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When pessimism takes over

Over 2015 quarter 3, stock markets around the world have seen their biggest falls for four years. As the BBC article states: ‘the numbers for the major markets from July to September make for sobering reading’.

•  US Dow Jones: –7.9%
•  UK FTSE 100: –7.04%
•  Germany Dax: –11.74%
•  Japan Nikkei: –14.47%
•  Shanghai Composite: –24.69%

So can these falls be fully explained by the underlying economic situation or is there an element of over-correction, driven by pessimism? And, if so, will markets bounce back somewhat? Indeed, from 30 September to 2 October, markets did experience a rally. For example, the FTSE 100 rose from a low of 5877 on 29 September to close at 6130 on 3 October (a rise of 4.3%). But is this what is known as a ‘dead cat bounce’, which will see markets fall back again as pessimism once more takes hold?

As far as the global economic scenario is concerned, things have definitely darkened in the past few months. As Christine Lagarde, Managing Director of the IMF, said in an address in Washington ahead of the release of the IMF’s 6-monthly, World Economic Outlook:

I am concerned about the state of global affairs. The refugee influx into Europe is the latest symptom of sharp political and economic tensions in North Africa and the Middle East. While this refugee crisis captures media attention in the advanced economies, it is by no means an isolated event. Conflicts are raging in many other parts of the world, too, and there are close to 60 million displaced people worldwide.

Let us also not forget that the year 2015 is on course to be the hottest year on record, with an extremely strong El Niño that has spawned weather-related calamities in the Pacific.

On the economic front, there is also reason to be concerned. The prospect of rising interest rates in the United States and China’s slowdown are contributing to uncertainty and higher market volatility. There has been a sharp deceleration in the growth of global trade. And the rapid drop in commodity prices is posing problems for resource-based economies.

Words such as these are bound to fuel an atmosphere of pessimism. Emerging economies are expected to see slowing economic growth for the fifth year in succession. And financial stability is still not yet assured despite efforts to repair balance sheets following the financial crash of 2008/9.

But as far as stock markets are concerned, the ECB is in the process of a massive quantitative easing programme, which will boost asset prices, and Japan looks as if it too will embark on a further round of QE. Interest rates remain very low, and, as we discussed in the blog Down down deeper and down, or a new Status Quo?, some central banks now have negative rates of interest. This makes shares relatively attractive for savers, so long as it is believed that they will rise over the medium term.

Then there is the question of speculation. The falls were partly due to people anticipating that share prices would fall. But has this led to overshooting, with prices set to rise again? Or, will pessimism set in once more as people become even gloomier about the world economy? If only I had a crystal ball!

Articles

Markets see their worst quarter in four years BBC News (1/10/15)
Weak Jobs Data Can’t Keep U.S. Stocks Down Wall Street Journal, Corrie Driebusch (2/10/15)
What the 3rd Quarter Tells Us About The Stock Market In October EFT Trends, Gary Gordon (2/10/15)
The bull market ahead: Why shares should make 6.7pc a year until 2025 The Telegraph, Kyle Caldwell (5/9/15)
Is the FTSE 100’s six year run at an end? The bull and bear points The Telegraph, Kyle Caldwell (24/8/15)

Webcasts

The stock market bull may not be dead yet CNNMoney (29/9/15)
IMF’s Lagarde: More volatility likely for emerging markets CNBC, Everett Rosenfeld (30/9/15)
What’s next for stocks after worst quarter in four year CNBC, Patti Domm (30/9/15)
Global markets to log worst quarter since 2011 CNBC, Nyshka Chandran (30/9/15)

Speech
Managing the Transition to a Healthier Global Economy IMF, Christine Lagarde (30/9/15)

Questions

  1. Distinguish between stabilising and destabilising speculation. Is it typical over a period of time that you will get both? Explain.
  2. What is meant by a ‘dead cat bounce’? How would you set about identifying whether a given rally was such a phenomenon?
  3. Examine the relationship between the state (and anticipated state) of the global economy and share prices.
  4. What is meant by (a) the dividend yield on a share; (b) the price/earnings ratio of a share? Investigate what has been happening to dividend yields and price/earnings ratios over the past few months. What is the relationship between dividend yields and share prices?
  5. Distinguish between bull and bear markets.
  6. What factors are likely to drive share prices (a) higher; (b) lower?
  7. Is now the time for investors to buy shares?
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Down down deeper and down, or a new Status Quo?

If you asked virtually any banker or economist a few years ago whether negative (nominal) interest rates were possible, the answer would almost certainly be no.

Negative real interest rates have been common at many points in time – whenever the rate of inflation exceeds the nominal rate of interest. People’s debts and savings are eroded by inflation as the interest due or earned does not keep pace with rising prices.

