As the prospects for the global recovery become more and more gloomy, so the need for a boost to aggregate demand becomes more pressing. But the scope for expansionary fiscal policy is very limited, given governments’ commitments around the world to deficit reduction.
This leaves monetary policy. In the USA, the Federal Reserve has announced a policy known as ‘Operation Twist’. This is a way of altering the funding of national debt, rather than directly altering the monetary base. It involves buying long-term government bonds in the market and selling shorter-dated ones (of less than three years) of exactly the same amount ($400bn). The idea is to drive up the price of long-term bonds and hence drive down their yield and thereby drive down long-term interest rates. The hope is to stimulate investment and longer-term borrowing generally.
Meanwhile in Britain it looks as if the Bank of England is about to turn to another round of quantitative easing (QE2). The first round saw £200bn of asset purchases by the Bank between March 2009 and February 2010. Up to now, it has resisted calls to extend the programme. However, it is now facing increased pressure to change its mind, not only from commentators, but from members of the government too.
But will expansionary monetary policy work, given the gloom engulfing the world economy? Is there a problem of a liquidity trap, whereby extra money will not actually create extra borrowing and spending? Many firms, after all, are not short of cash; they are simply unwilling to invest in a climate of falling sales and falling confidence.
Articles on Operation Twist
Fed takes new tack to avoid U.S. economic slump Reuters, Mark Felsenthal and Pedro da Costa (21/9/11)
How the Fed Can Act When Washington Cannot Associated Press on YouTube (20/9/11)
Analysis: Fed’s twist moves hurts company pension plans Reuters, Aaron Pressman (21/9/11)
What is Operation Twist? Guardian, Phillip Inman (21/9/11)
Operation Twist in the Wind Asia Times, Peter Morici (23/9/11)
Operation Twist won’t kickstart the US economy Guardian, Larry Elliott (21/9/11)
Stock markets tumble after Operation Twist … and doubt Guardian, Julia Kollewe (22/9/11)
‘Twist’ is a sign of the Fed’s resolve Financial Times, Robin Harding (22/9/11)
All twist, no shout, from the Fed Financial Times blogs, Gavyn Davies (21/9/11)
Twisting in the wind? BBC News, Stephanie Flanders (21/9/11)
Restraint or stimulus? Markets and governments swap roles BBC News, Stephanie Flanders (7/9/11)
FOMC Statement: Much Ado, Little Impact Seeking Alpha, Cullen Roche (21/9/11)
Why the Fed’s Operation Twist Will Hurt Banks International Business Times, Hao Li (21/9/11)
The Federal Reserve: Take that, Congress The Economist (21/9/11)
Articles on QE2
Bank of England’s MPC indicates QE2 is a case of if not when The Telegraph, Angela Monaghan (21/9/11)
Bank of England quantitative easing ‘boosted GDP’ BBC News (19/9/11)
Bank of England minutes indicate more quantitative easing on the cards Guardian, Julia Kollewe (21/9/11)
Fed and Bank of England publications
Press Release [on Operation Twist] Board of Governors of the Federal Reserve System (21/9/11) (Also follow links at the bottom of the Press Release for more details.)
Minutes of the Monetary Policy Committee Meeting, 7 and 8 September 2011 Bank of England (21/9/11) (See particularly paragraphs 29 to 32.)
Questions
- Explain what is meant by Operation Twist.
- What determines the extent to which it will stimulate the US economy?
- Why would quantitative easing increase the monetary base while Operation Twist would not? Would they both increase broad money? Explain.
- What is meant by the liquidity trap? Are central banks in such a trap at present?
- To what extent would a further round of quantitative easing in the UK drive up inflation?
- Why are monetary and fiscal policy as much about affecting expectations as ‘pulling the right levers’?
The debts of many countries in the eurozone are becoming increasingly difficult to service. With negative growth in some countries (Greece’s GDP is set to decline by over 5% this year) and falling growth rates in others, the outlook is becoming worse: tax revenues are likely to fall and benefit payments are likely to increase as automatic fiscal stabilisers take effect. In the light of these difficulties, market rates of interest on sovereign debt in these countries have been increasing.
