Ec 111 week 5(2)

EC-111 British EconomyRecent UK Macroeconomic

TrendsDr Catherine Robinson

F26, Richard Price BuildingOffice Hours: Mondays 10.30-11.30 and Thursdays 9.30-10.30

Appointments: [email protected]

NOTE: I’M AVAILABLE FOR SPECIAL

OFFICE HOURS ON MONDAY NEXT WEEK: 10.00 TO 12.00

Week 5:1 2

Outline for this week’s lectures…

Macro policy and the financial crisisWhat caused the financial meltdown of 2007?What were the consequences?How to recover from the global recession?Does this mean that existing macro models were

inadequate? Is the triple-dip recession likely? (TODAY WE FIND

OUT)

Note the global nature of this week In part a result of the problemAlso, increased globalisation means the UK cannot

be looked at in isolation

Week 5:1 3

What is a recession? 2 consecutive quarters of negative GDP growth

Caused by monetary policy being too tight

Policy response: loosen monetary policy Lower interest rates

A DEPRESSION on the other hand: A decline in real GDP that is greater than 10% A recession that lasts more than 3 years

An asset/credit bubble bursting Credit contraction followed by decline in price levels

Policy response: Fiscal stimulus to encourage spending; infrastructure projects

Week 5:1 4

The Financial Crisis of 2007The economic slow down began in 2006..and in

the US

Relatively high risk borrowers in the US lost their jobsUnable to pay their high monthly repayments Interest rates were rising too because of the

slowdown

Increased number of defaults led to concern about the ‘sub-prime’ market for loans“The mother of all housing bubbles” (Krugman 2009)

Week 5:1 5

ContagionBy 2010, house prices (and share prices) in the

US had fallen by 29% from their peak in 2007Reducing economic growth

Caused a big drop in UK inter-bank lending, with knock-on effects on other sectors such as manufacturing

Contagion as there was more and more scrutiny on the

lending practices of financial intermediaries

Week 5:1 6

Causes: Financial ‘innovations’

The Big Bang led to deregulation…

Deregulation of the financial sector led to innovations in products: Short sellingOver the counter derivativesSecuritisation Proprietary tradingSpeculation

SHADOW BANKING

Week 5:1 7

Structured Investment Vehicles (SIVs)

innovative ways to package debts

In such a way as to obscure the risks associated by creating a portfolio of liabilities some of which were the sub-prime mortgagesSome of which were short term debts (with

comparatively little risk)

Structured Investment Vehicle (SIV)Slide 30.8

Griffiths and Wall, Applied Economics 12th Edition © Pearson Education Limited 2012

ABS other, 2.2%

Student loans, 4.4%

RMBS (Residential mortgage backed securities) , 23.2%

Other, 3.3%Financial debt, 42.6%

Credit cards, 5%

CMBS (Commercial mortgage backed securities), 6.1%

CDO, 11.4%Auto loans, 1.1%

Sector composition

Week 5:1 9

Realisation – followed by PANIC!

Early 2007: saw 4 mortgage providers in the US file for bankruptcy Reported that sub-prime lenders were 5 times more likely to

incur defaults Bear Sterns lost 90% of its sub-prime loans and filed for

bankruptcy

August to November 2007: More banks collapsed BNP PARIBUS froze investment funds $300bn is pumped into the global system to maintain liquidity Northern Rock collapses Poor financial announcements in the US Freddie Mac and Fannie Mae announce record losses

Week 5:1 10

And the bad news continued…2008

Further write-downs and losses announced, interest rates slashed to record low levels

Northern Rock nationalised

In July in the US Indy Mac Bank collapses, the second largest bank failure ever

Lehman Brothers attempts to sell 50% of its shares to south Korea or China. Fails. In September enters bankruptcy, the largest in USA history

In the same month US Government takes control of Freddie Mac and Fanny Mae

Merrill Lynch, Bank of America, Bear Sterns and Lehmann Brothers have all by now ceased to trade

Week 5:1 11

Bank Bailout Events unfolded in such a way as to the extent to which

various banks were exposed to the sub-prime market via these SIVs Market sentiment ruled – investors panicked Required de-leveraging; savings required to pay some debts

For the first time since Victoria’s reign, there was a run on a UK bank Freddie Mac and Fannie Mae in the US were the initial lenders Northern Rock in the UK But all banks had some degree of exposure

Bank Bailout Problem was, banks were so big, it wasn’t always possible for

countries to save them Aggressive, orchestrated policy required by US, UK and EU.

Week 5:1 12

Crisis management Warren Buffett injected $5bn into Goldman Sachs

Lloyds rescues HBOS

US government provided $700bn to help banks recapitalise

Bradford and Bingley was nationalised in the UK

UK government saves RBS

US Fed paid $800bn to 21 US banks

UK Government announced £50bn to buy stakes and issue debt guarantees (up to £250bn)

Record low interest rates

Week 5:1 13

So, the UK policy response•To emphasise international co-operation and co-ordinated fiscal and monetary policy responses to help move the UK and world economies out of recession

•a number of levers during the recession:Bank base rate reduced to 0.5 per centBailing out of some banks and finance to support the balance sheets of the banksValue Added Tax temporarily reduced from 17.5% to 15%Quantitative easing of £200billion – Asset Purchase Facility by which the Bank of England can buy corporate bondsCar scrappage scheme

Week 5:1 14

Into 2009…heading into double dip…

But the market is still jittery (Flash crash of the NYSE in May 2010)

International organisations meeting to define standards in banking BASEL III

Contagion means that currencies are sufferingEuro problems in Ireland, Greece and now Portugal

and Italy…Cyprus problems in the news recently

Week 5:1 15

How can we ensure this mistake doesn’t happen again?

