After a week of turmoil in Cyprus (see the News item Ochi, ochi, ochi) a deal has been struck between Cyprus, the EU and the IMF over a €10bn bailout for the island’s banking system. But while the deal may bring the immediate crisis to an end, the Cypriot economy could face years of austerity and depression. And there remain questions over whether the deal sends the wrong message to depositors in banks in other eurozone countries whose banking systems are under pressure.
Unlike the original EU proposal, the deal will not impose a levy on deposits under €100,000, much to the relief of small and medium depositors. But individuals and businesses with deposits over €100,000 in the two main troubled banks (Laiki and the Bank of Cyprus) will face losses that could be as high as 40%. The precise size will become clear in the coming days.
The troubled second largest bank, Laiki (Popular) Bank, will be split into a ‘good’ and a ‘bad’ bank. The assets and liabilities of the good part will be taken over by the largest bank, the Bank of Cyprus. Thus people’s accounts under €100,000 will be moved from one to the other. The ‘bad’ part will include deposits over €100,000 and bonds. Holders of these could lose a substantial proportion of their value.
Many businesses will be hard hit and may be forced to close. This could have serious adverse multiplier effects on the economy. These effects will be aggravated by the fiscal austerity measures which are also part of the deal. The measures are also likely to discourage further inward investment, again pushing the economy further into recession.
And then there are the broader effects on the eurozone. The direct effect of a decline in the Cypriot economy would be tiny; the Cypriot economy accounts for a mere 0.2% of eurozone GDP. Also the effect on small savers in other eurozone countries is also likely to be limited, as people will probably be reassured that savings under €100,000 have remained protected, even in an economy as troubled as Cyprus.
But some commentators argue that the effect on large depositors in other troubled eurozone countries, such as Portugal, Spain, Greece and Italy, could be much more serious. Would people with large balances in these countries prefer to move their money to, say, Germany, or even out of the eurozone altogether? There is clearly disagreement over this last point as you will see from the articles below.
Webcasts and Podcasts
Cyprus agrees bailout with eurozone ministers The Guardian (25/3/13)
Cyprus bailout: Deal reached in Eurogroup talks BBC News (25/3/13)
‘Disaster avoided’ as Cyprus agrees EU bailout deal Euronews (25/3/13)
Cyprus saved from bankruptcy Channel 4 News on YouTube, Faisal Islam (25/3/13)
What are the implications of the Cyprus deal? BBC Radio 4 Today Programme, Stephanie Flanders (25/3/13)
Cyprus bailout deal: Russia riled but Germany relieved BBC News, Steve Rosenberg in Moscow and Stephen Evans in Berlin (25/3/13)
Cyprus bailout deal ‘durable’ says IMF chief BBC News, Christine Lagarde (25/3/13)
Cyprus Bailout Deal Raises Questions: Lombardi Bloomberg, Domenico Lombardi (25/3/13)
Minister Michalis Sarris: Cyprus paying ‘tremendous cost’ BBC Radio 4 Today Programme, Michalis Sarris (26/3/13)
Articles
Last-minute Cyprus deal to close bank, force losses Reuters, Jan Strupczewski and Annika Breidthardt (25/3/13)
Cyprus strikes last-minute EU bailout deal The Guardian, Ian Traynor (25/3/13)
‘There is no future here in Cyprus’ The Telegraph, Nick Squires (25/3/13)
Back from the brink: EU ministers approve €10bn bailout deal at 11th-hour to save Cyprus Independent, Charlotte McDonald-Gibson and Majid Mohamed (25/3/13)
Cyprus bailout: Deal reached in Eurogroup talks BBC News (25/3/13)
Q&A: Cyprus deal BBC News (25/3/13)
The rescue of Cyprus won’t feel like one to its people BBC News, Robert Peston (25/3/13)
Lessons of Cyprus BBC News, Stephanie Flanders (25/3/13)
Cyprus bailout: Dijsselbloem remarks alarm markets BBC News (25/3/13)
Cyprus saved – but at what cost? The Guardian, Helena Smith (25/3/13)
Cyprus bail-out: savers will be raided to save euro in future crisis, says eurozone chief The Telegraph, Bruno Waterfield (25/3/13)
Cyprus’s banks have been tamed – are Malta and Luxembourg next? The Guardian, Ian Traynor (25/3/13)
Lehman lessons weigh on Cyprus talks but 1920s slump must not be ignored The Guardian, Larry Elliott (24/3/13)
Questions
- Explain what is meant by ‘moral hazard’. What moral hazards are implicit in the deal that has been struck with Cyprus?