Talk of default has got louder. If Greece cannot service its public-sector debt, currently standing at around 150% of GDP (way above the 60% ceiling set in the Stability and Growth Pact), then simply lending it more will merely delay the problem. Ultimately, if it cannot grow its way out of the debt, then either it must receive a fiscal transfer from the rest of the eurozone, or part of its debts must be cancelled or radically rescheduled.
But Greece is a small country, and relative to the size of the whole eurozone’s GDP, its debt is tiny. Italy is another matter. It’s public-sector debt to GDP ratio, at around 120% is lower than Greece’s, but the level of debt is much higher: $2 trillion compared with Greece’s $480 billion. Increasingly banks are becoming worried about their exposure to Italian debt – both public- and private-sector debt.
As we saw in the news item “The brutal face of supply and demand”, stock markets have been plummeting because of the growing fears about debts in the eurozone. And these fears have been particularly focused on banks with high levels of exposure to these debts. French banks are particularly vulnerable. Indeed, Credit Agricole and Société Générale, France’s second and third largest banks, had their creidit ratings cut by Moody’s rating agency. They have both seen their share prices fall dramatically this year: 46% and 55% respectively.
Central banks have been becoming increasingly concerned that the sovereign debt crisis in various eurozone countries will turn into a new banking crisis. In an attempt to calm markets and help ease the problem for banks, five central banks – the Federal Reserve, the ECB, the Bank of England, the Bank of Japan and the Swiss National Bank – announced on 15 September that they would co-operate to offer three-month US dollar loans to commercial banks. They would provide as much liquidity as was necessary to ease any funding difficulties.
The effect of this action calmed the markets and share prices in Europe and around the world rose substantially. But was this enough to stave off a new banking crisis? And did it do anything to ease the sovereign debt crisis and the problems of the eurozone? The following articles explore these questions.
Articles
Central banks expand dollar operations Reuters, Sakari Suoninen and Marc Jones (15/9/11)
Europe’s debt crisis prompts central banks to provide dollar liquidity Guardian, Larry Elliott and Dominic Rushe (15/9/11)
From euro zone to battle zone Sydney Morning Herald, Michael Evans (17/9/11)
Global shares rise on central banks’ loan move BBC News (16/9/11)
Geithner warns EU against infighting over Greece BBC News (16/9/11)
How The European Debt Crisis Could Spread npr (USA), Marilyn Geewax (15/9/11)
No Marshall Plan for Europe National Post (Canada) (16/9/11)
Central banks act to help Europe lenders Financial Times, Ralph Atkins, Richard Milne and Alex Barker (15/9/11)
Central Banks Seeking Quick Fix Push Dollar Cost to August Lows Bloomberg Businesweek, John Glover and Ben Martin (15/9/11)
Central banks act to provide euro zone dollar liquidity Irish Times (15/9/11)
Central banks pump money into market: what the analysts say The Telegraph (15/9/11)
Central banks and the ‘spirit of 2008’ BBC News, Stephanie Flanders (15/9/11)
Central Bank statements
News Release: Additional US dollar liquidity-providing operations over year-end Bank of England (15/9/11)
Press Release: ECB announces additional US dollar liquidity-providing operations over year-end ECB (15/9/11)
Additional schedule for U.S. Dollar Funds-Supplying Operations Bank of Japan (15/9/11)
Central banks to extend provision of US dollar liquidity Swiss National Bank (15/9/11)
Questions
- Explain what is meant by debt servicing.
- How may the concerted actions of the five central banks help the banking sector?
- Distinguish between liquidity and capital. Is supplying extra liquidity a suitable means of coping with the difficulties of countries in servicing their debts?
- If Greece cannot service its debts, what options are open to (a) Greece itself; (b) international institutions and governments?
- In what ways are the eurozone countries collectively in a better economic and financial state than the USA?
- Is the best solution to the eurozone crisis to achieve greater fiscal harmonisation?
- What are the weaknesses of the European Financial Stability Facility (EFSF) as currently constituted? Should it be turned into a bank or special credit institution taking the role of a ‘European Monetary Fund’?
- Should countries in the eurozone be able to issue eurobonds?
