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
- How worried should I be about rising oil prices?
BBC News, Michael Race (4/10/24)
- Interest rates could fall more quickly, hints Bank
BBC News, Dearbail Jordan (3/10/24)
- Oil Prices Eye $100 A Barrel As War Risk Premium Returns
FX Empire, Phil Carr (8/10/24)
- Crude oil futures reverse previous gains following disappointing economic data from China
London Loves Business, Hamza Zraimek (14/10/24)
- Oil falls 2% as OPEC cuts oil demand growth view, China concerns
Reuters, Arathy Somasekhar (14/10/24)
- Could war in the Gulf push oil to $100 a barrel?
The Economist (7/10/24)
- The Commodities Feed: Oil remains volatile
ING Think, Ewa Manthey and Warren Patterson (8/10/24)
- Who and what is driving oil price volatility
FT Alphaville, George Steer (9/10/24)
- Brent crude surges above $80 as conflict and storm spark supply fears
Financial Times, Rafe Uddin and Jamie Smyth (7/10/24)
Questions
- 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.
- How are the price elasticities of demand and supply relevant to the size of any oil price change?
- What policy options do the governments have to deal with the potential of increasing energy prices?
- What are oil futures? What determines oil future prices?
- How does speculation affect oil prices?
A common practice of international investors is to take part in the so-called ‘carry trade’. This involves taking advantage of nominal interest rate differences between countries. For example, assume that interest rates are low in Japan and high in the USA. It is thus profitable to borrow yen in Japan at the low interest rate, exchange it into US dollars and deposit the money at the higher interest rate available in the USA. If there is no change in the exchange rate between the dollar and the yen, the investor makes a profit equal to the difference in the interest rates.
Rather than depositing the money in a US bank account, an alternative is to purchase US bonds or other assets in the USA, where the return is again higher than that in Japan.
If, however, interest-rate differentials narrow, there is the possibility of the carry trade ‘unwinding’. Not only may the carry trade prove unprofitable (or less so), but investors may withdraw their deposits and pay back the loans. This, as we shall, can have adverse consequences on exchange rates.
The problem of an unwinding of the carry trade is not new. It worsened the underlying problems of the financial crisis in 2008. The question today is whether history is about to repeat itself with a new round of unwinding of the carry trade threatening economic growth and recovery around the world.
We start by looking at what happened in 2008.
The carry trade and the 2008 financial crisis
Prior to the financial crisis of 2008, current account deficit countries, such as the UK, USA and Australia, typically had relatively high interest rates, while current account surplus countries such as Japan and Switzerland had relatively low ones. Figure 1 shows central bank interest rates from 2005 to the current day (click here for a PowerPoint).
The carry trade saw investors borrowing money in Japan and Switzerland, exchanging it on the foreign exchange market, with the currency then deposited in the UK, USA and Australia. Hundreds of billions worth of dollars were involved in this carry trade.
If, however, the higher interest rates in the UK and other deficit countries were simply to compensate investors for the risk of currency depreciation, then there would be no excessive inflow of finance. The benefit of the higher interest rate would be offset by a depreciating currency. But the carry trade had the effect of making deficit currencies appreciate, thereby further boosting the carry trade by speculation of further exchange rate rises.
Thus the currencies of deficit countries appreciated, making their goods less competitive and worsening their current account deficit. Between 1996 and 2006, the average current account deficits as a percentage of GDP for Australia, the USA and the UK were close to 4½, 4 and 2, respectively. Between January 1996 and December 2006, the broad-based real exchange rate index of the Australian dollar appreciated by 17%, of the US dollar by 4% and of sterling by some 23%.
Currencies of surplus countries depreciated, making their goods more competitive and further boosting their current account surpluses. For example, between 2004 and 2006 the average current account surpluses as a percentage of GDP for Japan and Switzerland were 3½ and 13, respectively. Their short-term interest rates averaged a mere 0.1% and 1.0% respectively (compared with 3.4%, 4.7% and 5.7% for the USA, the UK and Australia). Yet between January 2004 and December 2006, the real exchange rate index of the yen depreciated by 21%, while that of the Swiss franc depreciated by 6%.