- How does the size of the banking system in Cyprus as a proportion of GDP differ from that in other troubled eurozone countries? How does this affect the ‘contagion’ argument?
- Does the experience of Iceland and its troubled banks suggest that the Cypriot problem has nothing to do with its being in the eurozone?
- What options are open to the Cypriot government to stimulate the economy and prevent a severe recession? How realistic are these options (if any)?
- What are the likely implications of the deal for the economic relationships (as opposed to the political ones) between Cyprus and Russia and between the eurozone and Russia?
- Are there any similarities in the relationships between the weak and strong eurozone countries today and those between Germany and other countries in the 1920s and 30s?
The UK economy is suffering from a lack of aggregate demand. Low spending in real terms is preventing the economy from growing. A simple solution would seem to be to stimulate aggregate demand through fiscal policy, backed up by even looser monetary policy. But this is easier said than done and could result in undesirable consequences in the medium term.
If increased borrowing were to be used to fund increased government expenditure and/or cuts in taxes, would any resulting growth be sufficient in the medium term to reduce the public-sector deficit below the initial level through automatic fiscal stabilisers? And would the growth be sustainable? The answer to this second question depends on what happens to the supply side of the economy. Would there be an increase in aggregate supply to match the increase in aggregate demand?
This second question has led many economists to argue that we need to see a rebalancing of the economy. What is needed is an increase in investment and exports, rather than an increase in just consumer expenditure funded by private borrowing and government current expenditure funded by public borrowing.
But how will exports and investment be stimulated? As far as exports are concerned, it was hoped that the depreciation of the pound since 2008 would give UK exporters a competitive advantage. Also domestic producers would gain a competitive advantage in the UK from imports becoming more expensive. But the current account deficit has actually deteriorated. According to the EU’s AMECO database, in 2008 the current account deficit was 1% of GDP; in 2012 it was 3.7%. It would seem that UK producers are not taking sufficient advantage of the pound’s depreciation, whether for exports or import substitutes.
As far as investment is concerned, there are two major problems. The first is the ability to invest. This depends on financing and things such as available land and planning regulations. The second is the confidence to invest. With not little or no growth in consumer demand, there is little opportunity for the accelerator to work. And with forecasts of sluggish growth and austerity measures continuing for some years, there is little confidence in a resurgence in consumer demand in the future. (Click here for a PowerPoint of the above chart. Note that the 2013 plots are based on AMECO forecasts.)
So hope of a rebalancing is faint at the current time. Hence the arguments for an increase in government capital expenditure that we looked at in the last blog post (The political dynamite of calm economic reflection). The problem and the options for government are considered in the following articles.
Articles
Budget 2013: Chancellor’s rebalancing act BBC News, Stephanie Flanders (11/3/13)
Why George Osborne is failing to rebalance the economy The Guardian, Larry Elliott (17/3/13)
Economy fails to ‘rebalance’ Financial Times, Sarah O’Connor (27/2/13)
Analysis – Long haul ahead for Britain’s struggling economy Reuters, William Schomberg (3/3/13)
Can banks be forced to lend more? BBC News, Robert Peston (12/3/13)
Budget 2013: What the commentators are saying BBC News (13/3/13)
Data
UK Trade, January 2013 (ONS) (12/3/13)
Business investment, Q4 2012 ONS (27/2/13)
Questions
- Draw a diagram to illustrate the effects of a successful policy to increase both aggregate demand and aggregate supply. What will determine the effect on the output gap?
- For what reasons has the UK’s current account deteriorated over the past few years while those of the USA and the eurozone have not?
- Using ONS data, find out what has happened to the UK’s balance of trade in (a) goods and (b) services over the past few years and explain your findings.
- Why are firms reluctant to invest at the moment? What policy measures could the government adopt to increase investment?
- With interest rates so low, why don’t consumers borrow and spend more, thereby aiding the recovery?
Moody’s, one of the three main international credit rating agencies, has just downgraded the UK’s credit rating from the top Aaa rating to Aa1. The other two agencies, Standard & Poor’s and Fitch may follow suit as they have the UK’s triple A rating on ‘negative outlook’.
The reason for Moody’s decision can be see in its press statement:
The key interrelated drivers of today’s action are:
1. The continuing weakness in the UK’s medium-term growth outlook, with a period of sluggish growth which Moody’s now expects will extend into the second half of the decade;
2. The challenges that subdued medium-term growth prospects pose to the government’s fiscal consolidation programme, which will now extend well into the next parliament;
3. And, as a consequence of the UK’s high and rising debt burden, a deterioration in the shock-absorption capacity of the government’s balance sheet, which is unlikely to reverse before 2016.