But negative nominal rates? Surely this could never happen? It was generally believed that zero (or slightly above zero) nominal rates represented a floor – ‘a zero lower bound’.

The reasoning was that if there were negative nominal rates on borrowing, you would effectively be paid by the bank to borrow. In such a case, you might as well borrow as much as you can, as you would owe less later and could pocket the difference.

A similar argument was used with savings. If nominal rates were negative, savers might as well withdraw all their savings from bank accounts and hold them as cash (perhaps needing first to buy a safe!) Given, however, that this might be inconvenient and potentially costly, some people may be prepared to pay banks for looking after their savings.

Central bank interest rates have been hovering just above zero since the financial crisis of 2008. And now, some of the rates have turned negative (see chart above). The ECB has three official rates:

• The interest rate on the main refinancing operations (MRO), which provide the bulk of liquidity to the banking system.
• The rate on the deposit facility, which banks may use to make overnight deposits with the Eurosystem.
• The rate on the marginal lending facility, which offers overnight credit to banks from the Eurosystem.

The first of these is the most important rate and remains above zero – just. Since September 2014, it has been 0.05%. This rate is equivalent to the Bank of England’s Bank Rate (currently still 0.5%) and the Fed’s Federal Funds Rate (currently still between 0% and 0.25%).

The third of the ECB’s rates is currently 0.3%, but the second – the rate on overnight deposits in the ECB by banks in the eurozone – is currently –0.2%. In other words, banks have to pay the ECB for making these overnight deposits (deposits that can be continuously rolled over). The idea has been to encourage banks to lend rather than simply keeping unused liquidity.

In Nordic countries, the experiment with negative rates has gone further. With plenty of slack in the Swedish economy, negative inflation and an appreciating krona, the Swedish central bank – the Riksbank – cut its rates below zero.

Many City analysts believe that the Riksbank will continue cutting, reducing its key interest rate to minus 0.5% by the end of the year [it is currently 0.35%]. Switzerland’s is already deeper still, at minus 0.75%, while Denmark and the eurozone have joined them as members of the negative zone.

But the nominal interest rate on holding cash is, by definition, zero. If deposit rates are pushed below zero, then will more and more people hold cash instead? The hope is that negative nominal interest rates on bank accounts will encourage people to spend. It might, however, merely encourage them to hoard cash.

The article below from The Telegraph looks at some of the implications of an era of negative rates. The demand for holding cash has been increasing in many countries and, along with it, the supply of banknotes, as the chart in the article shows. Here negative interest are less effective. In Nordic countries, however, the use of cash is virtually disappearing. Here negative interest rates are likely to be more effective in boosting aggregate demand.

Article

How Sweden’s negative interest rates experiment has turned economics on its head The Telegraph, Peter Spence (27/9/15)

Data

Central bank and monetary authority websites Bank for International Settlements
Central banks – summary of current interest rates global-rates.com

Questions

  1. Distinguish between negative real and negative nominal interest rates.
  2. What is the opportunity cost of holding cash – the real or the nominal interest rate forgone by not holding it in a bank?
  3. Are there any dangers of central banks setting negative interest rates?
  4. Why may negative interest rates be more effective in Sweden than in the UK?
  5. ‘Andy Haldane, a member of the Monetary Policy Committee (MPC) … suggested that to achieve properly negative rates, the abolition of cash itself might be necessary.’ Why?
  6. Why does Switzerland have notes of SF1000 and the eurozone of €500? Should the UK have notes of £100 or even £500?
  7. Why do some banks charge zero interest rates on credit cards for a period of time to people who transfer their balances from another card? Is there any incentive for banks to cut interest rates on credit cards below zero?
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The effect of cutting greenhouse gas emissions on economic growth

Is slower economic growth a cost of cutting greenhouse gas emissions? Apparently not – at least according to two studies: one by DIW Econ, a German institute for economic research, and the other, earlier this year, by the International Energy Association (see reports below).

The IEA study found that, despite global GDP having grown by 6.4% in 2014, global emissions remained flat. The DIW Econ study found that from 2004 to 2014, OECD countries as a whole grew by 16% while cutting fossil fuel consumption by 6% and greenhouse gas emissions by 6.4%.

But what does this mean? If growth accelerated, what would happen to greenhouse gas emissions? Would they begin to rise again? Probably.

The point is that various developments, largely independent of economic growth have been reducing the greenhouse gas emissions/GDP ratio. These developments include: technological advances in energy generation; the switch to alternative fuels in many countries, thanks, in large part to lower renewable energy costs; increased energy efficiency by consumers; and a continuing move from energy-intensive manufacturing to less energy-intensive services.