With the credit crunch of 2007/8, the carry trade unwound. Much of the money deposited in the USA had been in highly risky assets, such as sub-prime mortgages. Investors scrambled to sell their assets in the USA, UK and the EU. Loans from Japan and Switzerland were repaid and these countries, seen as ‘safe havens’, attracted deposits. The currencies of deficit countries, such as the UK and USA, began to depreciate and those of surplus countries, such as Japan and Switzerland, began to appreciate. Between September 2007 and September 2008, the real exchange rate indices of the US dollar and sterling depreciated by 2% and 13% respectively; the yen and the Swiss franc appreciated by 3% and 2¾%.
This represented a ‘double whammy’ for Japanese exporters. Not only did its currency appreciate, making its exports more expensive in dollars, euros, pounds, etc., but the global recession saw consumers around the world buying less. As a result, the Japanese economy suffered the worst recession of the G7 economies.
The carry trade in recent months
Since 2016, there has been a re-emergence of the carry trade as the Fed began raising interest rates while the Bank of Japan kept rates at the ultra low level of –0.1% (see Figure 1). The process slowed down when the USA lowered interest rates in 2020 in response to the pandemic and fears of recession. But when the USA, the EU and the UK began raising rates at the beginning of 2022 in response to global inflationary pressures, while Japan kept its main rate at –0.1%, so the carry trade resumed in earnest. Cross-border loans originating in Japan (not all of it from the carry trade) had risen to ¥157tn ($1tn) by March 2024 – a rise of 21% from 2021.
The process boosted US stock markets and contributed to the dollar appreciating against the yen (see Figure 2: click here for a PowerPoint).
Although this depreciation of the yen helped Japanese exports, it also led to rising prices. Japanese inflation rose steadily throughout 2022. In the 12 months to January 2022 the inflation rate was 0.5% (having been negative from October 2020 to August 2021). By January 2023, the annual rate had risen to 4.3% – a rate not seen since 1981. The Bank of Japan was cautious about raising interest rates to suppress this inflation, however, for fear of damaging growth and causing the exchange rate to appreciate and thereby damaging exports. Indeed, quarterly economic growth fell from 1.3% in 2023 Q1 to –1.0% in 2023 Q3.
But then, with growth rebounding and the yen depreciating further, in March 2024 the Bank of Japan decided to raise its key rate from –0.1% to 0.1%. This initially had the effect of stabilising the exchange rate. But then with the yen depreciating further and inflation rising from 2.5% to 2.8% in May and staying at this level in June, the Bank of Japan increased the key rate again at the end of July – this time to 0.25% – and there were expectations that there would be another rise before the end of the year.
At the same time, there were expectations that the Fed would soon lower its main rate (the Federal Funds Rate) from its level of 5.33%. The ECB and the Bank of England had already begun lowering their main rates in response to lower inflation. The carry trade rapidly unwound. Investors sold US, EU and UK assets and began repaying yen loans.
The result was a rapid appreciation of the yen as Figure 3 shows (click here for a PowerPoint). Between 31 July (the date the Bank of Japan raised interest rates the second time) and 5 August, the dollar depreciated against the yen from ¥150.4 to ¥142.7. In other words, the value of 100 yen appreciated from $0.66 to $0.70 – an appreciation of the yen of 6.1%.
Fears about the unwinding of the carry trade led to falls in stock markets around the world. Not only were investors selling shares to pay back the loans, but fears of the continuing process put further downward pressure on shares. From 31 July to 5 August, the US S&P 500 fell by 6.1% and the tech-heavy Nasdaq by 8.0%.
As far as the Tokyo stock market was concerned, the appreciation of the yen sparked fears that the large Japanese export sector would be damaged. Investors rushed to sell shares. Between 31 July and 5 August, the Nikkei 225 (the main Japanese stock market index) fell by 19.5% – its biggest short-term fall ever (see Figure 4: click here for a PowerPoint).
