‘The world is sinking under a sea of debt, private as well as public, and it is increasingly hard to see how this might end, except in some form of mass default.’ So claims the article below by Jeremy Warner. But just how much has debt grown, both public and private? And is it of concern?
The doomsday scenario is that we are heading for another financial crisis as over leveraged banks and governments could not cope with a collapse in confidence. Bank and bond interest rates would soar and debts would be hard to finance. The world could head back into recession as credit became harder and more expensive to obtain. Perhaps, in such a scenario, there would be mass default, by banks and governments alike. This could result in a plunge back into recession.
The more optimistic scenario is that private-sector debt is under control and in many countries is falling (see, for example, chart 1 in the blog Looking once again through Minsky eyes at UK credit numbers for the case of the UK). Even though private-sector debt could rise again as the world economy grows, it would be affordable provided that interest rates remain low and banks continue to build the requisite capital buffers under the Basel III banking regulations.
As far as public-sector debt is concerned, as a percentage of GDP its growth has begun to decline in advanced countries as a whole and, although gently rising in developing and emerging economies as a whole, is relatively low compared with advanced countries (see chart). Of course, there are some countries that still face much larger debts, but in most cases they are manageable and governments have plans to curb them, or at least their growth.
But there have been several warnings from various economists and institutes, as we saw in the blog post, Has the problem of excess global debt been tackled? Not according to latest figures. The question is whether countries can grow their way out of the problem, with a rapidly rising denominator in the debt/GDP ratios.
Only mass default will end the world’s addiction to debt The Telegraph, Jeremy Warner (3/3/15)
Questions
- What would be the impact of several countries defaulting on debt?
- What factors determine the likelihood of sovereign defaults?
- What factors determine the likelihood of bank defaults?
- What is meant by ‘leverage’ in the context of (a) banks; (b) nations?
- What are the Basel III regulations? What impact will they have/are they having on bank leverage?
- Expand on the arguments supporting the doomsday scenario above.
- Expand on the arguments supporting the optimistic scenario above.
- What is the relationship between economic growth and debt?
- Explain how the explosion in global credit might merely be ‘the mirror image of rising output, asset prices and wealth’.
- Is domestic inflation a good answer for a country to the problems of rising debt denominated (a) in the domestic currency; (b) in foreign currencies?
Many UK coal mines closed in the 1970s and 80s. Coal extraction was too expensive in the UK to compete with cheap imported coal and many consumers were switching away from coal to cleaner fuels. Today many shale oil producers in the USA are finding that extraction has become unprofitable with oil prices having fallen by some 50% since mid-2014 (see A crude indicator of the economy (Part 2) and The price of oil in 2015 and beyond). So is it a bad idea to invest in fossil fuel production? Could such assets become unusable – what is known as ‘stranded assets‘?
In a speech on 3 March 2015, Confronting the challenges of tomorrow’s world, delivered at an insurance conference, Paul Fisher, Deputy Governor of the Bank of England, warned that a switch to both renewable sources of energy and actions to save energy could hit investors in fossil fuel companies.
‘One live risk right now is of insurers investing in assets that could be left ‘stranded’ by policy changes which limit the use of fossil fuels. As the world increasingly limits carbon emissions, and moves to alternative energy sources, investments in fossil fuels and related technologies – a growing financial market in recent decades – may take a huge hit. There are already a few specific examples of this having happened.
… As the world increasingly limits carbon emissions, and moves to alternative energy sources, investments in fossil fuels and related technologies – a growing financial market in recent decades – may take a huge hit. There are already a few specific examples of this having happened.’
Much of the known reserves of fossil fuels could not be used if climate change targets are to be met. And investment in the search for new reserves would be of little value unless they were very cheap to extract. But will climate change targets be met? 
That is hard to predict and depends on international political agreements and implementation, combined with technological developments in fields such as clean-burn technologies, carbon capture and renewable energy. The scale of these developments is uncertain. As Paul Fisher said in his speech:
‘Tomorrow’s world inevitably brings change. Some changes can be forecast, or guessed by extrapolating from what we know today. But there are, inevitably, the unknown unknowns which will help shape the future. … As an ex-forecaster I can tell you confidently that the only thing we can be certain of is that there will be changes that no one will predict.’
