Tag: trade-offs

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The ‘Basel Endgame’: how much capital is enough capital?

Recently, US regulators have decided not to impose further increases in capital requirements on US large and mid-sized banks. The increased requirements, proposed in late 2023, would have been stricter than required under the Bank for International Settlements’ Basel framework1 and provoked a fierce backlash, involving public statements by senior bank executives, aggressive lobbying and extensive media campaigns, including an ad-spot during the Superbowl.

Following bank insolvencies in the USA during 2023, such as Silicon Valley Bank (SVB) and First Republic, which required bailouts from US banking authorities, many commentators argued that the failures were caused by the institutions having insufficient capital to cover losses on their portfolios of US Treasuries. The implication was that banks, particularly mid-sized ones (which were exempt from the Basel framework), needed to have more capital.

US regulators duly responded by proposing what was officially known as ‘the finalisation of Basel III’, but was commonly referred to as ‘the Basel Endgame’. The proposed system-wide reforms involved more conservative calculations of the risk-weighted value of assets such as mortgages, corporate loans and loans to other financial institutions. Further, the proposals also sought to subject banks with $100bn to $250bn of assets to Basel capital adequacy requirements for the first time. Previously they applied only to banks with $250 of assets.

The issue focused attention on the capital banks hold to protect against insolvency and provoked discussion about how much of a capital buffer these institutions should have.

Critics argued the changes would lead to significant increases in the capital required to be held by all US banks compared to international rivals and have an adverse effect on their profitability and international competitiveness. Further, critics pointed out that problems at SVB and First Republic were down to confidence issues and it was argued that more capital would not have saved those institutions from insolvency.

This blog examines these issues. It analyses the role of capital in banks and discusses the trade-off that banks face between profitability and security in their activities which underpinned their resistance to the proposed increases. I will also discuss the other trade-off that banks face – between liquidity and profitability – and how liquidity is just as important an influence on bank’s survival in times of crisis.

The role of capital in banks

As with any limited company, a bank’s capital is the difference between total assets and its liabilities. It is the funding provided by long-term investors. These are primarily shareholders, but also long-term debtholders. Bank capital acts as a buffer to prevent insolvency. Capital represents the amount that the value of assets have to fall before the bank is insolvent (value of assets is below liabilities). Higher capital provides a greater buffer. Lower capital provides a smaller buffer.

Capital is uniquely important for commercial banks compared to non-financial companies because of the nature of the assets banks hold – financial securities and loans. Banks are susceptible to losses from financial securities and ‘bad debts’, which are directly reflected in the value of their capital. Further, unlike non-financial companies, the failure of a bank has a significantly negative impact on wider economic activity.

The trade-off between profitability and security

As limited companies, banks face a trade-off between profitability and security in lending. The more profitable a loan, the more risky (less secure) it is likely to be. This creates the potential for the interests of deposit holders and regulators on the one hand and bank executives and shareholders on the other to diverge.

Depositors place their funds with banks and will want the bank to be secure, holding lots of capital to prevent insolvency. However, bank executives and shareholders have a strong incentive to lower the capital buffer, particularly equity, because it produces a higher return for shareholders.

Let’s analyse the implications of different capital buffers on profitability and return, particularly the return to shareholders. A performance measure used to analyse the return to shareholders is Return on Equity (RoE) – the amount of profit each pound of equity capital generates, expressed as a percentage. It is calculated by dividing net profit by equity capital and multiplying by 100.


If a bank has a net profit of £1m and holds £10m of equity capital, the RoE is:


If it has a net profit of £1m and holds £5m of equity capital, the RoE is:


In the first case, the capital buffer generates a 10 per cent RoE. In the second case, the lower capital buffer generates a higher RoE of 20 per cent. This provides a simple illustration of the trade-off banks face. The lower the amount of capital they hold, the higher the return to shareholders but the lower capital buffer, which increases the risk of insolvency.

In different time periods, banks have held varying percentages of capital. For much of the 20th century, banks had capital ratios of around 20 per cent, generating a return on equity of between 5 and 10 per cent. Bank lending was restricted, with shareholders accepting a lower return on equity, while holding a higher amount of capital to cover potential losses from financial assets. Indeed, in the 19th century, banks typically held even more capital, amounting to about 50 per cent of their assets, making bank lending even more restricted.