Although the yen has since depreciated slightly (a rise in the yen/dollar rate) and stock markets have recovered somewhat, expectations of many investors are that the unwinding of the yen carry trade has some way to go. This could result in a further appreciation of the yen from current levels of around ¥100 = $0.67 to around $0.86 in a couple of years’ time.
There are also fears about the carry trade in the Chinese currency, the yuan. Some $500 billion of foreign currency holdings have been acquired with yuan since 2022. As with the Japanese carry trade, this has been encouraged by low Chinese interest rates and a depreciating yuan. Not only are Chinese companies investing abroad, but foreign companies operating in China have been using their yuan earnings from their Chinese operations to invest abroad rather than in China. The Chinese carry trade, however, has been restricted by the limited convertibility of the yuan. If the Chinese carry trade begins to unwind when the Chinese economy begins to recover and interest rates begin to rise, the effect will probably be more limited than with the yen.
Articles
- A popular trading strategy just blew up in investors’ faces
CNN, Allison Morrow (7/8/24)
- The big ‘carry trade’ unwind is far from over, strategists warn
CNBC, Sam Meredith (13/8/24)
- Unwinding of yen ‘carry trade’ still threatens markets, say analysts
Financial Times, Leo Lewis and David Keohane (7/8/24)
- The yen carry trade sell-off marks a step change in the business cycle
Financial Times, John Plender (10/8/24)
- Forbes Money Markets Global Markets React To The Japanese Yen Carry Trade Unwind
Forbes, Frank Holmes (12/8/24)
- 7 unwinding carry trades that crashed the markets
Alt21 (26/1/23)
- A carry crash also kicked off the global financial crisis 17 years ago — here’s why it’s unlikely to get as bad this time
The Conversation, Charles Read (9/8/24)
- What is the Chinese yuan carry trade and how is it different from the yen’s?
Reuters, Winni Zhou and Summer Zhen (13/8/24)
- Carry Trade That Blew Up Markets Is Attracting Hedge Funds Again
Yahoo Finance/Bloomberg, David Finnerty and Ruth Carson (16/8/24)
- Currency Carry Trades 101
Investopedia, Kathy Lien (9/8/24)
- Carry Trades Torpedoed The Market. They’re Still Everywhere.
Finimize, Stéphane Renevier (13/8/24)
Questions
- What factors drive the currency carry trade?
- Is the carry trade a form of arbitrage?
- Find out and explain what has happened to the Japanese yen since this blog was written.
- Find out and explain some other examples of carry trades.
- Why are expectations so important in determining the extent and timing of the unwinding of carry trades?
Gold has always held an allure and with the price of gold on international markets trending upwards since October 2022 (see Figure 1: click here for a PowerPoint), people seem to be attracted to it once again. The price reached successively higher peaks throughout 2023 before surging to above $2300 per oz in 2024 and peaking at $2425.31 per oz on 20 May 2024.
While gold tends to become attractive during wartime, economic uncertainty and bouts of inflation, all of which have characterised the last few years, the sustained price rise has perplexed market analysts and economists. The rally had been expected to peter out over the past 20 months. But, as the price of gold rose to sustained higher levels, with no significant reversals, some analysts have speculated that it is not the typical short-term factors which are driving the increased demand for and price of gold but more fundamental changes in the global economic system.
This blog will first discuss the typical short-term factors which influence gold prices before discussing the potential longer-term forces that may be at work.
Short-term factors
So, what are the typical short-term economic forces which drive the demand for gold?
The most significant are the real rates of interest on financial assets. These rates represent the opportunity cost of holding an asset such as gold which offers no income stream. When the real return from financial assets like debt and equity instruments is low, the demand for and price of gold tends to be high. In contrast, when the real return from such assets is high, the price of gold tends to be lower. An explanation for this is that real rates of return are strongly related to inflation rates and investors perceive gold as a hedge against inflation since its price is positively correlated with a general rise in prices. Higher unexpected inflation reduces the real rate of return of securities like debt and equity whose value is derived from cash flows anticipated in the future. In such circumstances, gold become an attractive alternative investment. As inflationary expectations decline, real returns from financial assets should rise, and the demand for gold should fall.
