Over the past few years, the term ‘bail-out’ has been a common phrase. But, what about the term ‘bail-in’? The latest bank to face financial ruin is the Co-operative Bank, but instead of turning to the tax-payer for a rescue, £1.5 billion will come from bond holders being offered shares in the bank. This will mean that the bank will become listed on the stock market.
Back in 2009, the Co-operative Bank bought Britannia Building Society and it seems that this was the start of its downfall. It took over many bad mortgage loans and loans to companies, and these played a large part in its current financial difficulties.
In order to rescue the bank and raise the capital needed to absorb current and future losses, without turning to the tax-payer, bond-holders of £1.3 billion of loans to the bank will be asked to swap them for shares and bonds, thus leading to significant losses for them. These bond-holders include 7000 private investors.
Since the financial crisis five years ago, the conventional banking model has seen much criticism and many suggested that the mutual structure of the Co-operative provided a better model, creating trust, due to its many stakeholders, who are not as focused on profitability and returns as those shareholders of a listed bank. However, the problems of the Co-operative seem to have put paid to that idea. The bail-in will mean that the bank is now listed on the stock market and thus will have shareholders expecting returns and profitability. This will undoubtedly change the focus of the bank. Euan Sutherland, the new Chief Executive said:
We are very clear that the bank will remain true to responsible and community-based banking and retain its ethical investment stance … Clearly there are lessons to learn and clearly there will be a time to look back and do that but, to be honest, in the last six weeks, where I have been involved with the Co-operative group, we have focused on driving a very solid future for this bank.
The good news is that the savings of those in the Co-operative are safe and taxpayers will not have to fork out any more money.
Yet, the co-operative structure of the bank has long been praised by customers and government alike. But is it perhaps this structure, which has led to its collapse? Furthermore, will the change in structure that will see it listed on the stock market, lead to a change in its approach to banking? The following articles consider the latest bank to run into difficulties.
Webcast
Co-op Bank unveils rescue plan to tackle the £1.5bn hole BBC News (17/6/13)
Articles
Co-op Bank travails show weakness of mutual model Financial Times, Sarah Gordon (21/6/13)
Co-operative Bank to list on stock market in rescue deal The Guardian, Jill Treanor (17/6/13)
Troubled Co-operative Bank unveils rescue plan to plug £1.5bn hole in balance sheet Independent, Nick Goodway (17/6/13)
Co-op Bank announces plan to plug £1.5bn hole Which? (17/6/13)
The Co-operative Bank and the challenge of finding co-op capital The Guardian, Andrew Bibby (13/6/13)
Co-op Bank seeks to fill £1.5bn capital hole Sky News (17/6/13)
Does Co-op Group deserve to keep control of Co-op Bank? BBC News, Robert Peston (9/7/13)
Questions
- Why did the Co-operative Bank move into financial trouble?
- What are the key characteristics of a Mutual? Are they disadvantages or advantages?
- What is a ‘bail-in’? Who will gain and who will lose?
- The Co-operative Bank will now be listed on the stock market. What does this mean?
- What are the advantages and disadvantages of floating a company on the stock market?
- Why are all banks required to hold capital to absorb losses?
Since the beginning of 2009, central banks around the world have operated an extremely loose monetary policy. Their interest rates have been close to zero (click here for a PowerPoint of the chart) and more than $20 trillion of extra money has been injected into the world economy through various programmes of quantitative easing.
The most recent example of loose monetary policy has been in Japan, where substantial quantitative easing has been the first of Japan’s three arrows to revive the economy (the other two being fiscal policy and supply-side policy).
One consequence of a rise in money supply has been the purchase of a range of financial assets, including shares, bonds and commodities. As a result, despite the sluggish or negative growth in most developed countries, stock markets have soared (see chart). From March 2009 to May 2013, the FTSE 100 rose by 91% and both the USA’s Dow Jones Industrial average and Germany’s DAX rose by 129%. Japan’s NIKKEI 225, while changing little from 2009 to 2012, rose by 78% from November 2012 to May 2013 (click here for a PowerPoint of the chart).