Cutting the budget deficit is a key government objective, but at the moment it seems to be in conflict with another objective, namely economic growth and thereby avoiding a double-dip recession. In order to raise tax revenue and meet the cries for more equity, the 50% tax rate above £150,000 was imposed, affecting some 310,000 people. However, in a recent letter from some top economists to the Financial Times, they called for the scrapping of the top rate of tax. They argue that it is hindering entrepreneurship and encouraging potential top rate tax payers to leave the UK, thereby hindering the economic situation. George Osborne has asked HMRC to evaluate just how effective the top rate of tax has been at generating government revenue.
In contrast to these calls for scrapping this top rate of tax, some of the richest people in the world have said that they would be happy to pay this rate of tax. In the words of Sir Stuart Rose, the ex-boss of Marks and Spencer:
“How would I explain to my secretary that I would pay less tax on my income, which is palpably bigger than hers, when her tax is not going down.”
Those against scrapping the tax argue that it will be ‘monstrously unfair’ and ‘phenomenally immoral’. This, combined with official figure that suggest by 2015/16 the top rate tax will bring in an extra £3.2bn more revenue than had the tax remained at 40%, certainly adds weight to their argument. In total, over the five year period, it is predicted to bring in an extra £12.6bn.
The policy to increase the tax threshold to £10,000 will meet with the critics’ approval, but less so, if it is accompanied by a scrapping of this top rate tax. Furthermore, the government’s coffers will take a significant beating if both of the above occur!
Another option to replace the 50% tax rate is a higher tax on high value homes – the so-called ‘mansion tax’. Whatever happens with taxation, one thing is clear: the government needs to find a way to generate tax revenue, without putting the economy back into recession. If the 50% tax rate encourages people to leave the UK to avoid the tax or to forego entrepreneurship, it will directly be acting as a disincentive. Fewer jobs will be created due to a lack of entrepreneurship, output may be lower and hence growth will not reach its potential. Crucially, the international competitiveness of the UK economy is being badly affected, as it becomes a less attractive place for investment and talented workers. The following articles consider the 50% tax rate and the controversy surrounding it, despite it only being a temporary policy.
Stuart Rose ‘would pay more tax’ BBC News (9/9/11)
Lawson: ‘dangerous’ and ‘foolish’ to keep 50p tax rate Telegraph, Louisa Peacock (10/9/11)
Rose calls 50p tax rate ‘only fair’ Financial Times, Elizabeth Rigby (9/9/11)
Top 50p tax rate damages economy, say economists BBC News (7/9/11)
George Osborne loses nerve on plan to cut 50p top tax rate Independent, Nigel Morris (8/9/11)
Top tax rate will raise £12.6bn more in revenue, official figures reveal Guardian, Polly Curtis (7/9/11)
Laffer curves and the logic of the 50p tax Financial Times, Tim Harford (9/9/11)
Row over ending of 50p tax rate threatens to spark Tory rebellion Guardian, Patrick Wintour and Polly Curtis (7/9/11)
I’d happily pay more tax, says former M&S boss Sir Stuart Rose Independent, Andy McSmith (10/9/11)
Questions
- What are the main arguments in favour of keeping the 50p tax rate?
- What are the main arguments in favour of scrapping the 50p tax rate?
- What does the Laffer curve show? Is it relevant in the case of the 50p top rate of tax? What does it suggest about the ability of the tax to generate income?
- How does the top rate of tax affect the international competitiveness of the UK economy?
- Why is there a trade-off between raising tax revenue and boosting economic growth through the use of the 50p tax rate?
- Why is there concern about the highest rate of tax actually causing tax revenue to fall?
- What are the equity arguments concerning the scrapping of the 50p tax and raising the tax threshold? Is there an equity argument in favour of the 50p tax rate?
The Brazilian economy is an emerging superpower (see A tale of two cities), but even its growth slowed in the second quarter of the year, although the economy still appears to be growing above capacity. In reaction to that latest economic data, the central bank slashed interest rates by 50 basis points to 12%. The Central Bank said:
‘Reviewing the international scenario, the monetary policy committee considers that there has been a substantial deterioration, backed up, for example, by large and widespread reductions to the growth forecasts of the main economic regions.’