However, starting from the 1960s, but accelerating during the 1980s, banks began to change their view of the trade-off between profitability and security. This coincided with the liberalisation of credit markets and a greater emphasis on ‘shareholder value’ in business. Average capital ratios fell from over 20 per cent in the 1960s to below 10 per cent in the early 2000s. The return on equity went in the opposite direction. In the 1960s, it was typically between 5 and 10 per cent; by the decade before the 2008 financial crisis it had risen to above 20 per cent. The trade-off had shifted in favour of profitability.

However, the dangers of this shift were exposed during the 2008 financial crisis. The capital held by banks was very thin and not designed to cope with extremely stressful economic circumstances. Banks found they had insufficient capital to cover losses from big decreases in the value of their securitised debt instruments like CDOs (collateralised debt obligations) and struggled to raise additional capital from worried investors.

After the crisis, the Bank of International Settlements (BIS) determined that banks needed to hold sufficient capital, not just to cope with the ebbs and flows of the business cycle but also as a buffer in the rare, yet extremely stressful, economic circumstances that might arise. Therefore, international bank regulations were redrafted under the auspices of the BIS’s Basel Committee. The third version of these regulations is known as ‘Basel III’. It was agreed in 2017, with the measures being phased in from 2022. Basel III significantly raised the capital buffers for large global banks, known as ‘globally systemically-important banks’ (G-SIBs) and the use of stress-tests to model the robustness of banks’ balance sheets to cope with severe economic pressures.

Figure 1 shows the changes to the average return on equity (RoE) and average tier 1 capital ratios for a sample of 10 G-SIBs as a result of Basel III. By 2022, all the banks had capital buffers which were well above the minimum required under Basel III for tier 1 capital – 8.5 per cent. The trade-off was that banks’ average return on equity was much lower – around 8 per cent in 2022, compared to 16 per cent in 2007.

How much capital is enough capital?

Ever since the Basel III agreement, there had been discussions around tightening capital requirements further but no agreement had been reached. One aspect of Basel III was that increased capital was only required of the largest banks. Mid-sized and smaller banks, which are a significant part of the US market, were exempt. The failures of the mid-sized US Silicon Valley Bank (SVB) and First Republic Bank provoked unilateral proposals by the US authorities through the ‘Basel Endgame’. This would raise capital requirements for large banks and extend capital requirements to mid-sized institutions.

But large US banks resisted these proposals, arguing that the authorities were pushing the trade-off too far in favour of security, attempting to make banks very safe but offering a poor return for investors and decreasing the amount of lending banks would conduct.

The furore raises the question as to what is an adequate amount of capital. One reference point is non-financial institutions. These typically hold much more capital relative to the value of total assets – in the range from 30 per cent to 40 per cent. If banks had capital ratios at that level, or even higher, they would be perceived as extremely safe, but might not offer much return to shareholders, impinging on the ability of banks to raise additional capital when they needed it.

Further, other critics argue that there is too much emphasis placed on capital adequacy. Focusing on capital ignores the other significant trade-off banks face in their activities – between liquidity and profitability. Indeed, recent bank failures were not due to insufficient capital but other problems relating to the management of the institution, which led to a loss of confidence by not only by investors, but primarily, deposit-holders.

The other trade-off: liquidity and profitability

While banks have to be solvent, they have to manage their trade-off between liquidity and profitability carefully too. A commercial bank’s basic business model involves maturity transformation – transforming liquid deposits into illiquid assets, such as government bonds and loans, to generate profit. This requires balancing the desire for profitability with the liquidity needs of depositors. If banks get it wrong, then it can lead to a loss of confidence and a ‘run’ on deposits. This is what happened to both Silicon Valley Bank (SVB) and Credit Suisse. The failures of both institutions were not due to insufficient capital but poor liquidity management, which eventually caused a loss of confidence.

Silicon Valley Bank (SVB) demonstrated poor liquidity management, involving a narrow depositor base which was very responsive to changes in interest rates, and an illiquid asset portfolio. During the coronavirus pandemic, tech start-ups received substantial venture capital funding and deposited it with SVB. SVB did not have the capacity or inclination to lend all of the extensive deposits which they were receiving. Instead, the management decided to invest in long-term fixed rate government debt securities. Such securities represented 56 per cent of SVB’s assets in 2020.