The US economy has been showing stronger growth in recent months and, as a result, the Fed has indicated that it may soon have to begin tightening monetary policy. It is not doing so yet, nor are other central banks, but the concern that this may happen in the medium term has been enough to persuade many investors that stock markets are likely to fall as money eventually becomes tighter. Given the high degree of speculation on stock markets, this has led to a large-scale selling of shares as investors try to ‘get ahead of the curve’.
From mid-May to mid-June, the FTSE 100 fell by 6.2%, the Dow Jones by 2.6%, the DAX by 4.5% and the NIKKEI by 15%. In some developing countries, the falls have been steeper as the cheap money that entered their economies in search of higher returns has been leaving. The falls in their stock markets have been accompanied by falls in their exchange rates.
The core of the problem is that most of the extra money that was created by central banks has been used for asset purchase, rather than in financing extra consumer expenditure or capital investment. If money is tightened, it is possible that not only will stock and bond markets fall, but the fragile recovery may be stifled. In other words, tighter money and higher interest rates may indeed affect the real economy, even though loose monetary policy and record low interest rates had only a very modest effect on the real economy.
This poses a very difficult question for central banks. If even the possibility of monetary tightening some time in the future has spooked markets and may rebound on the real economy, does that compel central banks to maintain their loose policy? If it does, will this create an even bigger adjustment problem in the future? Or could there be a ‘soft landing’, whereby real growth absorbs the extra money and gradually eases the inflationary pressure on asset markets?
Articles
How the Fed bosses all BBC News, Robert Peston (12/6/13)
The great reversal? Is the era of cheap money ending? BBC News, Linda Yueh (12/6/13)
The Great Reversal: Part II (volatility and the real economy) BBC News, Linda Yueh (14/6/13)
The end of the affair The Economist (15/6/13)
Out of favour The Economist, Buttonwood (8/6/13)
The Federal Reserve: Clearer, but less cuddly The Economist (22/6/13)
Global financial markets anxious to avoid many pitfalls of ‘political risk’ The Guardian, Heather Stewart (13/6/13)
Dow Falls Below 15,000; Retailers Add to Slump New York Times, (12/6/13)
Global market sell-off over stimulus fears The Telegraph, Rachel Cooper (13/6/13)
Nikkei sinks over 800 points, falls into bear market Globe and Mail (Canada), Lisa Twaronite (13/6/13)
Global shares drop, dollar slumps as rout gathers pace Reuters, Marc Jones (13/6/13)
The G8, the bond bubble and emerging threats BBC News, Stephanie Flanders (17/6/13)
Global monetary policy and the Fed: vive la difference BBC News, Stephanie Flanders (20/6/13)
The Federal Reserve’s dysfunctional relationship with the markets The Guardian, Heidi Moore (19/6/13)
Global stock markets in steep falls after Fed comment BBC News (20/6/13)
Federal Reserve’s QE withdrawal could signal real trouble ahead The Guardian, Nils Pratley (20/6/13)
Central banks told to head for exit Financial Times, Claire Jones (23/6/13)
Stimulating growth threatens stability, central banks warn The Guardian (23/6/13)
BIS Press Release and Report
Making the most of borrowed time: repair and reform the only way to growth, says BIS in 83rd Annual Report BIS Press Release (23/6/13)
83rd BIS Annual Report 2012/2013 Bank for International Settlements (23/6/13)
Data
Yahoo! Finance: see links for FTSE 100, DAX, Dow Jones, NIKKEI 225
Link to central bank websites Bank for International Settlements
Statistical Interactive Database – Interest & exchange rates data Bank of England
Questions
- Why have stock markets soared in recent years despite the lack of economic growth?
- What is meant by ‘overshooting’? Has overshooting taken place in stock markets (a) up to mid-May this year; (b) since mid-May? How would you establish whether overshooting has taken place?