The relationship between real returns, proxied by the yield on US 10-year TIPS (Treasury inflation-protected securities), and gold prices can be used to examine this explanation. Real returns rose steadily in the aftermath of the COVID-19 pandemic. Yet the price of gold, which rose during the early stages of the pandemic in 2020, has not fallen. Instead, it has remained at elevated levels for much of that time (see Figure 2: click here for a PowerPoint).
There have been short periods when changes in real returns seemed to have a high correlation with changes in gold prices. In late 2022, for example, falling real rates coincided with rising gold prices. The same pattern was repeated between October and December 2023. However, when real returns rose again in the New Year of 2024, in response to stubbornly higher expected inflation and the expectation of ‘higher-for-longer’ interest rates, particularly in the USA, gold prices continued to rise. Indeed, across the 5-year period the correlation coefficient between the two series is actually positive at 0.268, showing little evidence supporting this explanation for the pattern for the gold price.
Real returns in the USA, however, may not be the correct ones to consider when seeking explanations for the pattern of gold’s price. Much of the recent demand is from China. Analysts suggest that Chinese investors are looking for a safe asset to hold as their economy stagnates and real returns from alternatives, like domestic property and equity, have decreased. Further, there are some concerns that the Chinese currency, the renminbi, may be undervalued in response to the sluggish growth. Holding gold is a good hedge against inflation (currency depreciation produces inflationary pressure). Consequently, the Chinese market may be exerting pricing power in relation to real returns in a way not seen before (see the Dempsey and Leng FT article linked below).
However, some analysts suggest that the rise in price is disproportionate to these short-term factors and point to potential long-term structural changes in the global financial order which may produce significant changes in the market for gold.
Long-term factors
Since 2018, there have been bouts of gold purchasing by central banks around the world. In contrast to the 1990s and 2000s, central banks have been net purchasers since 2010. The purchasing fell back during the coronavirus pandemic but has surged again, with over 1000 metric tonnes purchased in both 2022 and 2023 (see Figure 3: click here for a PowerPoint).
Analysts have pointed to similarities between the recent pattern and central bank purchases of gold during the late 1960s and early 1970s (see The Conversation article linked below). Then, central banks sought to diversify themselves from dollar-denominated assets due to concerns about higher inflation in the USA and its impact on the value of the US dollar. Under the Bretton Woods fixed exchange rate system, central banks could redeem dollars for gold from the US Federal Reserve at a fixed rate. The pressure on the USA to redeem the gold led to the collapse of the Bretton Woods fixed exchange rate system.
While the current period of central bank purchases does not appear to be related to expected inflation, some commentators suggest it could signal a regime change in the global financial system as significant as the collapse of Bretton Woods. The rise of Chinese political power and the resurgence of US isolationist tendencies portend an increasingly multipolar geopolitical scene. Such concerns may cause central bankers to diversify away from dollar denominated assets to avoid being caught out by geopolitical tensions. Gold may be perceived as an asset through which investors can hedge that risk better.
Indeed, the rise in demand among Chinese investors may indicate a reluctance to hold US assets due to their risk of seizure during heightened geopolitical tensions between China and the USA. Chinese holdings of US financial assets as a percentage of GDP are back to the level they were when the country joined the World Trade Organisation (WTO) in 2001 (see the Rana Foroohar FT article linked below). Allied to this is an increasing tendency to repatriate gold bullion from centres such as London and New York.
Added to these worries about geopolitical risk are concerns about traditional safe-haven assets – government debt securities. US government budget deficits and debt levels continue to rise. Similar patterns are observed across many developed market economies (DMEs). Analysts are concerned such debts are reaching unsustainable levels (economist.com). The view is that at some point, perhaps soon, a tipping point will be reached where investors recognise this. They will demand higher rates of return on these government debt securities, pushing yields up and prices down (bond yields and prices have a negative relationship).
In expectation of this, investors may be wary of holding such government debt securities and move to hold gold as an alternative safe-haven asset to avoid potential capital losses. However, there has been no sign of this behaviour in bond prices and yields yet.