Since SVB’s depositors were businesses, unlike retail depositors they were more sensitive to changing interest rates. As rates rose, businesses moved their funds out in search of higher rates, creating a liquidity problem for SVB. The bank was forced to sell $21bn of its long-dated bonds to provide liquidity. However, it endured losses when it sold the bonds as bond prices had fallen, reflecting higher interest rates. Therefore, it needed to raise capital to replace the losses from those sales.

Investors baulked at this, however, particularly when they observed the accelerating deposit outflows. It was the ‘run’ on deposits that was the problem ($42 billion on 8 March 2023 alone), not the unrealised losses on government bonds relative to capital. It was only when the losses were realised that the problem arose. Indeed, Bank of America was in a similar situation with a substantial portfolio of long-term government debt. However, it did not have to realise its ‘paper losses’ since its deposits were more ‘sticky’.

Once confidence is lost and there is a run on deposits, even a bank which has a capital buffer deemed to be more than sufficient is doomed to fail. Take Credit Suisse. It was subject to the Basel framework and had capital ratios similar to its ultimate acquirer UBS. However, it had a risky business culture that pushed the trade-off too much towards profitability. This led to repeated scandals, fines and losses, which caused investors to lose confidence in the institution.

But, once again, it was not the financial losses that was the problem. It was the loss of confidence by depositors. The institution suffered deposit withdrawals of CHF 67 billion in the first three months of 2023. Attempts to stem the outflow with a ‘liquidity backstop’ provided by the Swiss National Bank on 15 March 2023 failed to reassure investors and depositors. Instead, the bank run intensified, with daily withdrawals of demand deposits topping CHF 10bn in the week afterwards. Credit Suisse failed and the Swiss banking regulators quickly forced its acquisition by UBS.

Conclusion

Bank capital is important. After the financial crisis, banks needed to redress the trade-off between profitability and security in lending. However, while the US authorities desire to improve the security of their banking system is laudable, the focus on capital is misplaced. Ever-increasing capital is not the solution to every banking crisis.

Ultimately, banks depend on confidence. Once that confidence is lost, there is little an institution can do to prevent failure. More emphasis needs to be placed on better management of assets and liabilities to maintain sufficient profitability, while at the same time being both liquid and secure. This will maintain confidence, not only by investors, but particularly by deposit-holders.

1 See Economics 11e, section 18.2; Economics for Business 9e, section 28.2; Essentials of Economics 9e, section 11.2.

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Questions

  1. Explain the role of capital for a commercial bank.
  2. Research the ‘Basel Endgame’ proposals. Why would US regulators want banks to hold more capital?
  3. Explain the trade-off between profitability and security that banks face.
  4. Explain the trade-off between profitability and liquidity that banks face.
  5. Research Silicon Valley Bank’s failure and trace the ‘run’ on deposits in the bank. Explain why investors baulked at injecting more capital.
  6. Research Credit Suisse’s demise and trace the ‘run’ on deposits in that bank. Explain why investors baulked at injecting more capital.
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The economics of ‘greeniums’ in sustainable finance: doing good has a price

Sustainability has become one of the most pressing issues facing society. Patterns of human production and consumption have become unsustainable. On the environmental front, climate change, land-use change, biodiversity loss and depletion of natural resource are destabilising the Earth’s eco-system.

Furthermore, data on poverty, hunger and lack of healthcare show that many people live below minimum social standards. This has led to greater emphasis being placed on sustainable development: ‘development that meets the needs of the present without compromising the ability of future generations to meet their own needs’ (The Brundtland Report, 1987: Ch.2, para. 1).

The financial system has an important role to play in channelling capital in a more sustainable way. Since current models of finance do not consider the welfare of future generations in investment decisions, sustainable finance has been developed to analyse how investment and lending decisions can manage the trade-off inherent in sustainable development: sacrificing return today to enhance the welfare of future generations.