The following articles look at the speech and at the financial risks of fossil fuel investment. The Guardian article also provides links to some useful resources.
Articles
Bank of England warns of huge financial risk from fossil fuel investments The Guardian, Damian Carrington (3/3/15)
PRA warns insurers on fossil fuel assets Insurance Asset Risk (3/3/15)
Energy trends changing investment dynamics UPI, Daniel J. Graeber (3/3/15)
Speech
Confronting the challenges of tomorrow’s world Bank of England, Paul Fisher (3/3/15)
Questions
- What factors are taken into account by investors in fossil fuel assets?
- Why might a power station become a ‘stranded asset’?
- How is game theory relevant in understanding the process of climate change negotiations and the outcomes of such negotiations?
- What social functions are filled by insurance?
- Why does climate change impact on insurers on both sides of their balance sheets?
- What is the Prudential Regulation Authority (PRA)? What is its purpose?
- Explain what is meant by ‘unknown unknowns’. How do they differ from ‘known unknowns’?
- How do the arguments in the article and the speech relate to the controversy about investing in fracking in the UK?
- Explain and comment on the statement by World Bank President, Jim Yong Kim, that sooner rather than later, financial regulators must address the systemic risk associated with carbon-intensive activities in their economies.
In recent times the notion that the financial sytem can be destabilising seems blindingly obvious. And, yet, for some time macroeconomic models of the economy tended to regard the financial system as benevolent. It served our interests. We were the masters; it was our servant. Now of course we accept that credit cycles can be destabilising. Policymakers, especially central banks, follow keenly the latest private-sector credit data. Here we look back at previous patterns in private-sector debt and crucially at what patterns are currently emerging.
First a bit of theory. The idea of credit cycles is not new. But the financial crisis of the late 2000s has helped to reignite analysis and interest. Economists are trying to gain a better understanding of the relationship between flows of credit and the state of the economy and, in particular, why might flows increase as the level of real GDP rises – why might they be endogenous variables in models of the determination of GDP. One possibility is the financial accelerator. This is the idea that as real GDP rises banks perceive lending to be less risky. After all, real incomes will tend to rise and collateral values (against which borrowing can be secured) are likely to be rising too.
Another possibility is growing exuberance as the economy grows. This has gained in popularity as an idea, with economists revisiting the work of Hyman Minsky (1919–96), an American economist. Here success breeds failure as the balance sheets of people and businesses deteriorate as they become increasingly burdened with debt. The balance sheets are said to be congested leading to a point when a deleveraging starts. A balance sheet recession then follows.
Now for the data. Consider first the stocks of debt acquired by households and private non-financial corporations from MFIs (Monetary Financial Institutions). The first chart shows debt stocks as a percentage of GDP. It illustrates nicely the phenomenon of financialisation. In essence, this is the increasing importance of MFIs to the economy. At the end of 2014, these two sectors had debt stocks outstanding equivalent to 90 per cent of GDP. In fact, this is down from a peak of 129 per cent in September 2009. (Click here for a PowerPoint of the chart.)
The growth in debt, especially in the 1990s and for much of the 2000s, was through financial innovation. In particular, the bundling of assets, such as mortgages, to form financial instruments which could then be purchased by investors helped to provide financial institutions with further funds for lending. This is the process of securitisation. Some argue that this was part of a super-cycle which works alongside the normal credit cycle, albeit over a much lengthier period. It can be argued that these cycles coincided during the 1990s and for much of the 2000s until financial distress hit. The distress was hastened by central banks raising interest rates to dampen the rising rate of inflation, partly attributable to rising global commodity prices, including oil.
Some refer to 2008 as a Minsky moment. Overstretched balance sheets needed repairing. But, the collective act of repair actually caused financial well-being to worsen as asset prices and aggregate demand fell.