Finally, there are economists who argue that the increased demand for gold is caused by a different regime-change in the global economy. This is not one driven by geopolitics, but by changing inflationary expectations – from a low-inflation, low-interest-rate environment to a higher-inflation, higher-interest-rate environment.
Some of the anticipation relating to inflation is derived from the persistent fiscal stimulus, evidenced by the higher government debt levels described above, coupled with the long period of monetary stimulus (quantitative easing) in developed market economies during the 2010s.
Further, some economists highlight the substantial capital investment needed for the green transition and reindustrialisation. While the financing for this capital investment may absorb some of the excess money flowing around financial markets, the scale involved will create a great demand for resources, fuelling inflation and raising the cost of capital as borrowers compete for resources.
Finally, the demographic forces from an aging population will also cause inflationary pressures. Rising dependency ratios across many developed market economics will create shortages, particularly of labour. This persistent scarcity of labour will continually drive up wages and prices, fuelling inflation and the demand for gold.
Conclusion
The recent surge in the price of gold has led to great interest by investors, financial market analysts and economists. At first, there was a perception that the price increase was similar to recent history and driven by short-term decreases in the real rate of return from financial assets, which reduced the opportunity cost of holding gold.
However, as the upward trend in the price of gold has persisted and does not seem to be explained by changes in real interest rates, economists have considered other reasons that might signal longer-term significant changes in the global financial system. These relate to changing geopolitical risk derived from an increasingly multipolar environment, concerns about the sustainability of government debt levels and expectations of persistently higher inflation in the world economy.
Only time will tell whether these explanations prove correct. If inflationary pressures subside, particularly in the USA, and if real returns from financial assets rebound, a decrease in the demand for and price of gold will suggest that the previous rise was driven by short-term forces.
If prices don’t fall back, it will only fuel the debate that it is a sign of significant changes in the global financial order.
Articles
- Gold’s weird rally
Financial Times, Robert Armstrong & Ethan Wu (11/12/23)
- A debt crisis at the economy’s edge
Financial Times, Robert Armstrong (15/5/24)
- Good, not great, news on inflation
Financial Times, Robert Armstrong (16/5/24)
- Gold prices are ‘dramatically outperforming’: Macquarie
Investing.com, Senad Karaahmetovic (30/5/24)
- Gold is back — and it has a message for us
Financial Times, Rana Foroohar (15/4/24)
- Countries went on a gold-buying spree before coronavirus took hold – here’s why
The Conversation, Drew Woodhouse (21/5/20)
- Why Gold Keeps Hitting Record Highs
Investopedia, Colin Laidley (9/4/24)
- Why Is the Price of Gold Rising?
Forbes, Wayne Duggan (23/4/24)
- Why gold prices are hitting record highs
TRT World, Kazim Alam (3/4/24)
- Chinese speculators super-charge gold rally
Financial Times, Harry Dempsey and Cheng Leng (23/4/24)
- This gold rally is made in China
Financial Times, Opinion Lex (21/5/24)
Speech
Data
Questions
- Explain the relationship between real returns and inflation for financial securities like debt and equity.
- Why is gold perceived to be an effective hedge against inflation?
- Contrast the factors which influenced the demand for gold in the period which preceded the end of Bretton Woods with those influencing demand now?
- What has happened to the price of gold since this blog was published? Is there any evidence for the profound changes in the global economic order suggested or was it the short-term forces driving demand after all?
Global long-term economic growth has slowed dramatically since the financial crisis of 2007–8. This can be illustrated by comparing the two 20-year periods 1988 to 2007 and 2009 to 2028 (where IMF forecasts are used for 2024 to 2028: see WEO Database under the Data link below). Over the two periods, average annual world growth fell from 3.8% to 3.1%. In advanced countries it fell from 2.9% to 1.6% and in developing countries from 4.8% to 4.3%. In the UK it fell from 2.4% to 1.2%, in the USA from 3.1% to 1.8% and in Japan from 1.9% to 0.5%.
In the UK, labour productivity growth in the production industries was 6.85% per annum from 1998 to 2006. If this growth rate had been maintained, productivity would have been 204% higher by the end of 2023 than it actually was. This is shown in the chart (click here for a PowerPoint).