However, some commentators argue that such trade-offs are not required. They suggest that investors can ‘do well by doing good’. In this blog, I will use ‘green’ bonds (debt instruments which finance projects or activities with positive environmental and social impacts) to explain the economics underpinning sustainable finance and show that doing good has a price that sustainable investors need to be prepared to pay.

I will analyse why investors might not be doing so and point to changes which may be required to ensure financial markets channel capital in a way consistent with sustainable development.

The growth of sustainable finance

Sustainable finance has grown rapidly over the past decade as concerns about climate change have intensified. A significant element of this growth has been in global debt markets.

Figure 1 illustrates the rapid growth in the issuance of sustainability-linked debt instruments since 2012. While issuance fell in 2022 due to concerns about rising inflation and interest rates reducing the real return of fixed-income debt securities, it rebounded in 2023 and is on course for record levels in 2024. (Click here for a PowerPoint.)

Green bonds are an asset class within sustainability-linked debt. Such bonds focus on financing projects or activities with positive environmental and social impacts. They are typically classified as ‘use-of-proceeds’ or asset-linked bonds, meaning that the proceeds raised from their issuance are earmarked for green projects, such as renewable energy, clean transportation, and sustainable agriculture. Such bonds should be attractive to investors who want a financial return but also want to finance investments with a positive environmental and/or social impact.

One common complaint from commentators and investors is the ‘greenium’ – the price premium investors pay for green bonds over conventional ones. This premium reduces the borrowing costs of the issuers (the ‘counterparties’) compared to those of conventional counterparties. This produces a yield advantage for issuers of green bonds (price and yield have a negative relationship), reducing their borrowing costs compared to issuers of conventional bonds.

An analysis by Amundi in 2023 using data from Bloomberg estimated that the average difference in yield in developed markets was –2.2 basis points (–0.022 percentage points) and the average in emerging markets was –5.6 basis points (–0.056 percentage points). Commentators and investors suggest that the premium is a scarcity issue and once there are sufficient green bonds, the premium over non-sustainable bonds should disappear.

However, from an economics perspective, such interpretations of the greenium ignore some fundamentals of economic valuation and the incentives and penalties through which financial markets will help facilitate more sustainable development. Without the price premium, investors could buy sustainable debt at the same price as unsustainable debt, earn the same financial return (yield) but also achieve environmental and social benefits for future generations too. Re-read that sentence and if it sounds too good to be true, it’s because it is too good to be true.

‘There is no such thing as a free lunch’

In theory, markets are institutional arrangements where demand and supply decisions produce price signals which show where resources are used most productively. Financial markets involve the allocation of financial capital. Traditional economic models of finance ignore sustainability when appraising investment decisions around the allocation of capital. Consequently, such allocations do not tend to be consistent with sustainable development.

In contrast, economic models of sustainable finance do incorporate such impacts of investment decisions and they will be reflected in the valuation, and hence pricing, of financial instruments. Investors, responding to the pricing signals will reallocate capital in a more sustainable manner.

Let’s trace the process. In models of sustainable finance, financial instruments such as green bonds funding investments with positive environmental impacts (such as renewable energy) should be valued more, while instruments funding investments with negative environmental impacts (such as fossil fuels) should be valued less. The prices of the green bonds financing renewable energy projects should rise while the prices of conventional bonds financing fossil-fuel companies should fall.

As this happens, the yield on the green bonds falls, lowering the cost of capital for renewable-energy projects, while yields on the bonds financing fossil-fuel projects rise, ceteris paribus. As with any market, these differential prices act as signals as to where resources should be allocated. In this case, the signals should result in an allocation consistent with sustainable development.

The fundamental point in this economic valuation is that sustainable investors should accept a trade-off. They should pay a premium and receive a lower rate of financial return (yield) for green bonds compared to conventional ones. The difference in price (the greenium), and hence yield, represents the return investors are prepared to sacrifice to improve future generations’ welfare. Investors cannot expect to have the additional welfare benefit for future generations reflected in the return they receive today. That would be double counting. The benefit will accrue to future generations.

A neat way to trace the sacrifice sustainable investors are prepared to make in order to enhance the welfare of future generations is to plot the differences in yields between green bonds and their comparable conventional counterparts. The German government has issued a series of ‘twin’ bonds in recent years. These twins are identical in every respect (coupon, face value, credit risk) except that the proceeds from one will be used for ‘green’ projects only.