Rates had previously been hiked up 5 times in the year to tackle rising inflation, which has been some way above its inflation target. Such tightening policies have become commonplace in many emerging economies to prevent overheating. However, following this reversal of policy, questions have been raised about the independence of the central bank, as some politicians have recently been calling for a cut in rates, including President Rousseff himself. As Tony Volpon at Nomura Securities said:
‘They gave in to political pressure. The costs will likely be much higher inflation and a deterioration of central bank credibility…It has damaged the inflation-targeting regime.’
Many believe the rate cut is premature and the last thing the economy needs given the inflationary pressures it’s been facing. Huge spending cuts have been announced to bring inflation back under control, together with the previous rate rises, so this cut in interest rates to stimulate growth is likely to put more pressure on costs and prices. Only time will tell exactly how effective or problematic this new direction of monetary policy will be.
Brazil’s growth slows despite resilient consumers Reuters, Brian Ellsworth and Brad Haynes (2/9/11)
Brail in surprise interest rate cut to 12% BBC News (1/9/11)
Rousseffl’s ‘Risky’ rate cut means boosting Brazil GDP outweighs inflation Bloomberg, Arnaldo Galvao and Alexander Ragir (2/9/11)
Brazil makes unexpected interest rate cut Financial Times, Samantha Pearson (1/9/11)
Brazil rate cut stirs inflation, political concerns Reuters (1/9/11)
Questions
- What is the relationship between the macroeconomic objectives of inflation and economic growth?
- Why are there concerns that the recent reduction in the interest rate may worsen inflation? Do you think that a decision has been made to sacrifice Brazil’s inflation-targeting regime to protect its economic growth?
- Why are there questions over the independence of the central bank and how will this affect its credibility? What are the arguments for central bank independence?
- Growth in Brazil, although lower this year, still remains very strong. Why has the Brazilian economy been able to continue its strong growth, despite worsening economic conditions worldwide?
- What type of inflation are emerging economies experiencing? Explain how continuous hikes in interest rates have aimed to bring it back under control.
- What is meant by overheating? How will the central bank’s past and current policies contribute towards it?
Friday 5 August 2011 saw the end of a very bad fortnight for stock markets around the world. In Japan the Nikkei 225 had fallen by 8.2%, in the USA the Dow Jones had fallen by 9.8%, in the UK the FTSE 100 was down 11.6% and in Germany the Dax was down 14.9%. In the first five days of August alone, £148 billion had been wiped off the value of the shares of the FTSE 100 companies and $2.5 trillion off the value of shares worldwide.
But why had this happened and what are likely to be the consequences?
The falls have been caused by the growing concerns of investors about the health of the global economy and the global financial system. There are worries that the European leaders at their summit on 21 July did not do enough to prevent the default of large countries such as Spain and Italy. There are concerns that the US political system, following the squabbling in Congress over raising the sovereign debt ceiling for the country, may not be up to dealing with the country’s huge debts. Indeed, the rating agency, Standard & Poor’s, downgraded the USA’s credit rating from AAA to AA+. This is the first time that the USA has not had top rating.
Then there are worries about the general slowing down of the world economy and how this will compound the problem of sovereign debt as it hits tax revenues and makes it harder to reduce social security payments. Underlying all this is the fear that the problem of indebtedness that contributed to the banking crisis of 2007/8 has not gone away; it has simply been transferred from banks to governments. As Robert Peston states in his article, linked to below:
The overall volume of indebtedness in the economy is therefore still with us – although it has been shuffled from financial sector to public sector.
And if you took the view four years ago that the quantum of debt in the system was unsustainably large, then you would argue that by propping up the banks, the day of reckoning was being postponed, not cancelled.
… just like the awakening in 2007 to the idea that many of the housing loans and associated financial products were worthless, so there is a growing fear that a number of financially overstretched governments, especially in the eurozone, will not be able to repay their debts in full.
Which brings us to the consequences. Key to the answer is confidence. If governments can reassure markets over the coming days and weeks that they have credible policies to support highly indebted countries in the short term and to sustain demand in the global economy (e.g. through further quantitative easing in the USA (QE3)); and if they can also reassure markets that they have tough and credible policies to reduce their debts over the longer term, then confidence may return. But it will not be an easy task to get the balance right between sustaining recovery in the short term and fiscal retrenchment over the long term. Meanwhile consumers are likely to become even more cautious about spending – hardly the recipe for recovery.