The global response to the events of the financial crisis has been for policy-makers to pay more attention to the aggregate level of credit provision. The Bank of England’s Financial Policy Committee (FPC) has responsibility for monitoring and helping to ensure the soundness of the UK financial system.
Undoubtedly, the FPC will have constructed a chart similar to our second chart. (Click here for a PowerPoint of the chart). This chart suggests some caution: the need for casting a ‘Minsky eye’ on lending patterns. Over 2014, the UK household sector undertook net lending (i.e. after deducting repayments) of £30 billion. While nothing like the £100 billion or so in 2007, this does mark something of a step up. Indeed it is almost exactly double the flow in 2013. In the months ahead we will continue to monitor the credit data. You can bet that the FPC will do too!
Articles
Comment: Household debt threatens return to spending Herald Scotland, Bill Jamieson (2/3/15)
Household debt rising at fastest rate for 10yrs moneyfacts.co.uk (10/2/15)
Housing starting to rally after home loan approvals rise in January London Evening Standard, Ben Chu (2/3/15)
Data
Bankstats (Monetary and Financial Statistics) – Latest Tables Bank of England
Statistical Interactive Database Bank of England
Questions
- What is meant by the term the business cycle?
- What does it mean for the determinants of the business cycle to be endogenous? What about if they are exogenous?
- Outline the ways in which the financial system can impact on the spending behaviour of households. Repeat the exercise for businesses.
- How might uncertainty affect spending and saving by households and businesses?
- What does it mean if bank lending is pro-cyclical?
- Why might lending be pro-cyclical?
- How might the differential between borrowing and saving interest rates vary over the business cycle?
- Explain what you understand by net lending to households or firms. How does net lending affect their stock of debt?
Ever been to the cinema and found it almost empty? And then wondered why you paid the full price? Perhaps you’ve taken advantage of Orange Wednesday or only go if there’s a particularly good film on? Often it might be cheaper to wait until the film is out on DVD!
Going to the cinema can be an expensive outing. The ticket, the popcorm, a drink, ice cream – it all adds up! Orange Wednesday has recently disappeared and this will definitely have an impact on consumption of movies at your local Odeon, Vue or Showcase. The impact will be on how many seats are left empty.
However, a new app could be set to generate revenues for the cinema and provide cheaper entertainment for your everyday consumer. This new app will allow cinemas to send out alerts to people in the local area advising them that a screening will have many empty seats. What’s the incentive? Perhaps a discount, or some food. But, why would they do such a thing?
If a movie is being shown at a cinema, there will be a large fixed cost. However, what happens as each additional consumer enters the theatre? Does the cost to the cinema rise? Perhaps there is a small cost with more cleaning required, but the additional cost of actually showing the film if there 11 rather than 10 people is almost (if not equal to) zero. That is, the marginal cost of an extra user is zero. Therefore, if there is a screening with many empty seats, wouldn’t the cinema be better to offer the seats for half price. After all, if you can earn £5 from selling a ticket and the additional cost is almost zero, then it’s better to sell it for £5 than not sell it for £10! The following article and video from BBC News considers this new app and other strategies to maximise cinema usage!
Apps in pockets, bums on cinema seats BBC News, Dave Lee (27/2/15)
Questions
- What would the budget constraint look like for a cinema where a discount was offered if you purchased two cinema tickets and then received the third ticket for half price?
- Why is the marginal cost of an extra user at the cinema almost zero?
- If the MC = 0, does this mean that a cinema is a public good?
- How will this new app allow a cinema to increase total revenue and profit?
- If it is cheaper to buy a DVD rather than go to a cinema, why do people still go to the cinema?
House prices are always a good signal for the strength or direction of the economy. While there will always be certain areas that are more sought after than others and such differences will be reflected in relative house prices, the regional divide that we currently see in the UK is quite astonishing.
Prior to the financial crisis, house prices had been rising across the county, but in the year following the financial crisis, they declined by 19 per cent. It was only in 2013, when prices began to increase and, perhaps more importantly, when the variation in regional house prices began to increase significantly. In mid-2014, the UK’s annual house price inflation rate was 11.7 per cent, but the rates in London and the South East were 19.1 and 12.2 per cent, respectively. Elsewhere in the UK, the average rate was 7.9 per cent.