Figure 2 shows the difference in yields on a ‘green bond’ and its conventional counterpart, both maturing on 15/8/2050, between June 2021 and July 2024. The yield on the green bond is lower – on average about 2.2 basis points (0.022 percentage points) over the period. This represents the sacrifice in financial return that investors are prepared to trade off for higher environmental and social welfare in the future. (Click here for a PowerPoint.)

The yield spread fluctuates through time, reflecting changing perceptions of environmental concerns and hence the changing value that sustainable investors attach to future generations. The spread tends to widen when there are heightened environmental concerns and to narrow when such concerns are not in the news. For example, the spread on the twin German bonds reached a maximum of 0.045 percentage points in November 2021. This coincided with the 26th UN Climate Change Conference of the Parties (COP26) in Glasgow. The spread has narrowed significantly since early 2022 as rising interest rates and falling real rates of return on bonds in the near-term seem to have dominated investors’ concerns.

These data suggest that, rather than being too large, the greeniums are too small. The spreads suggest that markets in debt instruments do not seem to attach much value to future generations. The valuation, price and yield of green bonds are not significantly different from their conventional counterparts. This narrow gap indicates insufficient reward for better sustainability impact and little penalty for worse sustainability impact.

This pattern is repeated across financial markets and does not seem to be stimulating the necessary investment to achieve sustainable development. An estimate of the scale of the deficit in green financing is provided by Bloomberg NEF (2024). While global spending on the green energy transition reached $1.8 trillion in 2023, Bloomberg estimates that $4.8 trillion needs to be invested every year for the remainder of this decade if the world is to remain on track under the ‘net zero’ scenario. Investors do not seem to be prepared to accept the trade-off needed to provide the necessary funds.

Can financial markets deliver sustainable development?

Ultimately, the hope is that all financial instruments will be sustainable. In order to achieve that, access to finance would require all investors to incorporate the welfare of future generations in their investment decisions and accept sacrificing sufficient short-term financial return to ensure long-term sustainable development. Unfortunately, the pricing of green bonds suggests that investors are not prepared to accept the trade-off. This restricts the ability of financial markets to deliver an allocation of resources consistent with sustainable development.

There are several reasons why financial markets may not be valuing the welfare of future generations fully.

  • Bounded rationality means that it is difficult for sustainable investors to assign precise values to future and distant benefits.
  • There are no standardised sustainability metrics available. This produces great uncertainty in the valuation of future welfare.
  • Investors also exhibit cognitive biases, which means they may not value the welfare of future generations properly. These include present bias (favouring immediate rewards) and hyperbolic discounting (valuing the near future more than the distant future).
  • Economic models of financial valuation use discount rates to assess the value of future benefits. Higher discount rates reduce the perceived value of benefits occurring in the distant future. As a result, long-term impacts (such as environmental conservation) may be undervalued.
  • There may be large numbers of investors who are only interested in financial returns and so do not consider the welfare of future generations in their investment decisions.

Consequently, investors need to be educated about the extent of trade-offs required to achieve the necessary investments in sustainable development. Furthermore, practical models which better reflect the welfare of future generations in investment decisions need to be employed. However, challenges persist in fully accounting for future generations and it may need regulatory frameworks to provide appropriate incentives for effective sustainable investment.

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Questions

  1. Using demand and supply analysis, illustrate and explain the impact of sustainable investing on the markets for (i) green bonds and (ii) conventional bonds. Highlight how this should produce an allocation of finance capital consistent with sustainable development.
  2. Research the yields on the twin bonds issued by Germany since this blog was published. Can you identify any association between heightened environmental concerns and the spread between the ‘green’ and conventional bond?
  3. Analyse the issues which prevent financial markets from producing the pricing signals which produce an allocation of resources consistent with sustainable development.
  4. Research some potential regulatory policies which may provide appropriate incentives for sustainable investment.
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Inflation targeting and policy trade-offs

The mandates of central banks around the world are typically focused on controlling inflation. In many cases, this is accompanied by operational independence from government, but with the government setting an inflation target. The central bank then chooses the appropriate monetary policy to achieve the inflation target. This is argued to provide the conditions that can deliver lower and less variable inflation rates – at least over the longer term.