The key driver of long-term economic growth is labour productivity, which can best be measured by real GDP per hour worked. This depends on three things: the amount of capital per worker, the productivity of this capital and the efficiency of workers themselves – the latter two giving total factor productivity (TFP). Productivity growth has slowed, and with it the long-term rate of economic growth.
If we are measuring growth in output per head of the population, as opposed to simple growth in output, then another important factor is the proportion of the population that works. With ageing populations, many countries are facing an increase in the proportion of people not working. In most countries, these demographic pressures are likely to increase.
A major determinant of long-term economic growth and productivity is investment. Investment has been badly affected by crises, such as the financial crisis and COVID, and by geopolitical tensions, such as the war in Ukraine and tensions between the USA and China and potential trade wars. It has also been adversely affected by government attempts to deal with rising debt caused by interventions following the financial crisis and COVID. The fiscal squeeze and, more recently higher interest rates, have dampened short-term growth and discouraged investment, thereby dampening long-term growth.
Another factor adversely affecting productivity has been a lower growth of allocative efficiency. Competition in many industries has declined as the rate of new firms entering and exiting markets has slowed. The result has been an increase in concentration and a growth in supernormal profits.
In the UK’s case, growth prospects have also been damaged by Brexit. According to Bank of England and OBR estimates, Brexit has reduced productivity by around 4% (see the blog: The costs of Brexit: a clearer picture). For many companies in the UK, Brexit has hugely increased the administrative burdens of trading with the EU. It has also reduced investment and led to a slower growth in the capital stock.
The UK’s poor productivity growth over many yeas is examined in the blog The UK’s poor productivity record.
Boosting productivity
So, how could productivity be increased and what policies could help the process?
Artificial intelligence. One important driver of productivity growth is technological advance. The rapid advance in AI and its adoption across much of industry is likely to have a dramatic effect on working practices and output. Estimates by the IMF suggest that some 40% of jobs globally and 60% in advanced countries could be affected – some replaced and others complemented and enhanced by AI. The opportunities for raising incomes are huge, but so too are the dangers of displacing workers and deepening inequality, as some higher-paid jobs are enhanced by AI, while many lower paid jobs are little affected and other jobs disappear.
AI is also likely to increase returns to capital. This may help to drive investment and further boost economic growth. However, the increased returns to capital are also likely to exacerbate inequality.
To guard against the growth of market power and its abuse, competition policies may need strengthening to ensure that the benefits of AI are widely spread and that new entrants are encouraged. Also training and retraining opportunities to allow workers to embrace AI and increase their mobility will need to be provided.
Training. And it is not just training in the use of AI that is important. Training generally is a key ingredient in encouraging productivity growth. In the UK, there has been a decline in investment in adult education and training, with a 70% reduction since the early 2000s in the number of adults undertaking publicly-funded training, and with average spending on training by employers decreasing by 27% per trainee since 2011. The Institute for Fiscal Studies identifies five main policy levers to address this: “public funding of qualifications and skills programmes, loans to learners, training subsidies, taxation of training and the regulation of training” (see link in articles below).
Competition. Another factor likely to enhance productivity is competition, both internationally and within countries. Removing trade restrictions could boost productivity growth; erecting barriers to protect inefficient domestic industry would reduce it.
Investment. Policies to encourage investment are also key to productivity growth. Private-sector investment can be encouraged by tax incentives. For example, in the UK the Annual Investment Allowance allows businesses to claim 100% of the cost of plant and machinery up to £1m in the year it is incurred. However, for tax relief to produce significant effects on investment, companies need to believe that the policy will stay and not be changed as economic circumstances or governments change.
Public-sector investment is also key. Good road and rail infrastructure and public transport are vital in encouraging private investment and labour mobility. And investment in health, education and training are a key part in encouraging the development of human capital. Many countries, the UK included, cut back on public-sector capital investment after the financial crisis and this has had a dampening effect on economic growth.
