will rise in April by 6.7% – from £11.44 to £12.41 per hour. The minimum wage paid to those aged 18 to 20 will rise 16.3% from £8.60 to £10.00 and for 16 and 17 year-olds and apprentices it will rise £18% from £6.40 to £7.55.

It has been an objective of governments for several years to relate the minimum wage to the median wage. In 2015, the Conservative Government set a target of raising the minimum wage rate to 60 per cent of median hourly earnings by 2020. When that target was hit a new one was set to reach two-thirds of median hourly earnings by 2024.

The Labour government has set a new remit for the minimum wage (NLW). There are two floors. The first is the previously agreed one, that the NLW should be at least two-thirds of median hourly earnings; the second is that it should fully compensate for cost of living rises and for expected inflation up to March 2026. The new rate of £12.41 will meet both criteria. According to the Low Pay Commission, ‘Wages have risen faster than inflation over the past 12 months, and are forecast to continue to do so up to March 2026’. This makes the first floor the dominant one: meeting the first floor automatically meets the second.

How effective is the minimum wage in reducing poverty and inequality?

Figure 1 shows the growth in minimum wage rates since their introduction in 1999. The figures are real figures (i.e. after taking into account CPI inflation) and are expressed as an index, with 1999 = 100. The chart also shows the growth in real median hourly pay. (Click here for a Powerpoint.)

As you can see, the growth in real minimum wage rates has considerably exceeded the growth in real median hourly pay. This has had a substantial effect on raising the incomes of the poorest workers and thereby has helped to reduce poverty and inequality.

The UK minimum wage compares relatively favourably with other high-income economies. Figure 2 shows minimum wage rates in 12 high-income countries in 2023 – the latest year for which data are available. (Click here for a PowerPoint.) The red bars (striped) show hourly minimum wage rates in US dollars at purchasing-power parity (PPP) rates. PPP rates correct current exchange rates to reflect the purchasing power of each country’s currency. The blue bars (plain) show minimum wage rates as a percentage of the median wage rate. In 2023 the UK had the fourth highest minimum wage of the 12 countries on this measure (59.6%). As we have seen above, the 2025 rate is expected to be 2/3 of the median rate.

Minimum wages are just one mechanism for reducing poverty and inequality. Others include the use of the tax and benefit system to redistribute incomes. The direct provision of services, such as health, education and housing at affordable rents can make a significant difference and, as we have seen, have been a major focus of the October 2024 Budget.

The government has been criticised, however, for not removing the two-child limit to extra benefits in Universal Credit (introduced in 2017). The cap clearly disadvantages poor families with more than two children. What is more, for workers on Universal Credit, more than half of the gains from the higher minimum wages will lost because they will result in lower benefit entitlement. Also the freeze in (nominal) personal income tax allowances will mean more poor people will pay tax even with no rise in real incomes.

Effects on employment: analysis

A worry about raising the minimum wage rate is that it could reduce employment in firms already paying the minimum wage and thus facing a wage rise.

In the case of a firm operating in competitive labour and goods markets, the demand for low-skilled workers is relatively wage sensitive. Any rise in wage rates, and hence prices, by this firm alone would lead to a large fall in sales and hence in employment.

This is illustrated in Figure 3 (click here for a PowerPoint). Assume that the minimum wage is initially the equilibrium wage rate We. Now assume that the minimum wage is raised to Wmin. This will cause a surplus of labour (i.e. unemployment) of Q3 – Q2. Labour supply rises from Q1 to Q3 and the demand for labour falls from Q1 to Q2.

But, given that all firms face the minimum wage, individual employers are more able to pass on higher wages in higher prices, knowing that their competitors are doing the same. The quantity of labour demanded in any given market will not fall so much – the demand is less wage elastic; and the quantity of labour supplied in any given market will rise less – the supply is less wage elastic. Any unemployment will be less than that illustrated in Figure 3. If, at the same time, the economy expands so that the demand-for-labour curve shifts to the right, there may be no unemployment at all.

When employers have a degree of monopsony power, it is not even certain that they would want to reduce employment. This is illustrated in Figure 4: click here for a PowerPoint (you can skip this section if you are not familiar with the analysis).

Assume initially that there is no minimum wage. The supply of labour to the monopsony employer is given by curve SL1, which is also the average cost of labour ACL1. A higher employment by the firm will drive up the wage; a lower employment will drive it down. This gives a marginal cost of labour curve of MCL1. Profit-maximising employment will be Q1, where the marginal cost of labour equals the marginal revenue product of labour (MRPL). The wage, given by the SL1 (=ACL1) line will be W1.

Now assume that there is a minimum wage. Assume also that the initial minimum wage is at or below W1. The profit-maximising employment is thus Q1 at a wage rate of W1.