- What role is speculation currently playing in stock markets? Would you describe this speculation as destabilising?
- What has been the impact of quantitative easing on (a) bond prices; (b) bond yields?
- Argue the case for and against central banks continuing with the policy of quantitative easing for the time being.
- Find out how much the Indian rupee and the Brazilian real have fallen in recent weeks. Explain your findings.
Since coming to office in December 2012, Shinzo Abe’s government has been determined to revive the Japanese economy. For the past 20 years, Japan’s growth has averaged only 0.8% per annum. This compares with 1.3% for Germany, 2.3% for the UK, 2.6% for the USA, 4.9% for South Korea and 10.4% for China.
Japanese real GDP per capita was only 14.5% higher in 2012 than 20 years earlier. This compares with figures for Germany, the UK, the USA, South Korea and China of 27%, 45%, 34%, 126% and 497% respectively.
So what has the Japanese government done to boost both short-term and long-term growth after years of stagnation? There are ‘three arrows’ to the policy, targeted at reviving and sustaining economic growth.
The first arrow is monetary policy. The Bank of Japan has engaged in extensive quantitative easing through bond purchases in order to drive down the exchange rate (see A J-curve for Japan?), stimulate expenditure and increase the rate of inflation. A target inflation rate of 2% has been set by the Bank of Japan. Part of the problem for the Japanese economy over the years has been stagnant or falling prices. Japanese consumers have got used to waiting to spend in the hope of being able to buy at lower prices. Similarly, Japanese businesses have often delayed stock purchase. By committing to bond purchases of whatever amount is necessary to achieve the 2% inflation target, the central bank hopes to break this cycle and encourage people to buy now rather than later.
The second arrow is fiscal policy. Despite having the highest debt to GDP ratio in the developed world, Japan is embarking on a large-scale programme of infrastructure investment and other public works. The package is worth over $100bn. The expansionary fiscal policy is accompanied by a longer-term plan for fiscal consolidation as economic growth picks up. In the short term, Japan should have no difficulty in financing the higher deficit, given that most of the borrowing is internal and denominated in yen.
The third arrow is supply-side policy. On 5 June, Shinzo Abe unveiled a series of goals his government would like to achieve in order to boost capacity and productivity. These include increasing private-sector investment (both domestic and inward), infrastructure expenditure (both private and public), increasing farmland, encouraging more women to work by improving day-care facilities for children, and deregulation of both goods, capital and labour markets. The prime minister, however, did not give details of the measures that would be introduced to achieve these objectives. More details will be announced in mid-June.
The following videos and articles look at the three arrows of Abenomics and the effects they are having on confidence and attitudes as well as on expenditure, output and the exchange rate. They also look at the crucial third arrow: at whether supply-side reforms will be enough to achieve a sustained increase in economic growth.
Videos
Abenomics an uncertain future for most Financial Times on YouTube, Ben McLannahan (30/5/13)
Assessing Abenomics NHK World (3/6/13)
Adam Posen on Abenomics NHK World (30/5/13)
Japanese concerned over ‘Abenomics’ AlJazeera on YouTube (30/5/13)
Abenomics – the cure for deflation? BBC News, Rupert Wingfield-Hayes (10/5/13)
Japan PM’s economic speech ‘short on detail’ BBC News, Rupert Wingfield Hayes (5/6/13)
Pretty Positive on Abenomics Bloomberg, Jan Hatzius, Goldman Sachs (5/6/13)
Why Abenomics is Bonkers: Pro CNBC, Graeme Maxton, (27/5/13)
‘Abe’nomics Not About BOJ Printing Money Bloomberg, Derek Halpenny (31/5/13)
Abenomics Aims `Third Arrow’ at Business Rules Bloomberg, Willie Pesek (5/6/13)
Analysis on Abe’s Growth Plan NHK World (5/6/13)
Articles
Will three arrows find their target? On Line Opinion, Andrew Leigh (6/6/13)
Japan Fires ‘Third Arrow,’ but Will It Work? CNBC, Dhara Ranasinghe (5/6/13)