Regional policy. External economies of scale could be encouraged by setting up development areas in various regions. Particular industries could be attracted to specific areas, where local skilled workers, managerial expertise and shared infrastructure can benefit all the firms in the industry. These ‘agglomeration economies’ have been very limited in the UK compared with many other countries with much stronger regional economies.
Changing the aims and governance of firms. A change in corporate structure and governance could also help to drive investment and productivity. According to research by the think tank, Demos (see the B Lab UK article and the second report below), if legislation required companies to consider the social, economic and environmental impact of their business alongside profitability, this could have a dramatic effect on productivity. If businesses were required to be ‘purpose-led’, considering the interests of all their stakeholders, this supply-side reform could dramatically increase growth and well-being.
Such stakeholder-governed businesses currently outperform their peers with higher levels of investment, innovation, product development and output. They also have higher levels of staff engagement and satisfaction.
Articles
- World Must Prioritize Productivity Reforms to Revive Medium-Term Growth
IMF Blog, Nan Li and Diaa Noureldin (10/4/24)
- Why has productivity slowed down?
Oxford Martin School News, Ian Goldin, Pantelis Koutroumpis, François Lafond and Julian Winkler (18/3/24)
- How can the UK revive its ailing productivity?
Economics Observatory, Michelle Kilfoyle (14/3/24)
- With the UK creeping out of recession, here’s an economist’s brief guide to improving productivity
The Conversation, Nigel Driffield (13/3/24)
- UK economy nearly a third smaller thanks to ‘catastrophically bad’ productivity slowdown
City A.M., Chris Dorrell (12/3/24)
- Can AI help solve the UK’s public sector productivity puzzle?
City A.M., Chris Dorrell (11/3/24)
- AI Will Transform the Global Economy. Let’s Make Sure it Benefits Humanity
IMF Blog, Kristalina Georgieva (14/1/24)
- Productivity and Investment: Time to Manage the Project of Renewal
NIESR, Paul Fisher (12/3/24)
- Productivity trends using key national accounts indicators
Eurostat (15/3/24)
- New report says change to company law could add £149bn to the UK economy
B Lab UK (28/11/23)
- Investment in training and skills: Green Budget Chapter 9
Institute for Fiscal Studies, Imran Tahir (12/10/23)
Reports
Data
Questions
- Why has global productivity growth been lower since 2008 than before 2008?
- Why has the UK’s productivity growth been lower than many other advanced economies?
- How does the short-run macroeconomic environment affect long-term growth?
- Find out why Japan’s productivity growth has been so poor compared with other countries.
- What are likely to be the most effective means of increasing productivity growth?
- How may demand management policies affect the supply side of the economy?
- How may the adoption of an ESG framework by companies for setting objectives affect productivity growth?
Climate change is not just an environmental challenge: its socioeconomic impacts are profound and far-reaching, touching every aspect of society. From agriculture to health, from urban infrastructure to coastal communities, the effects of climate change are evident and escalating.
The far-reaching effects
In agriculture, rising temperatures, more intense and frequent heatwaves and changing precipitation patterns pose significant threats to food security.1, 2 Crop yields decline as extreme weather events become more frequent and unpredictable, leading to increased food prices and economic instability. Smallholder farmers, who often lack the resources to adapt, are particularly vulnerable, exacerbating rural poverty and food insecurity.3
Coastal communities face the dual threats of sea-level rise and more intense storms.4 Erosion and inundation damage homes, infrastructure and livelihoods, displacing populations and disrupting local economies. The loss of coastal ecosystems further compounds these challenges, reducing natural defences against storm surges and exacerbating the impacts of climate-related disasters.
Health systems strain under the burden of climate-change-induced heatwaves, air pollution and the spread of vector-borne diseases.5, 6 Heat-related illnesses increase as temperatures rise, particularly affecting vulnerable populations such as the elderly and outdoor workers. Air pollution exacerbates respiratory conditions, leading to higher healthcare costs and decreased productivity. Vector-borne diseases, such as malaria and dengue fever, expand into new regions, placing additional strain on already overburdened health systems.