The minimum wage can be be raised as high as W2 and the firm will still want to employ as many workers as at W1. The point is that the firm can no longer drive down the wage rate by employing fewer workers, and so the ACL1 curve becomes horizontal at the new minimum wage and hence will be the same as the MCL curve (MCL2 = ACL2). Profit-maximising employment will be where the MRPL curve equals this horizontal MCL curve. The incentive to cut its workforce, therefore, has been removed.

Again, if we extend the analysis to the whole economy, a rise in the minimum wage will be partly passed on in higher prices or stimulate employers to increase labour productivity. The effect will be to shift the (MRPL) curve upwards to the right, thereby allowing the firm to pass on higher wages and reducing any incentive to reduce employment.

Effects on employment: evidence

There is little evidence that raising the minimum wage in stages will create unemployment, although it may cause some redeployment. In the Low Pay Commission’s 2019 report, 20 years of the National Minimum Wage (see link below), it stated that since 2000 it had commissioned more than 30 research projects looking at the NMW’s effects on hours and employment and had found no strong evidence of negative effects. Employers had adjusted to minimum wages in various ways. These included reducing profits, increasing prices and restructuring their business and workforce.

Along with our commissioned work, other economists have examined the employment effects of the NMW in the UK and have for the most part found no impact. This is consistent with international evidence suggesting that carefully set minimum wages do not have noticeable employment effects. While some jobs may be lost following a minimum wage increase, increasing employment elsewhere offsets this. (p.20)

There is general agreement, however, that a very large increase in minimum wages will impact on employment. This, however, should not be relevant to the rise in the NLW from £11.44 to £12.41 per hour in April 2025, which represents a real rise of around 4.5%. This at worst should have only a modest effect on employment and could be offset by economic growth.

What, however, has concerned commentators more is the rise in employers’ National Insurance contributions (NICs) that were announced in the Budget. In April 2025, the rate will increase from 13.8% to 15%. Employers’ NICs are paid for each employee on all wages above a certain annual threshold. This threshold will fall in April from £9100 to £5000. So the cost to an employer of an employee earning £38 000 per annum in 2024/25 would be £38 000 + ((£38 000 – £9100) × 0.138) = £41 988.20. For the year 2025/26 it will rise to £38 000 + ((£38 000 – £5000) × 0.15) = £42 950. This is a rise of 2.29%. (Note that £38 000 will be approximately the median wage in 2025/26.)

However, for employees on the new minimum wage, the percentage rise in employer NICs will be somewhat higher. A person on the new NLW of £12.41, working 40 hours per week and 52 weeks per year (assuming paid holidays), will earn an annual wage of £25 812.80. Under the old employer NIC rates, the employer would have paid (£25 812.80 + (£25 812.80 – £9100) × 0.138) = £28 119.17. For the year 2025/26, it will rise to £25 812.80 + ((£25 812.80 – £5000) × 0.15) = £28 934.72. This is a rise of 2.90%.

This larger percentage rise in employers’ wage costs for people on minimum wages than those on median wages, when combined with the rise in the NLW, could have an impact on the employment of those on minimum wages. Whether it does or not will depend on how rapid growth is and how much employers can absorb the extra costs through greater productivity and/or passing on the costs to their customers.

Articles

UK Government reports and information

Data

Questions

  1. How is the October 2024 Budget likely to affect the distribution of income?
  2. What are the benefits and limitations of statutory minimum wages in reducing (a) poverty and (b) inequality?
  3. Under what circumstances will a rise in the minimum wage lead or not lead to an increase in unemployment?
  4. Find out what is meant by the UK Real Living Wage (RLW) and distinguish it from the UK National Living Wage (NLW). Why is the RLW higher?
  5. Why is the median wage rather than the mean wage used in setting the NLW?
Posted on

UK banking regulation: ring-fencing revisited

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

  1. How did the structure of UK banks cause contagion risk in the period before the global financial crisis?
  2. How does ring-fencing aim to address this and protect depositors and taxpayers?
  3. 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?
  4. 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.
  5. What are the risks for financial stability of raising the threshold?
Posted on

Crude oil – a volatile market

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

Questions

  1. 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.
  2. How are the price elasticities of demand and supply relevant to the size of any oil price change?
  3. What policy options do the governments have to deal with the potential of increasing energy prices?
  4. What are oil futures? What determines oil future prices?
  5. How does speculation affect oil prices?
Posted on

World Uncertainty Index

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

Articles

Data

Questions

  1. (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.
  2. Explain the distinction between confidence and uncertainty when analysing macroeconomic shocks.
  3. Discuss which types of expenditures you think are likely to be most susceptible to uncertainty shocks.
  4. Discuss how economic uncertainty might affect productivity and the growth of potential output.
  5. How might the interconnectedness of economies affect the transmission of uncertainty effects through economies?