You may have been following the posts on the US debt ceiling and budget crisis: Over the cliff and Over the cliff: an update. Well, after considerable brinkmanship over the past couple of weeks, and with the government in partial shutdown since 1 October thanks to no budget being passed, a deal was finally agreed by both Houses of Congress, less than 12 hours before the deadline of 17 October. This is the date when the USA would have bumped up against the debt ceiling of $16.699 trillion and would be in default – unable to borrow sufficient funds to pay its bills, including maturing debt.
But the deal only delays the problem of a deeply divided Congress, with the Republican majority on the House of Representatives only willing to make a long-term agreement in exchange for concessions by President Obama and the Democrats on the healthcare reform legislation. All that has been agreed is to suspend the debt ceiling until 7 February 2014 and fund government until 15 January 2014.
A more permanent solution is clearly needed: not just one that raises the debt ceiling before the next deadline, but one which avoids such problems in the future. Such concerns were echoed by Christine Lagarde, Managing Director of the International Monetary Fund (IMF), who issued the following statement:
The U.S. Congress has taken an important and necessary step by ending the partial shutdown of the federal government and lifting the debt ceiling, which enables the government to continue its operations without disruption for the next few months while budget negotiations continue to unfold.
It will be essential to reduce uncertainty surrounding the conduct of fiscal policy by raising the debt limit in a more durable manner. We also continue to encourage the U.S. to approve a budget for 2014 and replace the sequester with gradually phased-in measures that would not harm the recovery, and to adopt a balanced and comprehensive medium-term fiscal plan.
US default: Congress votes to end shutdown crisis The Telegraph, Raf Sanchez (17/10/13)
US shutdown: Christine Lagarde calls for stability after debt crisis is averted The Guardian,
James Meikle, Paul Lewis and Dan Roberts (17/10/13)
America’s economy: Meh ceiling? The Economist (15/10/13)
Relief as US approves debt deal BBC News (17/10/13)
Shares in Europe dip after US debt deal BBC News (17/10/13)
Dollar slides as relief at U.S. debt deal fades Reuters, Richard Hubbard (17/10/13)
US debt deal: Analysts relieved rather than celebrating Financial Times, John Aglionby and Josh Noble (17/10/13)
Greenspan fears US government set for more debt stalemate BBC News (21/10/13)
Questions
- Explain what is meant by default and how the concept applies to the USA if it had not suspended or raised its budget ceiling.
- Is the agreement of October 16 likely to ‘reassure markets’? Explain your reasoning.
- What is likely to happen to long-term interest rates as a result of the agreement?
- Will the imposition of a new debt ceiling by February 2014 remove the possibility of using fiscal policy to stimulate aggregate demand and speed up the recovery?
- What is meant by ‘buy the rumour, sell the news’ in the context of stock markets? How was this relevant to the agreement on the US debt ceiling and budget?
The rate of growth in India has fallen to its lowest level since the first three months of 2009 – the period when many countries were plunging into recession. Although the annual rate was still 4.4% in Q2 2013 (a rate most Western governments would love to achieve!), it had averaged 8.2% from 2003 to 2007 and 9.5% from 2010 to 2011 (see).
And the rupee has been falling in value (see chart below). The exchange rate of the rupee to the dollar has depreciated by 21% since the start of the year and by 14% since the beginning of August (click here for a PowerPoint of the chart). This has pushed up the price of imports and raised fears that inflation, already approaching 10%, will rise.
There have also been concerns about the health of India’s banking sector, with worries over the possible rise in bad loans.
One result of all these factors is that the confidence of investors has been shaken. Bond prices have fallen and so too have share prices. The Mumbai Sensex index fell by 11.5% from 22 July to 27 August. Worried about possible capital flight, the Indian government imposed capital controls on Indian residents on 14 August. It has, however, since ruled out limiting the outflow of funds by foreign investors.
The following articles and videos look at the causes of the current economic problems and what can be done about them.