Videos
Markets turmoil: What you need to know BBC News, Jonty Bloom (5/8/11)
Turmoil on stock markets persists as share prices fall BBC News, Robert Peston (5/8/11)
Global stock market crash – video analysis Guardian, Larry Elliott and Cameron Robertson (5/8/11)
S&P downgrade US AAA credit rating BBC News, Marcus George (6/8/11)
U.S. loses AAA credit rating Reuters, Paul Chapman (6/8/11)
U.S. loses AAA credit rating from S&P CNN (5/8/11)
US loses AAA rating ITN (6/8/11)
Shares slump amid euro fears Channel 4 News, Faisal Islam (4/8/11)
What triggered the turmoil? Financial Times, Sarah O’Connor and Edward Hadas (5/8/11)
Fears eurozone woes will spread BBC News, Stephanie Flanders (5/8/11)
Articles
FTSE 100 tumbles in worst week since height of the crisis The Telegraph, Richard Blackden (5/8/11)
Global recession fears as stock markets tumble to nine-month low The Telegraph, Alistair Osborne (3/8/11)
Global markets on the brink of crisis Guardian, Larry Elliott (5/8/11)
A week of financial turmoil: interactive Guardian, Nick Fletcher, Paddy Allen and James Ball (5/8/11)
Turmoil on stock markets persists BBC News (5/8/11)
Bank worries bring echoes of 2008 BBC News, Stephanie Flanders (5/8/11)
The origins of today’s market mayhem BBC News, Robert Peston (5/8/11)
Time for a double dip? The Economist (6/8/11)
Rearranging the deckchairs The Economist (6/8/11)
High hopes, low returns The Economist (4/8/11)
The debt-ceiling deal: No thanks to anyone The Economist (6/8/11)
Six years into a lost decade The Economist (6/8/11)
Debt crisis Q&A: what you need to know about Standard & Poor’s credit rating The Telegraph, Richard Tyler (6/8/11)
U.S. Will Roll Out QE3 After S&P Rating Cut, Li Daokui Says Bloomberg (6/8/11)
China flays U.S. over credit rating downgrade Reuters, Walter Brandimarte and Gavin Jones (6/8/11)
US credit rating downgraded to AA+ by Standard & Poor’s Guardian, Larry Elliott, Jill Treanor and Dominic Rushe (5/8/11)
Reaction to the US credit rating downgrade Guardian (6/8/11)
Market turmoil and the economics of self-harm Guardian, Mark Weisbrot (5/8/11)
Week ahead: Markets will sort through credit downgrade Moneycontrol (6/8/11)
S&P Statement
S&P statement on lowering US long-term debt to AA+ Guardian (6/8/11)
Stock market indices
FTSE 100: historical prices, 1984 to current day Yahoo Finance
Dow Jones Industrial Average: historical prices, 1928 to current day Yahoo Finance
Nikkei 225 (Japan): historical prices, 1984 to current day Yahoo Finance
DAX (Germany): historical prices, 1990 to current day Yahoo Finance
CAC 40 (France): historical prices, 1990 to current day Yahoo Finance
Hang Seng (Hong Kong): historical prices, 1986 to current day Yahoo Finance
SSE Composite (China: Shanghai): historical prices, 2000 to current day Yahoo Finance
BSE Sensex (India): historical prices, 1997 to current day Yahoo Finance
Stock markets BBC
Questions
- Why have share prices been falling?
- Does the fall reflect ‘rational’ behaviour on the part of investors? Explain.
- Why does ‘overshooting’ sometimes occur in share price movements?
- Why has the USA’s credit rating been downgraded by Standard & Poor’s? What are the likely implications for the USA and the global economy of this downgrading?
- How is the downgrading likely to affect the return on (a) existing US government bonds; (b) new US government bonds?
- Why might worries about the strength of the global recovery jeopardise that recovery?
- To what extent has the debt problem simply been transferred from banks to governments? What should governments do about it in the short term?