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Ten years ago, the financial crisis deepened and stock markets around the world plummeted. The trigger was the collapse of Lehman Brothers, the fourth-largest US investment bank. It filed for bankruptcy on September 15, 2008. This was not the first bank failure around that time. In 2007, Northern Rock in the UK (Aug/Sept 2007) had collapsed and so too had Bear Stearns in the USA (Mar 2008).

Initially there was some hope that the US government would bail out Lehmans. But when Congress rejected the Bank Bailout Bill on September 29, the US stock market fell sharply, with the Dow Jones falling by 7% the same day. This was mirrored in other countries: the FTSE 100 fell by 15%.

At the core of the problem was excessive lending by banks with too little capital. What is more, much of the capital was of poor quality. Many of the banks held securitised assets containing ‘sub-prime mortgage debt’. The assets, known as collateralised debt obligations (CDOs), were bundles of other assets, including mortgages. US homeowners had been lent money based on the assumption that their houses would increase in value. When house prices fell, homeowners were left in a position of negative equity – owing more than the value of their house. With many people forced to sell their houses, prices fell further. Mortgage debt held by banks could not be redeemed: it was ‘sub-prime’ or ‘toxic debt’.

Response to the crisis

The outcome of the financial crash was a series of bailouts of banks around the world. Banks cut back on lending and the world headed for a major recession.

Initially, the response of governments and central banks was to stimulate their economies through fiscal and monetary policies. Government spending was increased; taxes were cut; interest rates were cut to near zero. By 2010, the global economy seemed to be pulling out of recession.

However, the expansionary fiscal policy, plus the bailing out of banks, had led to large public-sector deficits and growing public-sector debt. Although a return of economic growth would help to increase revenues, many governments felt that the size of the public-sector deficits was too large to rely on economic growth.

As a result, many governments embarked on a period of austerity – tight fiscal policy, involving cutting government expenditure and raising taxes. Although this might slowly bring the deficit down, it slowed down growth and caused major hardships for people who relied on benefits and who saw their benefits cut. It also led to a cut in public services.

Expanding the economy was left to central banks, which kept monetary policy very loose. Rock-bottom interest rates were then accompanied by quantitative easing. This was the expansion of the money supply by central-bank purchases of assets, largely government bonds. A massive amount of extra liquidity was pumped into economies. But with confidence still low, much of this ended up in other asset purchases, such as stocks and shares, rather than being spent on goods and services. The effect was a limited stimulation of the economy, but a surge in stock market prices.

With wages rising slowly, or even falling in real terms, and with credit easy to obtain at record low interest rates, so consumer debt increased.

Lessons

So have the lessons of the financial crash been learned? Would we ever have a repeat of 2007–9?

On the positive side, financial regulators are more aware of the dangers of under capitalisation. Banks’ capital requirements have increased, overseen by the Bank for International Settlements. Under its Basel II and then Basel III regulations (see link below), banks are required to hold much more capital (‘capital buffers’). Some countries’ regulators (normally the central bank), depending on their specific conditions, exceed these the Basel requirements.

But substantial risks remain and many of the lessons have not been learnt from the financial crisis and its aftermath.

There has been a large expansion of household debt, fuelled by low interest rates. This constrains central banks’ ability to raise interest rates without causing financial distress to people with large debts. It also makes it more likely that there will be a Minsky moment, when a trigger, such as a trade war (e.g. between the USA and China), causes banks to curb lending and consumers to rein in debt. This can then lead to a fall in aggregate demand and a recession.

Total debt of the private and public sectors now amounts to $164 trillion, or 225% of world GDP – 12 percentage points higher than in 2009.

China poses a considerable risk, as well as being a driver of global growth. China has very high levels of consumer debt and many of its banks are undercapitalised. It has already experienced one stock market crash. From mid-June 2015, there was a three-week fall in share prices, knocking about 30% off their value. Previously the Chinese stock market had soared, with many people borrowing to buy shares. But this was a classic bubble, with share prices reflecting exuberance, not economic fundamentals.

Although Chinese government purchases of shares and tighter regulation helped to stabilise the market, it is possible that there may be another crash, especially if the trade war with the USA escalates even further. The Chinese stock market has already lost 20% of its value this year.