However, some economists argue that this has the potential to create the conditions for greater economic volatility and financial instability. The events surrounding the collapse of Silicon Valley Bank (SVB) – the largest since the global financial crisis – have helped to reignite these debates.

Inflation targeting central banks

The theoretical foundations for delegating monetary policy to central banks with mandates to meet an inflation rate target is often attributed to the paper of Fynn Kydland and Edward Prescott published in the Journal of Political Economy in 1977. It argues that if governments, rather than independent central banks, operate monetary policy, systemically-high inflation can become established if low-inflation announcements by governments lack credibility. Delegation of monetary to a central bank with an inflation rate target, however, can create the necessary conditions for credibility. This, in turn, gives the public confidence to maintain lower and more stable inflationary expectations than would otherwise be the case.

To mitigate the problem of a potential inflationary bias, it is argued that governments should delegate monetary policy to a conservative central banker: one that places less weight on output or employment stabilisation and more weight on inflation stabilisation than does society. However, as identified by Kenneth Rogoff in his paper published in the Quarterly Journal of Economics in 1985, this raises the spectre of greater volatility in output and employment when economies are buffeted by supply shocks.

Inflation–output stabilisation trade-off

The inflation–output stabilisation trade-off identified by Rogoff has particular relevance to the macroeconomic environment experienced by many countries in recent times. As economies began to open up after the pandemic, demand–supply imbalances saw the emergence of inflationary pressures. These pressures were then exacerbated by the Russian invasion of Ukraine, which drove up commodity prices.

Rather than pursuing a less contractionary policy in the face of these supply shocks so as to avoid recession, central banks stuck to their inflation mandates and hence raised interest rates significantly so as to bring inflation back to target as soon as possible. But this hampered economic recovery.

Inflation–financial stability trade-off

Yet the recent financial turmoil suggests a further inflation–stability trade-off: an inflation–financial stability trade-off. By raising interest rates, different sectors of the economy are liable to greater financial distress. This distress has contributed to the collapse of Silicon Valley Bank and Signature Bank, and led to a significant injection of funds by large US banks into First Republic. The fear is of a contagion within the financial sector, which then spills into other sectors of the economy.

The debate about central bank mandates and the weight attached to inflation stability relative to other objectives is therefore centre stage of macroeconomic policy debates.

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Questions

  1. Explain the argument that the delegation of monetary policy can help to keep the average rate of inflation lower.
  2. How might the monetary policy responses of central banks to an inflation shock create the possibility of an inflation–output stabilisation trade-off?
  3. What do you understand by a Taylor rule? Could this help to alleviate the inflation-output stabilisation trade-off?
  4. Some economists argue that there is less of a trade-off between inflation and output stability with demand-pull inflation because of a so-called ‘divine coincidence’ in monetary policy. Why might this be the case?
  5. What do you understand by the term ‘financial distress’? What metrics could be used to capture this for different sectors of the economy?
  6. Explain how financial contagion can spread both within and between different sectors of the economy.
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Health vs the economy: is there a trade off?

Throughout the pandemic, the fight against COVID-19 has often been framed in terms of striking a balance between the health of the public and the health of the economy. This leads to the assumption that a trade-off must exist between these two objectives. Countries, therefore, have to decide between lives and livelihoods. However, one year on since lockdowns swept the globe the evidence suggests that the trade-off between sacrificing lives and sacrificing the economy is not necessarily clear cut.

Controlling the virus

Restrictions such as social distancing and lockdowns were introduced in order to minimise the spread of the virus, prevent hospitals from being overwhelmed, and ultimately save lives. However, as these measures are put in place, schools were closed, businesses and factories stopped operating, and economic activity shrank. This would suggest therefore, that society inevitably faces a trade-off between lost lives versus lost livelihoods.

It could be argued, therefore, that in the short run these interventions create a ‘health–wealth trade-off’. The lockdown restrictions save lives by preventing transmission, but they came at the cost of lost output, income and therefore GDP. This would also imply that the trade-off works in reverse when the lockdown restrictions are eased. As measures are relaxed, the economy can begin to recover but at the cost of an increased threat of the virus spreading again.

What are the costs?