The direct economic consequences of Moody’s action are likely to be minimal. People were excpecting a downgrade sooner or later for the reasons Moody’s quotes. Thus stock markets, bond markets and foreign exchange markets already reflect this. Indeed, in the first seven weeks of 2013, the sterling exchange rate index has depreciated by over 6%.
The political consequences, however, are likely to be significant. The Chancellor of the Exchequer, George Orborne, has put considerable emphasis on the importance of maintaining a triple A rating. He has seen it as a sign of the confidence of investors in the government’s policy of focusing on cutting the public-sector deficit and, ultimately, of cutting the public-sector debt as a proportion of GDP. His response, therefore, has been that the government will redouble its efforts to reduce the deficit.
Not surprisingly the Labour opposition claims the downgrading is evidence that the government’s austerity policies are not working. If the aim is to cut the deficit/GDP ratio, this is difficult if GDP is falling or just ‘flat lining’. A less aggressive austerity policy, it is argued, would allow growth to recover and this rise in the denominator would allow the deficit/GDP ratio to fall.
Latest forecasts are that government borrowing is set to rise. The average of 24 independent forecasts of the UK economy, published by the Treasury on 13/2/13, is that public-sector net borrowing will rise from £90.7bn in 2012/13 to £107bn in 2013/14. And the European Commission forecast of the UK economy is that the general government deficit will rise from 5.9% of GDP in 2012/13 to 7.0% of GDP in 2013/14.
So what will be the economic and political consequences of the loss of the triple A rating? What policy options are open to the government? The following articles explore these questions. Not surprisingly, they don’t all agree!
Downgrading Britain: The Friday night drop The Economist, Buttonwood’s notebook (23/2/13)
Rating downgrade: Q&A The Observer, Josephine Moulds (24/2/13)
Downgrade is Osborne’s punishment for deficit-first policy The Guardian, Phillip Inman (23/2/13)
Britain’s downgraded credit rating: Moody’s wake-up call must trigger a change of course The Observer (24/2/13)
Editorial: AAA loss is a sign of failure Independent (24/2/13)
It’s not the end of the world – but it’s the end of any false complacency Independent, Hamish McRae (24/2/13)
Moody’s downgrade will stiffen George Osborne’s resolve The Telegraph, Kamal Ahmed (23/2/13)
UK AAA downgrade: Budget is now George Osborne’s make or break moment The Telegraph, Philip Aldrick (23/2/13)
Britain’s credit downgrade is a call to live within our means The Telegraph, Liam Halligan (23/2/13)
Britain will take years to earn back AAA rating, says Ken Clarke The Telegraph, Rowena Mason (24/2/13)
Questions
- How important are credit agencies’ sovereign credit ratings to a country (a) economically; (b) politically? Why may the political effects have subsequent economic effects?
- Explain the meaning of the terms ‘exogenous’ and ‘endogenous’ variables. In terms of the determination of economic growth, are government expenditure and tax revenue exogenous or endogenous variables? What are the implications for a policy of cutting the government deficit?
- Identify the reasons for the predicted rise in the public-sector deficit as a proportion of GDP. Which of these, if any, are ‘of the government’s own making’?
- In the absence of a change in its fiscal stance, what policies could the government adopt to increase business confidence?
Each month the accountancy firm BDO publishes its Business Trends Indices. These indices “are ‘polls of polls’ that pull together the results of all the main UK business surveys”. The latest report shows that the January 2013 Optimism Index was its lowest since the report began 21 years ago.
The Optimism Index predicts business performance two quarters ahead. In January 2013 it was 88.9. The way the index is constructed, a reading of 95 or more suggests that firms are optimistic about business performance. Clearly, they were pessimistic.
Although there was an increase in hiring intentions, firms were still predicting a fall in output. The indices for optimism, employment and output are shown in the chart. (Click here for a PowerPoint.)
As Peter Hemington, Partner, BDO LLP, commented:
In spite of a strengthening Labour Market, business confidence continues to weaken, and improved hiring intentions are not translating into growth plans. It seems the damaging effects on businesses of five years’ zigzagging economic growth, has left them wary of making concrete plans for expansion and resigned to the ‘new normal’ of economic stagnation.
To end this cycle, it is imperative that the Government implements plans to expedite growth. Without growth incentives, we will continue to see UK businesses reluctant to invest and expand, which poses a grave threat to the UK’s economic recovery.
The following articles comment on the gloomy mood of business and on its implications for output and investment. They also look at the implications for government policy.