Webcasts
India’s sliding economy Aljazeera (24/8/13)
Economic woes grow for Indians as rupee continues to slide BBC News, Sanjoy Majumder (30/8/13)
What is behind the Indian economy’s fall from grace? BBC News, Yogita Limaye (30/8/13)
Indian rupee: How onions reflect health of economy BBC News, Nitin Srivastava (30/8/13)
The rise and fall of India’s economy NDTV (20/8/13)
Is the Indian economy heading for a doom? NDTV, Dr Arvind Virmani, Adi Godrej, P N Vijay, Sanjay Nirupam and Prakash Javadekar (20/7/13)
Can Rajan stabilise India’s economy? FT Video, Stuart Kirk and Julia Grindell (7/8/13)
Articles
India in trouble: The reckoning The Economist (24/8/13)
PM warns of short term shocks, attacks BJP for stalling Parliament The Economic Times of India (31/8/13)
External global factors led to rupee slide: Manmohan in Lok Sabha Hindustan Times (30/8/13)
India seeks allies to defend rupee as growth skids to four-year low Reuters, Manoj Kumar and Frank Jack Daniel (30/8/13)
Rupee charts in uncharted territory Reuters, Saikat Chatterjee and Subhadip Sircar (30/8/13)
Indian Prime Minister Says Rupee Crisis Will Only Make Country Stronger Time World, ilanjana Bhowmick (30/8/13)
Is India in danger of another crisis? BBC News, Linda Yueh (8/8/13)
India’s GDP shows continuing slowdown BBC News (30/8/13)
Slowest India Growth Since 2009 Pressures Singh to Support Rupee Bloomberg, Unni Krishnan (30/8/13)
Questions
- Why has the rupee fallen in value so dramatically? Is there likely to have been overshooting?
- What are the economic consequences of this large-scale depreciation? Who gain and who lose?
- What factors are likely to affect the rate of growth in India over the coming months?
- Why is the Indian economy more vulnerable than many other Asian economies?
- What economic policies are being pursued by the Indian government? How successful are they likely to be?
Each day many investors anxiously watch the stock market to see if their shares have gone up or down. They may also speculate: buying if they think share prices are likely to go up; selling if they think their shares will fall. But what drives these expectations?
To some extent, people will look at real factors, such as company sales and profits or macroeconomic indicators, such as the rate of economic growth or changes in public-sector borrowing. But to a large extent people are trying to predict what other people will do: how other people will react to changes in various indicators.
John Maynard Keynes observed this phenomenon in Chapter 12 of his General Theory of Employment, Interest and Money of 1936. He likened this process of anticipating what other people will do to a newspaper beauty contest, popular at the time. In fact, behaviour of this kind has become known as a Keynesian beauty contest (see also).
Keynes wrote that:
professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgement, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.
When investors focus on people’s likely reactions, it can make markets very unstable. A relatively minor piece of news can cause people to buy or sell in anticipation that others will do the same and that others will realise this and do the same themselves. Markets can overshoot, until, when prices have got out of line with fundamentals, buying can turn into selling, or vice versa. Prices can then move rapidly in the other direction, again driven by what people think other people will do. Sometimes, markets can react to very trivial news indeed. As the New York Times article below states:
On days without much news, the market is simply reacting to itself. And because anxiety is running high, investors make quick, sometimes impulsive, responses to relatively minor events.
The rise of the machine
In recent years there is a new factor to account for growing stock market volatility. The Keynesian beauty contest is increasingly being played by computers. They are programmed to buy and sell when certain conditions are met. The hundreds of human traders of the past who packed trading floors of stock markets, have been largely replaced by just a few programmers, trained to adjust the algorithms of the computers their finance companies use as trading conditions change.
And these computers react in milliseconds to what other computers are doing, which in turn react to what others are doing. Markets can, as a result, suddenly soar or plummet, until the algorithms kick the market into reverse as computers sell over-priced stock or buy under-priced stock, which triggers other computers to do the same.
Robot trading is here to stay. The articles and podcast consider the implications of the ‘games’ they are playing – for savers, companies and the economy.
Articles
Questions
- Give some other examples of human behaviour which is in the form of a Keynesian beauty contest.
- Why may playing a Keynesian beauty contest lead to an undesirable Nash equilibrium?
- Does robot trading do anything other than simply increase the speed at which markets adjust?
- Can destabilising speculation continue indefinitely? Explain.
- Explain what is meant by ‘overshooting’? Why is overshooting likely to occur in stock markets and foreign exchange markets?
- In what ways does robot trading (a) benefit and (b) damage the interests of savers?
Since the beginning of 2009, central banks around the world have operated an extremely loose monetary policy. Their interest rates have been close to zero (click here for a PowerPoint of the chart) and more than $20 trillion of extra money has been injected into the world economy through various programmes of quantitative easing.