Then there is the problem with shadow banking. This is the provision of loans by non-bank financial institutions, such as insurance companies or hedge funds. As the International Business Times article linked below states:

A mind-boggling study from the US last year, for example, found that the market share of shadow banking in residential mortgages had rocketed from 15% in 2007 to 38% in 2015. This also represents a staggering 75% of all loans to low-income borrowers and risky borrowers. China’s shadow banking is another major concern, amounting to US$15 trillion, or about 130% of GDP. Meanwhile, fears are mounting that many shadow banks around the world are relaxing their underwriting standards.

Another issue is whether emerging markets can sustain their continued growth, or whether troubles in the more vulnerable emerging-market economies could trigger contagion across the more exposed parts of the developing world and possibly across the whole global economy. The recent crises in Turkey and Argentina may be a portent of this.

Then there is a risk of a cyber-attack by a rogue government or criminals on key financial insitutions, such as central banks or major international banks. Despite investing large amounts of money in cyber-security, financial institutions worry about their vulnerability to an attack.

Any of these triggers could cause a crisis of confidence, which, in turn, could lead to a fall in stock markets, a fall in aggregate demand and a recession.

Finally there is the question of the deep and prolonged crisis in capitalism itself – a crisis that manifests itself, not in a sudden recession, but in a long-term stagnation of the living standards of the poor and ‘just about managing’. Average real weekly earnings in many countries today are still below those in 2008, before the crash. In Great Britain, real weekly earnings in July 2018 were still some 6% lower than in early 2008.

Articles

Information and data

Questions

  1. Explain the major causes of the financial market crash in 2008.
  2. Would it have been a good idea to have continued with expansionary fiscal policy beyond 2009?
  3. Summarise the Basel III banking regulations.
  4. How could quantitative easing have been differently designed so as to have injected more money into the real sector of the economy?
  5. What are the main threats to the global economy at the current time? Are any of these a ‘hangover’ from the 2007–8 financial crisis?
  6. What is meant by ‘shadow banking’ and how might this be a threat to the future stability of the global economy?
  7. Find data on household debt in two developed countries from 2000 to the present day. Chart the figures. Explain the pattern that emerges and discuss whether there are any dangers for the two economies from the levels of debt.

The median pay of chief executives of the FTSE 100 companies rose 11% in 2017 to £3.93 million per year, according to figures released by the High Pay Centre. By contrast, the median pay of full-time workers rose by just 2%. Given two huge pay increases for the CEOs of Persimmon and Melrose Industries of £47.1 million and £42.8 million respectively, the mean CEO pay rose even more – by 23%, from £4.58 million in 2016 to £5.66 million in 2017. This brings the ratio of the mean pay of FTSE 100 CEOs to that of their employees to 145:1. In 2000, the ratio was around 45:1.

These huge pay increases are despite criticisms from shareholders and the government over excessive boardroom pay awards and the desire for more transparency. In fact, under new legislation, companies with more than 250 employees must publish the ratio of the CEO’s total remuneration to the full-time equivalent pay of their UK employees on the 25th, 50th (median) and 75th percentiles. The annual figures will be for pay starting from the financial year beginning in 2019, which for most companies would mean the year from April 2019 to April 2020. Such a system has been introduced in the USA this year.

So why has the gap in pay widened so much? One reason is that there is no formal mechanism whereby workers can apply downward pressure on such awards. Although Theresa May, in her campaign to become Prime Minister in 2016, promised to put workers on company boards, the government has since abandoned the idea.

Executive pay is awarded by remuneration committees. Membership of such committees consists of independent non-executive directors, but their degree of independence has frequently been called into question and there has been much criticism of such committees being influenced by their highest paying competitors or peers. This has had the effect of ratcheting up executive pay.

Then there is the question of the non-salary element in executive pay. The incentive and bonus payments are often linked to the short-term performance of the company, as reflected in, for example, the company’s share price. In a period when share prices in general rise rapidly – as we have seen over the past two years – executive pay tends to rise rapidly too. A frequent criticism of large UK businesses is that they have been too short-termist. What is more, bonuses are often paid despite poor performance.

There has been some move in recent years to make incentive pay linked more to long-term performance, but this has still led to many CEOs getting large pay increases despite lack-lustre long-term performance.

Then there is the question of shareholders and their influence on executive pay. Despite protests by many smaller shareholders, a large proportion of shares are owned by investment funds and their managers are often only too happy to vote through large executive pay increases at shareholder meetings.