In order to work out if a trade-off exists and what costs are involved, there must be a monetary value placed on human life. While this may seem unethical, governments, civil courts, regulatory bodies and companies do it all the time. The very existence of the life insurance industry is testament to the fact that human lives can be measured in monetary terms. One approach to measuring valuing life, commonly used by economists who conduct cost-benefit analyses, is the ‘value of statistical life’. It measures the loss or gain that arises from changes in the incidence of death, by eliciting people’s willingness to pay for small reductions in the probability of death, or their willingness to accept compensation in exchange for tolerating a small increase in the chance of death. (see the blog Lockdown – again. Is it worth it?)

Take the example of a complete lockdown. The potential number of lives saved can be estimated based on infection and fatality rates estimated from epidemiological models. This can then be multiplied by value of statistical life to compute the monetary value of saved lives. If this number exceeds the economic costs of a complete lockdown, then we know that it is desirable.

The trade-off between lost lives versus the economy is often erroneously viewed as an all-or-nothing choice between complete lockdown versus zero restrictions. However, in reality, there is a continuum in stringency of restrictions and it is not an all-or-nothing comparison.

Death rates vs downturns

In order to explore the existence of this trade-off, we can compare the health and economic impacts of the pandemic in different countries. If such a trade-off exists, then countries with lower death rates should have experienced larger economic downturns. However, when comparing the COVID-19 death rates with GDP data, the result is the opposite: countries that have managed to protect their population’s health in the pandemic have generally also protected their economy too. This suggests that there was never a simple binary trade-off between the two factors. Those countries that experienced the biggest first wave of excess deaths, also had the biggest hits to the economy.

The UK was the hardest hit of similar countries on both measures within the G7 group of industrialised countries. The shape of the recession in the UK from the pandemic and lockdowns was extraordinary and historic. However, it was also unique as there was a very sharp fall followed by a rapid rebound. Over 2020, GDP saw the largest hit in three centuries; larger than any single year of the Great Wars or the 1920s Depression.

Studies of the declines in GDP contradict the idea of a trade-off, showing that countries that suffered the most severe economic downturns, such as Peru, Spain and the UK, were generally among the countries with the highest COVID-19 death rates. There are countries that have experienced the reverse too; Taiwan, South Korea, and Lithuania all experienced modest declines in economic output but have also managed to keep the death rate low.

It should also be noted that some countries that had similar falls in GDP experienced very different death rates from each other. When comparing the USA and Sweden with Denmark and Poland, they all saw similar declines in the economy with contractions of around 8–9%. However, the USA and Sweden recorded 5–10 times more deaths per million. This therefore suggests that there is no clear trade-off between the health of the population and the health of the economy.

There will be many different factors that impact on the death rate for each individual country and by how much the economy has been affected. Such factors will even go beyond the policy decisions that have been made throughout the pandemic about how best to suppress the transmission of the virus. However, from the data available, there is no clear evidence to suggest that a trade-off between the health and the economy exists. If anything, it suggests that the relationship works in the opposite direction.

Save the economy by saving lives

Given the arguments against the existence of the trade-off, it could be argued that in order to limit the economic damage caused by the pandemic, the focus needs to start and end with controlling the spread of the virus. Experiments that have been conducted across the world definitively show that no country can prevent the economic damage without first addressing the pandemic that causes it. Those countries that acted swiftly in implementing harsh measures to control the virus, are now reopening in stages and their economies are growing. Countries such as China, Australia, New Zealand, Iceland, and Singapore, which all invested primarily in swift coronavirus suppression, have effectively eliminated the virus and are seeing their economies begin to grow again.

China, in particular, stands out amongst this group of countries. The Chinese authorities acted very quickly, and firmly, but also the levels of compliance of the population have been very high. However, it could be argued that few countries possess the infrastructure that exists in China to facilitate such high compliance. The fact that the lockdown in China was so effective reduced both losses to the economy and the need for stimulus measures. China is also one of the few countries that have achieved a “V-shaped” recovery. Countries such as Korea, Norway and Finland also appear to have responded relatively well.