So if governments forced more radical cuts in greenhouse gases, would this reduce the rate of economic growth or have no effect? For a given level of technological advancement, the initial effect would probably be a reduction in economic growth. But to the extent that this encouraged further investment in renewables and energy saving, it might even stimulate economic growth over the longer term, especially if it helped to bring lower energy prices.

A big problem in decoupling economic growth from fossil fuel usage is that developing countries, which are taking a growing share of world manufacturing, are more heavily dependent on coal than most developed countries. But even here there seems to be some hope. China, the biggest manufacturer in the developing world, is rapidly increasing its use of renewables. As the IEA press release states:

In China, 2014 saw greater generation of electricity from renewable sources, such as hydropower, solar and wind, and less burning of coal.

If the world is to tackle global warming by making significant cuts in greenhouse gases, there must be a way for developing countries to continue growing while making less use of fossil fuels.

Article

Cutting greenhouse gas emissions won’t slow global economic growth — report The Guardian, Bruce Watson (26/9/15)

Reports

Turning point: Decoupling Greenhouse Gas Emissions from Economic Growth DIW Econ, Lars Handrich, Claudia Kemfert, Anselm Mattes, Ferdinand Pavel, Thure Traber (September 2015)
World Energy Outlook Special Report 2015: Energy and Climate Change International Energy Agency (June 2015)

Questions

  1. What are the possible causal relationships between cutting greenhouse gas emissions and the rate of economic growth?
  2. What incentive mechanisms can governments or other agencies adopt to encourage reductions in greenhouse gas emissions without reducing economic growth?
  3. Can a cap and trade system, such as the European Emissions Trading Scheme help to achieve a given level of emissions reduction at minimum cost to economic growth? Explain.
  4. How might the developed world support developing countries in moving to a low carbon technology?
  5. What factors lie behind the falling costs of renewable energy? Are these the same factors that lie behind the falling cost of oil?
  6. What political problems might hinder the greater production of renewable energy?
  7. How might an economist set about determining a socially optimal amount of fossil fuel production? What conceptual and philosophical problems might there be in agreeing what is meant by a social optimum?
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Got milk?

You’ll be familiar with these types of posts from me, which typically start with a comment like: ‘On my commute to work on …’. That’s one of the good things about a long drive – the interesting and informative discussions that you hear on the radio. This one is another interesting piece from BBC Radio 4, looking at a very topical issue, especially to those living in the South West and other rural areas in the UK.

We have recently seen pictures of farmers protesting about the price of milk and in places like Somerset, the protest took a rather odd method, where farmers from across the region entered supermarkets and simply bought all of the milk, before giving it away. The issue is that dairy farming is no longer profitable, as the price that dairy farmers receive for each pint of milk is now lower than the cost of providing it. Thus, for each pint they make a loss.

There are many reasons that have contributed to this situation, including pressures imposed by customers demanding cheaper prices; pressures from supermarkets using their monopsony power to force down the prices paid to farmers; and pressures from abroad. In the case of milk, we have a surplus and with a perishable product, i.e. one that cannot be stored, unlike wheat, this has contributed to falling prices. Data suggest that we are seeing approximately one farmer per day being forced to leave the indsutry.

This programme explores the current dairy farming crisis and draws some similarities with the wheat crisis that the UK experienced in the 1930s. The programme below is 30 minutes and provides some interesting insights on two important commodities and the economics behind the markets.

Today’s crisis in dairy farming and the wheat crisis of the 1930s BBC Radio 4; The Long View, Jonathan Freedland (29/9/15)

Questions

  1. Using demand and supply analysis, explain the situation in the milk market.
  2. Now consider the wheat industry and provide a similar analysis of how prices are set and what caused the problems seen in the 1930s.
  3. Although these two commodities have similarities they are also very different. Why can two different commodities experience such similar problems at such different times?
  4. What are the key demand and supply-side factors affecting the current low price of milk?
  5. Consider the market for (a) milk and (b) wheat. What are (if any) the market failures within each area?
  6. Agriculture is an area where we do see significant government intervention. Should the UK government be doing more to help the UK’s dairy farmers? If so, what should they do and would this intervention create further problems, e.g. unintended consequences?
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The rise of the machines

What will production look like in 20 years time? Will familiar jobs in both manufacturing and the services be taken over by robots? And if so, which ones? What will be the effect on wages and on unemployment? Will most people be better off, or will just a few gain while others get by with minimum-wage jobs or no jobs at all?