So, while the pressures for containing the rise in executive pay remain small, the pay gap is likely to continue to widen. This raises the whole question of a society becoming increasingly divided between the few at the top and a large number of people ‘just getting by’ – or not even that. Will this make society even more fractured and ill at ease with itself?

Articles

Information and data

Questions

  1. How would you set about establishing whether CEOs’ pay is related to their marginal revenue product?
  2. To what extent is executive pay a reflection of oligopolistic/oligopsonistic behaviour?
  3. In what ways can game theory shed light on the process of setting the remuneration packages of CEOs? Is there a Nash equilibrium?
  4. What are the advantages and disadvantages of linking senior executives’ remuneration to (a) short-term company performance; (b) long-term company performance?
  5. What is/are the best indicator(s) of long-term company performance for determining the worth of senior executives?
  6. Consider the arguments for and against capping the ratio of CEOs’ remuneration to a particular ratio of either the mean or median pay of employees. What particular ratio might be worth considering for such a cap?

Houses of Parliament: photo JSThe last two weeks have been quite busy for macroeconomists, HM Treasury staff and statisticians in the UK. The Chancellor of the Exchequer, Mr Phillip Hammond, delivered his (fairly upbeat) Spring Budget Statement on 13 March, highlighting among other things the ‘stellar performance’ of UK labour markets. According to a Treasury Press Release:

Employment has increased by 3 million since 2010, which is the equivalent of 1,000 people finding work every day. The unemployment rate is close to a 40-year low. There is also a joint record number of women in work – 15.1 million. The OBR predict there will be over 500,000 more people in work by 2022.

To put these figures in perspective, according to recent ONS estimates, in January 2018 the rate of UK unemployment was 4.3 per cent – down from 4.4 per cent in December 2017. This is the lowest it has been since 1975. This is of course good news: a thriving labour market is a prerequisite for a healthy economy and a good sign that the UK is on track to full recovery from its 2008 woes.

The Bank of England welcomed the news with a mixture of optimism and relief, and signalled that the time for the next interest rate hike is nigh: most likely at the next MPC meeting in May.

But what is the practical implication of all this for UK consumers and workers?

Money: photo JS

For workers it means it’s a ‘sellers’ market’: as more people get into employment, it becomes increasingly difficult for certain sectors to fill new vacancies. This is pushing nominal wages up. Indeed, UK wages increased on average by 2.6 per cent year-to-year.

In real terms, however, wage growth has not been high enough to outpace inflation: real wages have fallen by 0.2 per cent compared to last year. Britain has received a pay rise, but not high enough to compensate for rising prices. To quote Matt Hughes, a senior ONS statistician:

Employment and unemployment levels were both up on the quarter, with the employment rate returning to its joint highest ever. ‘Economically inactive’ people — those who are neither working nor looking for a job — fell by their largest amount in almost five and a half years, however. Total earnings growth continues to nudge upwards in cash terms. However, earnings are still failing to outpace inflation.

An increase in interest rates is likely to put further pressure on indebted households. Even more so as it coincides with the end of the five-year grace period since the launch of the 2013 Help-to-Buy scheme, which means that many new homeowners who come to the end of their five year fixed rate deals, will soon find themselves paying more for their mortgage, while also starting to pay interest on their Help-to-buy government loan.

Will wages grow fast enough in 2018 to outpace inflation (and despite Brexit, which is now only 12 months away)? We shall see.

Articles

Data, Reports and Analysis

Questions

  1. What is monetary policy, and how is it used to fine tune the economy?
  2. What is the effect of an increase in interest rates on aggregate demand?
  3. How optimistic (or pessimistic) are you about the UK’s economic outlook in 2018? Explain your reasoning.

On 8 February, the Bank of England issued a statement that was seen by many as a warning for earlier and speedier than previously anticipated increases in the UK base rate. Mark Carney, the governor of the Bank of England, referred in his statement to ‘recent forecasts’ which make it more likely that ‘monetary policy would need to be tightened somewhat earlier and by a somewhat greater extent over the forecast period than anticipated at the time of the November report’.

A similar picture emerges on the other side of the Atlantic. With labour markets continuing to deliver spectacularly high rates of employment (the highest in the last 17 years), there are also now signs that wages are on an upward trajectory. According to a recent report from the US Bureau of Labor Statistics, US wage growth has been stronger than expected, with average hourly earnings rising by 2.9 percent – the strongest growth since 2009.