Japan’s ‘3 Arrows’ May Run Into German Wall CNBC, Michael Ivanovitch (19/5/13)
Japan’s recovery – the power of Abe’s three arrows Commonwealth Bank, Australia, Melanie Timbrell (31/5/13)
So Far, the Battery Charger Is Working in Japan The New York Times, Jeff Sommer (18/5/13)
Abenomics Could Light A Fire Under The Japan Trade Again Business Insider, Matthew Boesler (4/6/13)
Japan’s New Prime Minister Unveils The ‘Most Important’ Plank Of Abenomics Business Insider (5/6/13)
Japan PM pledges to boost incomes by 30% Channel NewsAsia (5/6/13)
Abe’s growth strategy disappoints economists, investors The Asahi Shimbun (6/6/13)
Abenomics Won’t Be ’Magic Bullet’ for Japan, Says Johnson of MIT Bloomberg, Cordell Eddings (5/6/13)
Too soon to call time on Abenomics BBC News, Stephanie Flanders (19/6/13)
Abenomics: The objectives and the risks BBC News, Puneet Pal Singh (19/7/13)
Data
World Economic Outlook Database IMF
Bank of Japan Statistics Bank of Japan
Economic Outlook Annex Tables OECD
Country statistical profile: Japan 2013 OECD
Questions
- Demonstrate on (a) an aggregate demand and supply diagram and (b) a Keynesian 45° line diagram the effects of the three arrows (assuming they are successful) in meeting their objectives.
- What will determine the effectiveness of the first two arrows in boosting short-term economic growth?
- Would you characterise the policies of the third arrow as interventionist or market-orientated, or as a mixture? Explain.
- What are the dangers in ‘Abenomics’?
- Find out what has been happening to Japanese bond rates. What are the implications of this for monetary policy?
- What are the ‘markets telling Abe’?
- In what ways will expectations influence the effectiveness of Abenomics?
Here are a series of videos examining the case for and against austerity policy. Is such policy necessary to re-balance countries’ economies and retain or regain the confidence of investors? Or does such policy harm not just short-run growth but long-run growth too? Does it reduce investment and thereby aggregate supply?
These videos follow on from the news item Keynes versus the Classics: a new version of an old story. In the first video, Mark Blyth, author of Austerity: the History of a Dangerous Idea, argues that austerity policy has not worked and never can. George Osborne, by contrast, argues that although it has been a ‘hard road to recovery’, austerity policy is working.
International bodies take a more nuanced stand. The IMF, while supporting the objective of reducing the government deficit, argues that the pace of the cuts in the UK should be slowed until more robust growth returns. The OECD, in examining the global economy, is more supportive of countries maintaining the pace of deficit reduction, but argues that the ECB needs to take stronger monetary measures to boost bank lending in the eurozone.
With austerity having increasingly alarming effects on unemployment and social cohesion, especially within certain eurozone countries, such as Greece, Portugal and Spain, it is not surprising that there are growing demands for rethinking macroeconomic policy.
There is general agreement that more needs to be done to promote economic growth, and a growing consensus that an increase in infrastructure expenditure is desirable. But whether such expenditure should be financed by increased borrowing (with the extra deficit being reduced subsequently as a result of the extra growth), or whether it should be financed by reductions in expenditure elsewhere, is a continuing focus of debate.
Austerity: the History of a Dangerous Idea The Guardian, Mark Blyth (27/5/13) (see also)
IMF: UK austerity will be a ‘drag on growth’ BBC News. Hugh Pym (22/5/13)
George Osborne: ‘Hard road to recovery for UK economy’ BBC News (22/5/13)
Economy and austerity BBC News, Sajid Javid and Stephen Timms (1/5/13)
IMF’s Olivier Blanchard urges UK austerity rethink BBC News (16/4/13)
OECD ‘supportive of Osborne austerity plans’ BBC news (29/5/13)
Stimulus vs. austerity measures in EU CNN, Mohamed El-Erian (29/5/13)
‘No time to wobble’ on deficit reduction YouTube, Sir Roger Carr (CBI president) (16/5/13)
Deficit-Cutting: Not If, But When Wall Street Journal Live, David Wessel (8/5/13)
Questions
- What are the arguments for maintaining a policy of deficit reduction through tight fiscal policy?