The BBC has been running a series looking at new uses for robots and whether they will take people’s jobs? This complements three reports: one by Boston Consulting one by Deloitte and an earlier one by Deloitte and Michael Osborne and Carl Frey from Oxford University’s Martin School. As Jane Wakefield, the BBC’s technology reporter states:

Boston Consulting Group predicts that by 2025, up to a quarter of jobs will be replaced by either smart software or robots, while a study from Oxford University has suggested that 35% of existing UK jobs are at risk of automation in the next 20 years.

Jobs at threat from machines include factory work, office work, work in the leisure sector, work in medicine, law, education and other professions, train drivers and even taxi and lorry drivers. At present, in many of these jobs machines work alongside humans. For example, robots on production lines are common, and robots help doctors perform surgery and provide other back-up services in medicine.

A robot may not yet have a good bedside manner but it is pretty good at wading through huge reams of data to find possible treatments for diseases.

Even if robots don’t take over all jobs in these fields, they are likely to replace an increasing proportion of many of these jobs, leaving humans to concentrate on the areas that require judgement, creativity, human empathy and finesse.

These developments raise a number of questions. If robots have a higher marginal revenue product/marginal cost ratio than humans, will employers choose to replace humans by robots, wholly or in part? How are investment costs factored into the decision? And what about industrial relations? Will employers risk disputes with employees? Will they simply be concerned with maximising profit or will they take wider social concerns into account?

Then there is the question of what new jobs would be created for those who lose their jobs to machines. According to the earlier Deloitte study, which focused on London, over 80% of companies in London say that over the next 10 years they will be most likely to take on people with skills in ‘digital know-how’, ‘management’ and ‘creativity’.

But even if new jobs are created through the extra spending power generated by the extra production – and this has been the pattern since the start of the industrial revolution some 250 years ago – will these new jobs be open largely to those with high levels of transferable skills? Will the result be an ever widening of the income gap between rich and poor? Or will there be plenty of new jobs throughout the economy in a wide variety of areas where humans are valued for the special qualities they bring? As the authors of the later Deloitte paper state:

The dominant trend is of contracting employment in agriculture and manufacturing being more than offset by rapid growth in the caring, creative, technology and business services sectors.

The issues of job replacement and job creation, and of the effects on income distribution and the balance between work and leisure, are considered in the following videos and articles, and in the three reports.

Videos

What is artificial intelligence? BBC News, Valery Eremenko (13/9/15)
What jobs will robots take over? BBC News, David Botti (15/8/14)
Could a robot do your job? BBC News, Rory Cellan-Jones (14/9/15)
Intelligent machines: The robots that work alongside humans BBC News, Rory Cellan-Jones (14/9/15)
Intelligent machines: Will you be replaced by a robot? BBC News, John Maguire (14/9/15)
Will our emotions change the way adverts work? BBC News, Dan Simmons (24/7/15)
Could A Robot Do My Job? BBC Panorama, Rohan Silva (14/9/15)

Articles

Technology has created more jobs in the last 144 years than it has destroyed, Deloitte study finds Independent, Doug Bolton (18/8/15)
Technology has created more jobs than it has destroyed, says 140 years of data The Guardian, Katie Allen (18/8/15)
Will a robot take your job? BBC News (11/9/15)
Intelligent Machines: The jobs robots will steal first BBC News, Jane Wakefield (14/9/15)
Robots Could Take 35 Per Cent Of UK Jobs In The Next 20 Years Says New Study Huffington Post, Thomas Tamblyn (14/9/15)
The new white-collar fear: will robots take your job? The Telegraph, Rohan Silva (12/9/15)
Does technology destroy jobs? Data from 140 years says no Catch news, Sourjya Bhowmick (11/9/15)

Reports

Takeoff in Robotics Will Power the Next Productivity Surge in Manufacturing Boston Consulting Group (10/2/15)
Agiletown: the relentless march of technology and London’s response Deloitte (November 2014)
Technology and people: The great job-creating machine Deloitte, Ian Stewart, Debapratim De and Alex Cole (August 2015)

Questions

  1. Which are the fastest growing and fastest declining occupations? To what extent can these changes be explained by changes in technology?
  2. What type of unemployment is caused by rapid technological change?
  3. Why, if automation replaces jobs, have jobs increased over the past 250 years?
  4. In what occupations is artificial intelligence (AI) most likely to replace humans?
  5. To what extent are robots and humans complementary rather than substitute inputs into production?
  6. “Our analysis of more recent employment data also reveals a clear pattern to the way in which technology has affected work.” What is this pattern? Explain.
  7. Why might AI make work more interesting for workers?
  8. Using a diagram, show how an increase in workers’ marginal productivity from working alongside robots can result in an increase in employment. Is this necessarily the case? Explain.