These statements have coincided with a week of sharp corrections and turbulence in the world’s largest capital markets, as investors become increasingly conscious of the threat of rising inflation – and the possibility of tighter monetary policy.

The Dow Jones plunged from an all-time high of 26,186 points on 1 February to 23,860 a week later – losing more than 10 per cent of its value in just five trading sessions (suffering a 4.62 percentag fall on 5 February alone – the worst one-day point fall since 2011). European and Asian markets followed suit, with the FTSE-100, DAX and NIKKEI all suffering heavy losses in excess of 5 per cent over the same period.

But why should higher inflationary expectations fuel a sell-off in global capital markets? After all, what firm wouldn’t like to sell its commodities at a higher price? Well, that’s not entirely true. Investors know that further increases in inflation are likely to be met by central banks hiking interest rates. This is because central banks are unlikely to be willing or able to allow inflation rates to rise much above their target levels.

The Bank of England, for instance, sets itself an inflation target of 2%. The actual ongoing rate of inflation reported in the latest quarterly Inflation Report is 3% (50 per cent higher than the target rate).

Any increase in interest rates is likely to have a direct impact on both the demand and the supply side of the economy.

Consumers (the demand side) would see their cost of borrowing increase. This could put pressure on households that have accumulated large amounts of debt since the beginning of the recession and could result in lower consumer spending.

Firms (the supply side) are just as likely to suffer higher borrowing costs, but also higher operational costs due to rising wages – both of which could put pressure on profit margins.

It now seems more likely that we are coming towards the end of the post-2008 era – a period that saw the cost of money being driven down to unprecedentedly low rates as the world’s largest economies dealt with the aftermath of the Great Recession.

For some, this is not all bad news – as it takes us a step closer towards a more historically ‘normal’ equilibrium. It remains to be seen how smooth such a transition will be and to what extent the high-leveraged world economy will manage to keep its current pace, despite the increasingly hawkish stance in monetary policy by the world’s biggest central banks.

Video

Dow plunges 1,175 – worst point decline in history CNN Money, Matt Egan (5/2/18)

Articles

Global Markets Shed $5.2 Trillion During the Dow’s Stock Market Correction Fortune, Lucinda Shen (9/2/18)
Bank of England warns of larger rises in interest rates Financial Times, Chris Giles and Gemma Tetlow (8/2/18)
Stocks are now in a correction — here’s what that means Business Insider, Andy Kiersz (8/2/18)
US economy adds 200,000 jobs in January and wages rise at fastest pace since recession Business Insider, Akin Oyedele (2/2/18)

Questions

  1. Using supply and demand diagrams, explain the likely effect of an increase in interest rates to equilibrium prices and output. Is it good news for investors and how do you expect them to react to such hikes? What other factors are likely to influence the direction of the effect?
  2. Do you believe that the current ultra-low interest rates could stay with us for much longer? Explain your reasoning.
  3. What is likely to happen to the exchange rate of the pound against the US dollar, if the Bank of England increases interest rates first?
  4. Why do stock markets often ‘overshoot’ in responding to expected changes in interest rates or other economic variables

These are challenging times for business. Economic growth has weakened markedly over the past 18 months with output currently growing at an annual rate of around 1.5 per cent, a percentage point below the long-term average. Spending power continues to be squeezed, with the annual rate of inflation in October reported to be running at 3.1 per cent compared to annual earnings growth of 2.5 per cent (see the squeeze continues). Moreover, consumer confidence remains fragile with households continuing to express particular concerns about the general economy and unemployment.

Here, we update our blog of July 2016 which, following the UK vote to leave the European Union, noted the fears for UK growth as confidence fell sharply. Consumer confidence is frequently identified by macro-economists as an important source of economic volatility. Indeed many macro models use a change in consumer confidence as a means of illustrating how economic shocks affect a range of macro variables, including growth, employment and inflation. Many economists agree that, in the short term at least, falling levels of confidence adversely affect activity because aggregate demand falls as households spend less.

The European Commission’s confidence measure is collated from questions in a monthly survey. In the UK around 2000 individuals are surveyed. Across the EU as a whole over 41 000 people are surveyed. In the survey individuals are asked a series of 12 questions which are designed to provide information on spending and saving intentions. These questions include perceptions of financial well-being, the general economic situation, consumer prices, unemployment, saving and the undertaking of major purchases.