Most of the countries that prioritised supporting their economies and resisted, limited, or prematurely curtailed interventions to control the pandemic faced runaway rates of infection and further national lockdowns. The examples of the UK, the USA and Brazil are often quoted, with many arguing that these countries responded too late and too haphazardly. Both have experienced high numbers of deaths.

Conclusion

Discussions around the responses to the pandemic and what appropriate action should be taken have predominately been about how countries can strike the balance between protecting people’s health and protecting the economy. However, from observing the GDP data available there is no clear evidence of a definitive trade-off; rather the relationship between the health and economic impacts of the pandemic goes in the opposite direction. As well as saving lives, countries controlling the outbreak effectively may have adopted the best economic strategy too. It is important to recognise that many factors have affected the death rate and the impact on the economy, and the full impacts of the pandemic are yet to be seen. However, it is by no means clear that the trade-off between greater emphasis on sacrificing lives or sacrificing the economy is as real as has been suggested. If such a trade-off does exist, it is, at best, a weak one.

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Questions

  1. Define and explain the difference between a substitute and complementary good.
  2. Using your answer to question 1, describe the existence of a trade-off.
  3. Discuss the reasons why the trade-off between health and the economy would work in the opposite direction.
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PFIs: Poorly Financed Initiatives?

Private Finance Initiatives were first introduced by the Conservatives in the early 1990s and they became a popular method of funding a variety of new public projects under New Labour. These included the building of prisons, new roads, hospitals, schools etc. The idea is that a private firm funds the cost and maintenance of the public sector project, whilst the public sector makes use of it and begins repaying the cost – something like a mortgage, with contracts lasting for about 30 years. As with a mortgage, you are saddled with the payments and interest for many years to come. This is the problem now facing many NHS trusts, who are finding it too expensive to repay the annual charges to the PFI contractors for building and servicing the hospitals.

Undoubtedly, there are short term benefits – the public sector gets a brand new hospital without having to raise the capital, but in the long term, it is the public who end up repaying more than the hospital (or the PFI project) is actually worth. Data suggests that a hospital in Bromley will cost the NHS £1.2 billion, which is some 10 times more than it is worth. Analysis by the Conservatives last year suggested that the 544 projects agreed under Labour will cost every working family in the UK about £15,000. This, compared with the original building cost of £3,000, is leading to claims that the PFI projects do not represent ‘value for money.’

More and more NHS trusts are contacting Andrew Lansley to say that the cost of financing the PFI project is undermining their ‘clinical and financial stability’. More than 60 hospitals and 12 million patients could be affected if these hospitals are forced to close. Health Secretary Andrew Lansley commented that:

‘Like the economy, Labour has brought some parts of the NHS to the brink of financial collapse.’

Labour, on the other hand, argue that the PFI contracts they created were essential at the time ‘to replace the crumbling and unsafe building left behind after years of Tory neglect.’ Although the public have benefited from the development of new hospitals, schools, roads etc, the long term costs may still be to come. Once the schemes are paid off, in 2049, over £70billion will have been paid to private contractors – significantly more than the cost and value of the projects and it will be the taxpayer who foots the bill. The following articles consider this controversial issue.

Labour’s PFI debt will cost five times as much, Conservatives claim The Telegraph, Rosa Prince (27/12/10)
Rising PFI costs ‘putting hospitals at risk’ BBC News (22/9/11)
Hospitals face collapse over PFIs The Press Association (22/9/11)
NHS hospitals crippled by PFI scheme The Telegraph, Robert Winnett (21/9/11)
60 hospitals face crisis over Labour’s PFI deals Mail Online, Jason Groves (22/9/11)
Private Finance Initiative: where did all go wrong? The Telegraph (22/9/11)
PFI schemes ‘taking NHS trusts to brink of financial collapse’ Guardian, Lizzy Davies (22/9/11)
Hospitals ‘struggling with NHS mortgage repayments’ BBC News, Nick Triggle (22/9/11)

Questions

  1. What is a PFI?
  2. Briefly outline the trade-off between the short term and the long term when it comes to Private Finance Initiatives.
  3. What are the arguments for a PFI? What are the arguments against PFIs?
  4. If PFIs had not been used to finance building projects, how do you think that would have impacted the current budget deficit?
  5. Is the cost of financing PFIs likely to have an adverse effect on the future prosperity of the UK economy?