- What are the three principles put forward by Mark Blyth for designing an appropriate macroeconomic policy?
- How does the fallacy of composition relate to the effects of all countries pursuing austerity policy simultaneously?
- Is the IMF for or against austerity? Explain.
- Assess the policies advocated by the OECD to stimulate economic growth in the eurozone.
At a cost of €1 trillion to EU states, tax evasion is undoubtedly an area in need of attention. With government finances in deficit across the world, part of the gap could be plugged by preventing tax revenues from going unpaid. Well-known companies and individuals have been accused of tax evasion (and avoidance), but part of the problem is the existence of countries that make such activities possible.
Tax havens not only offer favourable tax rates, but also have in place regulations that prevent the effective exchange of information. That is, they are able to keep the identity and income information of depositors a private affair and are not required to share that information with other governments. This means that other tax authorities are unable to demand the tax revenue from income earned, when it is held in some of these countries. This can deprive the government’s coffers of substantial amounts of money.
In 2000, the OECD produced a report naming so-called ‘uncooperative tax havens’, including Monaco, Andorra, Liechtenstein and Liberia. Since then, all nations on this list have pledged their cooperation and been removed and in a recent step, Andorra has announced a proposal to implement its first ever income tax. This move is partly in response to pressures from EU governments to tackle tax evasion. Furthermore, talks between the finance ministers of tax havens, such as Switzerland and Liechtenstein have been agreed with the aim of improving the flow of bank account information and thus combating tax evasion. The Council of the European Union said:
The decision represents an important step in the EU’s efforts to clamp down on tax evasion and tax fraud”
Countries, such as Switzerland (a non-EU member) are likely to find requests for information difficult to ignore, if they want to have access to EU financial markets. However, any concessions on information provision will come at a significant cost for a country that has long regarded its banking secrecy as an ‘honourable policy.
Reforming policy on tax havens is essential, not only to help tackle tax evasion and thus government deficits, but also to generate investment into countries that don’t offer such favourable tax rates. Investors naturally want to invest in those countries with low tax rates and as such, could it be that countries like the UK suffer from a loss of investment and that the only way to encourage it is to offer similarly low tax rates? International agreement is certainly needed to tackle the worldwide issue of tax evasion and at the moment, it seems as though pressure is building on secretive countries. The following articles consider this controversial issue.
Clock ticks on Swiss banking secrecy BBC News, Imogen Foulkes (21/5/13)
Andorra bows to EU pressure to introduce income tax The Telegraph, Fiona Govan (2/6/13)
Andorra to introduce income tax for first time BBC News (2/6/13)
Andorra to introduce income tax for the first time Economy Watch (3/6/13)
Swiss have no choice but to bow to US ultimatum – Ackermann Reuters, Katharina Bart> (3/6/13)
Austria out front as EU zeroes in on tax evasion The Budapest Times (29/5/13)
EU to start talks with non-EU countries on tax evasion BBC News (14/5/13)
Questions
- What is tax evasion?
- Using game theory, explain why an international agreement on tax evasion might be needed?
- When an income tax is imposed in Andorra, what will be the impact on government revenues?
- How might the labour supply incentive change once an income tax is imposed?
- How do tax havens affect investment in other countries?
- Is there an argument that countries such as the UK should cut its tax rates to encourage investment?
Over the past few years, the term ‘bail-out’ has been a common phrase. But, what about the term ‘bail-in’? The latest bank to face financial ruin is the Co-operative Bank, but instead of turning to the tax-payer for a rescue, £1.5 billion will come from bond holders being offered shares in the bank. This will mean that the bank will become listed on the stock market.