The responses elicit either negative or positive responses. For example, respondents may feel that over the next 12 months the financial situation of their household will improve a little or a lot, stay the same or deteriorate a little or a lot. A weighted balance of positive over negative replies can be calculated. The balance can vary from -100, when all respondents choose the most negative option, to +100, when all respondents choose the most positive option.

The European Commission’s principal consumer confidence indicator is the average of the balances of four of the twelve questions posed: the financial situation of households, the general economic situation, unemployment expectations (with inverted sign) and savings, all over the next 12 months. These forward-looking balances are seasonally adjusted. The aggregate confidence indicator is thought to track developments in households’ spending intentions and, in turn, likely movements in the rate of growth of household consumption.

Chart 1 shows the consumer confidence indicator for the UK. The long-term average of –8.6 shows that negative responses across the four questions typically outweigh positive responses. In November 2017 the confidence balance stood at -5.2 roughly on par with its value in the previous two months, though marginally up on values of close to -7 over the summer. However, as recently as the beginning of 2016 the aggregate confidence score was running at around +4. In this context, current levels do constitute a significant change in consumer sentiment, changes which do ordinarily mark similar turning points in economic activity.(Click here to download a PowerPoint of the chart.)

Chart 2 allows to look behind the European Commission’s headline confidence indicator for the UK by looking at its four component balances. From it, we can see a deterioration in all four components. However, by far the most significant change in the individual confidence balances has been the sharp deterioration in expectations for the general economy. In November the forward-looking general economic situation stood at -25.5, compared to its long-run average of -11.6. (Click here to download a PowerPoint of the chart.)

The fall in UK consumer confidence is even more stark when compared to developments in consumer confidence across the whole of the European Union and in the 19 countries that make up the Euro area. Chart 3 shows how UK consumer confidence recovered relatively more strongly following the financial crisis of the late 2000s. The headline confidence indicator rose strongly from the middle of 2013 and was consistently in positive territory during 2014, 2015 and into 2016. The fall in consumer confidence in the UK has seen the headline confidence measure fall below that for the EU and the euro area. (Click here to download a PowerPoint of the chart.)

Consumer (and business) confidence is closely linked to uncertainty. The circumstances following the UK vote to leave the EU have undoubtedly created the conditions for acute uncertainty. Uncertainty breeds caution. Economists sometimes talk about spending being affected by two conflicting motives: prudence and impatience. While impatience creates a desire for spending now, prudence pushes us towards saving and insuring ourselves against uncertainty and unforeseen events. The worry is that the twin forces of fragile confidence and squeezed real earning are weighting heavily in favour of prudence and patience (a reduction in impatience). Going forward, this could create the conditions for a sustained period of subdued growth which, if it were to impact heavily on firms’ investment plans, could adversely impact on the economy’s productive potential. The hope is that the Brexit negotiations can move apace to reduce uncertainty and limit uncertainty’s adverse impact on economic activity.

Articles

UK consumer confidence slips in December – Thomson Reuters/Ipsos Reuters (14/12/17)
UK consumer confidence drops to lowest level since Brexit result Independent, Ben Chu (30/11/17)
2017 set to be worst year for UK consumer spending since 2012, Visa says Independent, Josie Cox, (11/12/17)
Carpetright boss warns of ‘fragile’ consumer confidence after profits plunge Telegraph, Jack Torrance (12/12/17)
UK consumers face sharpest price rise in services for nearly a decade Guardian, Richard Partington (5/12/17)
UK average wage growth undershoots inflation again squeezing real incomes Independent, Josie Cox (13/12/17)
Bank sees boost from Brexit progress BBC News (14/12/17)

Data

Business and Consumer Surveys European Commission

Questions

  1. Draw up a series of factors that you think might affect consumer confidence.
  2. Explain what you understand by a positive and a negative demand-side shock. How might changes in consumer confidence generate demand shocks?
  3. Analyse the ways in which consumer confidence might affect economic activity.
  4. Which of the following statements is likely to be more accurate: (a) Consumer confidence drives economic activity or (b) Economic activity drives consumer confidence?
  5. What macroeconomic indicators would those compiling the consumer confidence indicator expect the indicator to predict?
  6. Analyse the possible short-term and longer-term economic implications of a fall in consumer confidence.
  7. How might uncertainty affect consumer confidence?
  8. What do the concepts of impatience and prudence mean in the context of consumer spending? When consumer confidence falls which of these might become more significant for consumer spending?