The most recent example of loose monetary policy has been in Japan, where substantial quantitative easing has been the first of Japan’s three arrows to revive the economy (the other two being fiscal policy and supply-side policy).
One consequence of a rise in money supply has been the purchase of a range of financial assets, including shares, bonds and commodities. As a result, despite the sluggish or negative growth in most developed countries, stock markets have soared (see chart). From March 2009 to May 2013, the FTSE 100 rose by 91% and both the USA’s Dow Jones Industrial average and Germany’s DAX rose by 129%. Japan’s NIKKEI 225, while changing little from 2009 to 2012, rose by 78% from November 2012 to May 2013 (click here for a PowerPoint of the chart).
The US economy has been showing stronger growth in recent months and, as a result, the Fed has indicated that it may soon have to begin tightening monetary policy. It is not doing so yet, nor are other central banks, but the concern that this may happen in the medium term has been enough to persuade many investors that stock markets are likely to fall as money eventually becomes tighter. Given the high degree of speculation on stock markets, this has led to a large-scale selling of shares as investors try to ‘get ahead of the curve’.
From mid-May to mid-June, the FTSE 100 fell by 6.2%, the Dow Jones by 2.6%, the DAX by 4.5% and the NIKKEI by 15%. In some developing countries, the falls have been steeper as the cheap money that entered their economies in search of higher returns has been leaving. The falls in their stock markets have been accompanied by falls in their exchange rates.
The core of the problem is that most of the extra money that was created by central banks has been used for asset purchase, rather than in financing extra consumer expenditure or capital investment. If money is tightened, it is possible that not only will stock and bond markets fall, but the fragile recovery may be stifled. In other words, tighter money and higher interest rates may indeed affect the real economy, even though loose monetary policy and record low interest rates had only a very modest effect on the real economy.
This poses a very difficult question for central banks. If even the possibility of monetary tightening some time in the future has spooked markets and may rebound on the real economy, does that compel central banks to maintain their loose policy? If it does, will this create an even bigger adjustment problem in the future? Or could there be a ‘soft landing’, whereby real growth absorbs the extra money and gradually eases the inflationary pressure on asset markets?
Articles
How the Fed bosses all BBC News, Robert Peston (12/6/13)
The great reversal? Is the era of cheap money ending? BBC News, Linda Yueh (12/6/13)
The Great Reversal: Part II (volatility and the real economy) BBC News, Linda Yueh (14/6/13)
The end of the affair The Economist (15/6/13)
Out of favour The Economist, Buttonwood (8/6/13)
The Federal Reserve: Clearer, but less cuddly The Economist (22/6/13)
Global financial markets anxious to avoid many pitfalls of ‘political risk’ The Guardian, Heather Stewart (13/6/13)
Dow Falls Below 15,000; Retailers Add to Slump New York Times, (12/6/13)
Global market sell-off over stimulus fears The Telegraph, Rachel Cooper (13/6/13)
Nikkei sinks over 800 points, falls into bear market Globe and Mail (Canada), Lisa Twaronite (13/6/13)
Global shares drop, dollar slumps as rout gathers pace Reuters, Marc Jones (13/6/13)
The G8, the bond bubble and emerging threats BBC News, Stephanie Flanders (17/6/13)
Global monetary policy and the Fed: vive la difference BBC News, Stephanie Flanders (20/6/13)
The Federal Reserve’s dysfunctional relationship with the markets The Guardian, Heidi Moore (19/6/13)
Global stock markets in steep falls after Fed comment BBC News (20/6/13)
Federal Reserve’s QE withdrawal could signal real trouble ahead The Guardian, Nils Pratley (20/6/13)
Central banks told to head for exit Financial Times, Claire Jones (23/6/13)
Stimulating growth threatens stability, central banks warn The Guardian (23/6/13)
BIS Press Release and Report
Making the most of borrowed time: repair and reform the only way to growth, says BIS in 83rd Annual Report BIS Press Release (23/6/13)
83rd BIS Annual Report 2012/2013 Bank for International Settlements (23/6/13)
Data
Yahoo! Finance: see links for FTSE 100, DAX, Dow Jones, NIKKEI 225
Link to central bank websites Bank for International Settlements
Statistical Interactive Database – Interest & exchange rates data Bank of England
Questions
- Why have stock markets soared in recent years despite the lack of economic growth?