Articles
Confidence slumps despite optimism from manufacturers Insider News (11/2/13)
Fears of a triple-dip recession return as survey puts business confidence at a 21-year low This is Money (11/2/13)
Pressure grows on ministers for growth strategy Yorkshire Post (11/2/13)
Triple-dip jitters as business confidence hits 21-yr low Management Today, Michael Northcott (11/2/13)
Report and data
Business Trends: Business confidence hits 21-year low signalling economic contraction BDO Press Release (11/2/13)
BDO Monthly Business Trends Indices, February 2013 – Full Report BDO (11/2/13)
Business and Consumer Surveys European Commission: Economic and Financial Affairs
Questions
- What reasons are given by the report for a decline in business optimism?
- Explain how an accelerator/multiplier interaction could compound the recession or help to cause a bounce back from recession.
- How does business sentiment in one country affect business sentiment in others?
- In the absence of a change in its fiscal stance, what policies could the government adopt to increase business confidence?
- Why might firms’ hiring intentions increase even though they are predicting a fall in output?
In a previous blog, Anyone got a crystal ball?, we reported on the Bank of England’s and other agencies’ difficulty in making forecasts. As the Governor, Mervyn King, said, “There is just enormous uncertainty out there.”
The Bank of England has just published its November Inflation Report. This quarterly publication gives forecasts of inflation, GDP and other indicators. It is clear that forecasting hasn’t become any easier. In his opening remarks, Dr. King says:
Continuing the recent zig-zag pattern, output growth is likely to fall back sharply in Q4 as the boost from the Olympics in the summer is reversed – indeed output may shrink a little this quarter. It is difficult to discern the underlying picture. It is probably neither as good as the zigs suggest nor as bad as the zags imply.
The Inflation Report looks at the various factors affecting aggregate demand, inflation, unemployment and aggregate supply. It is quite clear on reading the report why there is so much uncertainty.
A salutary lesson is to look back at previous forecasts and see just how wrong they have been. The chart above shows the forecasts for GDP made in the Inflation Reports of Nov 2012 and Aug 2011. You can see that they are significantly different and yet just 15 months apart. You might also like to compare the forecasts made a year ago (or even two!) about 2012 with the actual situation today. A good source for this is the Treasury’s Forecasts for the UK economy. This collates the forecasts from a range of independent forecasters.
The inaccuracy of forecasting is an inevitable consequence of a highly interdependent world economy that is subject to a range of economic shocks and where confidence (or lack of it) is a major determinant of aggregate demand. But when firms, governments, individuals and central banks have to make plans, it is still necessary to project into the future and try to forecast as accurately as possible – even though it might mean keeping your fingers firmly crossed.
Articles
Bank of England downgrades growth forecast for 2013 Daily Record (14/11/12)
A gloomy picture from the Old Lady Financial Times (14/11/12)
Will Britain’s post-recession economy be resurgent, stagnant or greener? The Guardian, Larry Elliott (11/11/12)
Economics must heed political risk Financial Times, Sebastian Mallaby (6/11/12)
European Commission autumn forecast: overoptimistic and in denial Social Europe Journal, Andrew Watt (7/11/12)
Bank of England gets long to-do list for overhaul Reuters, Sven Egenter (2/11/12)
Data
Inflation Report, November 2012 Bank of England
Index of economic forecasts European Commission DGECFIN
Economic Outlook Annex Tables OECD
World Economic Outlook Reports IMF
Forecasts for the UK economy HM Treasury
Questions
- What was being forecast for economic growth and inflation for 2012 (a) one year ago; (b) two years ago?
- What are the main reasons for the inaccuracy of forecasts?
- How might forecasting be made more reliable?
- If sentiment is a key determinant of economic activity, how might politicians increase the confidence of firms and consumers? What are the political constraints on doing this?
- Explain the following statement from the Guardian article: “The problem … is that last decade’s tailwind has become this decade’s headwind.” Why is it difficult to forecast the strength of this ‘headwind’?
- How useful is it to use past trends as a guide to the future course of the economy?
After a week of turmoil in Cyprus (see the News item Ochi, ochi, ochi) a deal has been struck between Cyprus, the EU and the IMF over a €10bn bailout for the island’s banking system. But while the deal may bring the immediate crisis to an end, the Cypriot economy could face years of austerity and depression. And there remain questions over whether the deal sends the wrong message to depositors in banks in other eurozone countries whose banking systems are under pressure.
Many businesses will be hard hit and may be forced to close. This could have serious adverse multiplier effects on the economy. These effects will be aggravated by the fiscal austerity measures which are also part of the deal. The measures are also likely to discourage further inward investment, again pushing the economy further into recession.