Regulate the financial sector more effectively Commission a report – the Independent Commission on

BankingSir John VickersReport published in September 2011recommendations on ring-fencing domestic retail banking, 1/6 th

to 1/3rd of banking assets to be within the ring-fenceCompetition in banking sector needs to be improved

“Future of Finance”, 2010Report by LSE stars – Adair Turner, Andy Haldane and lots of

othersHighlights that central banks and governments should shoulder

some of the responsibility for the failure – argue as yet, this hasn’t happened

Week 5:1 16

Management of the financial system

Increasingly understood that the financial system had changed beyond recognition from the 1980s

Many banking investments were obscured, bordering on illegal (Barclays fined £500m by the UK treasury)

Week 5:1 17

Why are banks regulated in the first place?

Goodhart (2010)Market failures:

Monopoly controlAsymmetric information Externalities (social costs to bankruptcies)

Week 5:1 18

What has happened to our macro variables?

Source: Gregg and Wadsworth (2010)

Week 5:1 19

International variations• Gregg and Wadsworth (2010) group countries into 5 categories on the basis of changes in the GDP and unemployment over the recession:

Those with small falls in employment relative to GDP (UK and Sweden) Those with small falls in employment relative to GDP, having introduced employment subsides (Italy, Germany, Netherlands and Japan) Those with similar employment and GDP falls (France) Those with larger employment falls than GDP (US, Spain and Ireland) Those with little fall in GDP (Australia)

Week 5:1 20

Why did the UK labour market hold up?

Employers entered the recession in fairly good financial shape Able to absorb some of the downturn without shedding jobs

Total hours worked have fallen sharply and the share of part-timers risen

Workers accepted nominal wage moderation early on in the recession

increased chances of finding work if they are made redundant

• The impact on productivity (and international competitiveness) and public finances has been large; hence the cuts

Week 5:1 21

Cost of crisisThe level of debt in most Western Economies is

a direct result of bank bailouts

Severe recessionBank of England policy of “quantitative easing”

Exchange rate system in Europe under threatGreece most obviously Irish IMF loan and the austerity measures Italy, Spain and Portugal also under pressure

Budgetary issues (% of GDP)Slide 30.22

Griffiths and Wall, Applied Economics 12th Edition © Pearson Education Limited 2012

Country National Debt 2009

National Debt 2014

Budget deficit 2009

Budget surplus

required* in 2014

US 88.8 121.0 -12.3 4.3

Japan 217.4 239.2 -9.0 9.8

Germany 79.8 91.4 -2.3 2.8

France 77.4 95.5 -5.3 3.1

Britain 68.6 99.7 -10.0 3.4

G20 100.6 119.7 -8.6 4.5

*To bring respective national debts back to a maximum of 60% of GDP by 2014

Source: IMF, World Economic Outlook (various)

Week 5:1 23

And now the Euro…Weaker countries within the Eurozone have

suffered – especially GreeceNo longer considered to be a good debtor Agreed to a range of austerity measures for the

foreseeable future in exchange for Euro bailout to prevent national bankruptcy

A wider EU problem The ECB issued €530bn of cheap loans for Banks

to ease liquidity concerns

Week 5:1 24

Failures of macro models?How come no one saw this coming?

Well, some did (but not as many as now claim they did)

Housing market had been overvalued for years in the UK

Savings far too low

Did our macroeconomic models let us down?Over-reliance on inflation targeting?

Argued that MONEY is a glaring omission from existing new Keynesian macro models

Week 5:1 25

There will be other mistakes…

Macroeconomic models will not cover all eventualitiesAbstractions from the real worldSimplificationsBUT still powerful tools

A new focus on risk?The role of credit ratings are also under scrutiny

Week 5:1 26

Road to recoveryOsborne:

Treat the recessionTighten the fiscal belt – balance the budgetReduce government spending – rebalance the UK economyEncourage growth through private sector enterprise and growing

exports Regulatory reform of the financial sector

Balancing the need for reform against the footloose nature of financial intermediaries

Balls: Treat the depression

Looser fiscal policy to encourage growthShort term increase in government spending to get the economy

back on track Tougher stance on financial sector reform

Is the second policy approach viable?

Week 5:1 27

References Griffiths and Wall (2012) Applied Economics, Chapter 30 for the basics

Crafts and Fearon (2010) ‘Lessons from the 1930s Great Depression’, Oxford Review of Economic Policy, 26(3), 285-317

Drinkwater, Blackaby and Murphy (2011) ‘The Welsh Labour Market Following the Great Recession’, WISERD Policy Brief

A play by Julian Gough: goat futures explains the housing bubble

For up to date information, have a look at the Economist blog: http://www.economist.com/blogs/blighty

Deeper understanding in the current debates going on: Finance for the Future, LSE Report of 2010, available at

http://www.financeforthefuture.org.uk. This is really tough stuff though, so just read the summary!