- What is meant by ‘overshooting’? Has overshooting taken place in stock markets (a) up to mid-May this year; (b) since mid-May? How would you establish whether overshooting has taken place?
- What role is speculation currently playing in stock markets? Would you describe this speculation as destabilising?
- What has been the impact of quantitative easing on (a) bond prices; (b) bond yields?
- Argue the case for and against central banks continuing with the policy of quantitative easing for the time being.
- Find out how much the Indian rupee and the Brazilian real have fallen in recent weeks. Explain your findings.
On several occasions in the past on this site we’ve examined proposals for a Tobin tax: see, for example: A ‘Robin Hood’ tax (Feb 2010), Tobin or not Tobin: the tax proposal that keeps reappearing (Dec 2009) and A Tobin tax – to be or not to be? (Aug 2009). A Tobin tax is a tax on trading in financial products, sometimes known as a ‘financial transactions tax’ (FTT). It could also be levied on trading in foreign currencies. It is considered in Economics (7th ed) (section 26.3) and Economics for Business (5th ed) (section 32.4).
The tax would be levied at a very low rate: somewhere between 0.01% and 0.5% and would be too small to affect trading in shares or other financial products for purposes of long-term investment. It would, however, dampen speculative trades that take advantage of tiny potential gains from very short-term price movements. Such trades account for huge financial flows between financial institutions around the world and tend to make markets more volatile. The short-term dealers are known as high-frequency traders (HFTs) and their activities now account for the majority of trading on exchanges. Most of these trades are by computers programmed to seek out minute gains and respond in milliseconds. And whilst they add to short-term liquidity for much of the time, this liquidity can suddenly dry up if HFTs become pessimistic.
The President of the European Commission, José Manuel Barroso, has announced that the Commission has adopted the idea of a financial transactions tax with the backing of Germany, France and other eurozone countries. This Tobin tax could be in operation by 2014. According to the Commission, it could raise some €57bn a year. Unlike earlier proposals for a Tobin tax (sometimes called the ‘Robin Hood tax’), the money raised would probably be used to reduce EU deficits, rather than being given in aid to developing countries.
The UK government has been highly critical of the proposal, arguing that, unless adopted world-wide, it would divert trade away from the City of London.
The following articles consider how such a tax would work and its potential advantages and disadvantages.
Theory inches ever closer to practice Guardian, Larry Elliott (28/9/11)
Osborne expected to oppose EU’s proposal for Tobin tax on banks Guardian, Jill Treanor (28/9/11)
Tobin tax could ‘destroy’ business models Accountancy Age, Jaimie Kaffash (30/9/11)
Tobin tax is likely, says banking chief Accountancy Age, Jaimie Kaffash (5/10/11)
Could a transactions tax be good for capitalism? BBC News, Robert Peston (3/10/11)
EU to propose tax on financial transactions BusinessDay (South Africa), Mariam Isa (5/10/11)
European politicians plot to block UK veto on ‘Tobin tax’ The Telegraph, Louise Armitstead (3/10/11)
Opinion Divided on EU Transaction Tax Tax-News, Ulrika Lomas (5/10/11)
Tobin taxes and audit reform: the blizzard from Brussels The Economist (1/10/11)
Questions
- What are HFTs and what impact do they have on the stability and liquidity of markets?
- Explain how a Tobin tax would work.
- What would be the potential advantages and disadvantages of the Tobin tax as proposed by the European Commission (the ‘financial transactions tax’)?
- Are financial markets efficient? Can a market be ‘excessively efficient’?
- How are ‘execute or cancel’ orders used by HFTs?
- Why do HFTs have an asymmetric information advantage?
- How does a financial transactions tax differ from the UK’s stamp duty reserve tax?
- Explain why the design of the stamp duty tax has prevented the flight of capital and trading from London. Could a Tobin tax be designed in such a way?
You may have been following the posts on the US debt ceiling and budget crisis: Over the cliff and Over the cliff: an update. Well, after considerable brinkmanship over the past couple of weeks, and with the government in partial shutdown since 1 October thanks to no budget being passed, a deal was finally agreed by both Houses of Congress, less than 12 hours before the deadline of 17 October. This is the date when the USA would have bumped up against the debt ceiling of $16.699 trillion and would be in default – unable to borrow sufficient funds to pay its bills, including maturing debt. 