Displacement due to climate-related disasters amplifies social inequalities and challenges urban planning and infrastructure.7 Vulnerable communities, often located in low-lying areas or informal settlements, bear the brunt of climate impacts, facing the loss of homes, livelihoods and community cohesion. Inadequate housing and infrastructure increase the risks associated with extreme weather events, perpetuating cycles of poverty and vulnerability.
Furthermore, climate change exacerbates existing socioeconomic disparities, disproportionately affecting marginalised and vulnerable populations. Indigenous communities, women, children and people living in poverty are often the hardest hit, lacking access to resources, information, and adaptive capacity.8
Policy responses
Addressing the socioeconomic impacts of climate change requires co-ordinated action across sectors and scales. Policy interventions, such as investment in climate-resilient infrastructure and the promotion of sustainable agriculture practices, are essential for building resilience and reducing vulnerability. Community-led initiatives that prioritise local knowledge and empower marginalised groups are also critical for fostering adaptive capacity and promoting social equity.
To address these challenges, projects like CROSSEU, the new €5 million Horizon Europe project (that I have the pleasure to be part of), play a crucial role in enhancing our understanding of these impacts and developing actionable strategies for resilience and adaptation. One of the key contributions of CROSSEU lies in its development of a Decision Support System (DSS) that integrates tools, measures, and policy options to address these risks in a cross-sectoral and cross-regional perspective. This DSS will support (and hopefully improve) decision-making processes at various levels, from local to EU-wide, and facilitate the adoption of evidence-based policies and measures to enhance resilience and mitigate the impacts of climate change.
Would you like to know more about CROSSEU? Follow our journey and be informed of our publications and events in our new webpage: https://crosseu.eu/9
Articles/References
- Global food security under climate change
Proceedings of the National Academy of Sciences, Josef Schmidhuber and Francesco N Tubiello (11/12/2007)
- Reducing risks to food security from climate change
Global Food Security, Bruce M Campbell et al. (2016: 11, pp 34–43)
- The value-add of tailored seasonal forecast information for industry decision making
Climate, Clare Mary Goodess et al (16/10/2022)
- Assessing climate change impacts, sea level rise and storm surge risk in port cities: a case study on Copenhagen
Climatic change, Stéphane Hallegatte, Nicola Ranger, Olivier Mestre, Patrice Dumas, Jan Corfee-Morlot, Celine Herweijer and Robert Muir Wood (7/12/2010)
- Health risks of climate change: An assessment of uncertainties and its implications for adaptation policies
Environmental Health, J Arjan Wardekker, Arie de Jong, Leendert van Bree, Wim C Turkenburg and Jeroen P van der Sluijs (19/9/2012)
- Climate Change and Temperature-related Mortality: Implications for Health-related Climate Policy
Biomedical and Environmental Sciences, Tong Shi Lu, Jorn Olsen and Patrick L Kinney (2021: 34(5) pp 379–86 )
- Climate Change, Inequality, and Human Migration
IZA Discussion Paper No. 12623, Michał Burzyński, Christoph Deuster, Frédéric Docquier and Jaime de Melo (23/9/2019)
- The trap of climate change-induced “natural” disasters and inequality
Global Environmental Change, Federica Cappelli, Valeria Costantini and Davide Consoli (30/7/2021)
- Cross-sectoral Framework for Socio-Economic Resilience to Climate Change and Extreme Events in Europe
UEA Research Project, Nicholas Vasilakos, Katie Jenkins and Rachel Warren
Questions
- How do the socioeconomic impacts of climate change differ between rural and urban communities? What factors contribute to these disparities, and how can policies address them effectively?
- In what ways do vulnerable populations, such as indigenous communities and those living in poverty, bear the brunt of climate change impacts? How can we ensure that climate adaptation strategies prioritise their needs and promote social equity?
- The blog mentions the importance of community-led initiatives in building resilience to climate change. What examples of successful community-based adaptation projects can you identify, and what lessons can be learned from their implementation?
- How can governments and organisations collaborate to address the socioeconomic impacts of climate change while also promoting economic growth and development? What role do cross-sectoral partnerships play in building resilience and fostering sustainable practices?