These regional differences have continued and figures show that the current differential between the cheapest and most expensive regional average house price is now over £350,000. In particular, data from the Land Registry shows that the average house price in London is £458,283, while in the North East, it is only £97,974.
Those people who own a house in London have benefited from such high house prices, in many cases finding that their equity in their house has grown significantly. Furthermore, any home-owners selling their house in London and moving elsewhere are benefiting from lower house prices outside London.
However, most first-time buyers looking for a house in London are being competed out of the market, finding themselves unable to gain a mortgage and deposit for the amount that they require. The opposite is, of course, happening in other parts of the country. First-time buyers are more able to enter the property market, but home-owners are finding that they have much less equity in their house.
This has also caused other problems, in particular in the labour market. Workers who are moving to jobs in London are finding the house price differentials problematic. Although wage rates are often higher in London than in other parts of the country, the house price differential is significantly bigger. This means that if someone is offered a job in London, they may find it impossible to find a house of similar size in London compared to where they had been. After all, an average family home in the North East can be purchased for under £100,000, whereas an average family home in London will cost almost £500,000.
The housing market is problematic because of particular characteristics.
Supply tends to be relatively fixed, as it can take a long time to build new houses and hence to boost supply. Furthermore, the UK has a relatively dense population, with limited available land, and so planning restrictions have to be kept quite tight, which is another reason why supply can be difficult to increase.
On the demand-side, we are seeing a change in demographics, with more single-person households; people living longer; second home purchases and many other factors. 
These things tend to push up demand and, with restricted supply, house prices rise. Furthermore, with certain areas being particularly sought after, perhaps due to greater job availability, ease of commuting, schools, etc., house price differentials can be significant.
The Conservatives, together with the other main parties, have promised to build more houses to help ease the problem, but this really is a long-run solution.
The Bank of England will undoubtedly have a role to play in the future of the housing market. The affordability of mortgages is very dependent on interest rate changes by the Bank’s Monetary Policy Committee.
Although house prices in London have recently fallen a little, the housing cost gap between living in London and other areas is unlikely to close by much as long as people continue to want to live in the capital. The following articles consider the housing market and its regional variations.
Articles
London’s homeowners have made £144,000 on average since 2009 International Business Times, Sean Martin (20/2/15)
Wide gap in regional house prices, Land Registry figures show BBC News, Kevin Peachey (27/2/15)
Mapped: 10 years of Britain’s house price boom (and bust) The Telegraph, Anna White (27/2/15)
Oxford houses less affordable than London Financial Times, Kate Allen (26/2/15)
January’s UK house prices show unexpected climb The Guardian (5/2/15)
House prices since 2008: best and worst regions The Telegraph, Tom Brooks-Pollock (22/8/14)
House prices hit new record high of £274k with six regions now past pre-crisis peak – but the North lags behind This is Money, Lee Boyce (14/10/14)
Data
House price indices: Data Tables ONS
Links to sites with data on UK house prices Economic Data freely available online, The Economics Network
Regional House Prices Q4 2014 Lloyds Banking Group
Questions
- What are the main factors that determine the demand for housing? In each case, explain what change would shift the demand curve for housing to the right or the left.
- Which factors determine supply? Which way will they shift the supply curve?
- Put the demand and supply for housing together and use that to explain the recent trends we have seen in house prices.
- Use your answers to question 1 – 3 to explain why house prices in London are so much higher than those in the North East of England.
- Why are interest rates such an important factor in the housing market?
- Explain the link between house prices and the labour market.
- Do you think government policy should focus on reducing regional variations in house prices? What types of policies could be used?
‘The world is sinking under a sea of debt, private as well as public, and it is increasingly hard to see how this might end, except in some form of mass default.’ So claims the article below by Jeremy Warner. But just how much has debt grown, both public and private? And is it of concern?
