Tag Archives: uk economy

Desperately Seeking Stimulus

Plan B is for Bankruptcy? Bullshit. Bold, government backed programmes are needed to kick-start the economy and stem the jobs crisis.

No, we are not out of the woods. The green shoots of recovery still remain smothered by a thick layer of mud. UK unemployment rose to 2.51million people in July. That’s 7.9% of the workforce. A fifth of UK youths are now jobless. These dismal figures are a consequence of hefty falls in public sector employment and pathetic rates of private sector job creation, much lower than that expected by the Treasury and OBR. Furthermore, the UK ranked a pitiful 25th out of 27 countries for growth over the past year, only Romania and Portugal did worse. The Institute for Fiscal Studies shovels more gloom into the mix with the news that median net household income suffered its largest one-year drop since 1981 in the last financial year, battered by the real falls in earnings, benefits and tax credits.

These are not transient troubles. Martin Weale and co authors estimate that the current recession will be the longest since the war, highly likely to lead to a greater cumulative loss of value than the Great Depression. Martin Wolf in the FT argues that it is probable for the depression to last 72 months, making it 50% longer than its longest predecessor in a century. Furthermore, the singular focus on austerity across Europe will act to black out any light at the end of the tunnel. Cameron’s description of the current figures as “disappointing” is, therefore, a gross understatement.

You would think that the continued flow of feeble figures would trigger a revaluation of the current macroeconomic strategy. But no, “Plan B is for BANKRUPTCY” we are told, “The UK will be able to ‘weather the storm’”. Little convincing evidence has been supplied to support these claims. Despite all signals pointing towards a need for change, Osborne insists that no amendments will be made to Britain’s deficit reduction programme. Although Britain does need to make credible its promise to get the public finances in better shape, such policy inflexibility is reckless. We need to slow down austerity implementation to ensure that the scars this recession leaves on the economy are not deeper than need be.

The slowdown began with a collapse in economic demand. However, it is looking more and more likely that this will get locked in by a contraction of supply. A contraction in supply means that we will find it harder to produce ‘stuff’ at the same rate as before. That a fall in demand can feed into a permanent downgrade to our growth prospects is a phenomenon known as hysteresis by economists. If demand for a firm’s output is depressed for a prolonged period, machinery may be scrapped and businesses could decide not to follow through on planned investments. The chaos in the financial sector has resulted in credit being allocated inefficiently at the wrong cost. Others note that a worker’s productivity can be harmed by unemployment. If one is out of a job for a long time, workplace skills start to fade and you become less employable. In addition, the longer someone is out of a job, the more likely it is for them to drop out of the labour market altogether. For example, women may decide to stay at home, early retirement may become an option or that back pain that’s always plagued you may become a reason to seek different types of benefits.

All of this acts to depress the trend rate of growth that the economy can sustainably achieve and will ultimately make it harder to pay those dreaded debts. With slower growth, tax revenues will remain depressed for longer than the Treasury and OBR expected when making their budget projections. Preventing the temporary blemishes associated with recession from becoming permanent scars is of upmost importance.

Unemployment of all ilks is associated with economic and social ills but the current concentration of joblessness among the young and low skilled is something of particular concern. Youth unemployment has especially pernicious consequences, affecting the individual and economy for far longer than the spell of joblessness itself. Those experiencing spells of unemployment while young face significant wage penalties and a higher risk of future joblessness compared to their peers for decades, even after controlling for a wide array of individual and family characteristics. For example, see the evidence in Gregg and Tominey (2005) for the UK and Mroz and Savage (2006) for the US. Thus, the fact that 18% of 16-24year olds are ‘NEETs’ (Not in Employment, Education or Training) should be sending alarm bells ringing through Whitehall. Their current idleness is not just an awful waste of their talents at this particular moment but makes it more likely for them to become trapped in dead-end areas of the labour market for much of their adult life. This is unfair for them, it’s not their fault that their birth date dictated they join the workforce during the worst post-war recession, as well as being highly damaging to the wider economy.

Furthermore, as the riots bought to attention earlier in the summer, unemployed youths facing a dearth of opportunity are not guaranteed to sit quietly. Unsurprisingly, increases in youth unemployment are associated with a range of social ills. For example, Carmichael and Ward (2001) found youth unemployment is associated with a statistically significant increase in burglary, fraud and forgery, theft and total crime rates. A third of NEETs agree with the statement that their life has ‘no purpose’. The social consequences of a large number of marginalised youths, who are assess their lives as purposeless, are scary to think about.

Some argue that government led job creation is a misnomer. They are wrong. The government has a role in supporting employment through this recession. Bold, innovative programmes are required to help ease the jobs crisis. Given the uncertainty and pessimism that currently clouds private sector vision and judgement, government involvement and financial backing are required to get them started. Technological change and globalisation imply that we also need to shift are thinking on how best to deal with the current labour market woes. Public works programmes represent one strategy to be explored but they are expensive and will create far fewer jobs today than they did in the past. Quoted in The Economist, the major of New York, Michael Bloomberg, notes that new government sponsored construction works will not solve the problem. “The technology is different. If you built the Hoover dam today, you would do it with far fewer people… The average worker standing in line for benefits tends not to be muscular.”

One new idea which I find particularly attractive is the creation of a small business bank. It could either be created through an initial injection of government capital or bonds funded by the Monetary Policy Committee and make use of existing agencies to allocate and dispense the loans. Credit allocation is currently a total mess. Banks aren’t lending to solvent businesses which need cash to invest and grow. If such a bank was set up, it could offer loans to small businesses at low rates, potentially concentrating funds in areas of especially afflicted by unemployment. This strategy has a number of attractions. Easing the funding restrictions on entrepreneurs and small businesses should help to kick-start innovation and growth while supporting employment. The focus on small businesses should prove especially affective at job creation. Research funded by the Kauffman Foundation shows that all net new private-sector jobs in America were created by companies less than five years old. Further, no one can turn round and say, “Oh, think of the benefits culture you’re creating”. This strategy is positive; it’s about supporting new ideas and existing businesses to thrive. In this way, the roots of the problem, as well as its consequences, are targeted.

Over the last few decades, a polarisation of the labour market into ‘lousy’ and ‘lovely’ jobs with little in between has been noted. Many routine manual jobs can now be coded up and performed by computers and machines. Other jobs are now able to be performed by individuals on the other side of the world. These hard facts need to be acknowledged by policymakers and reflected in the design of new labour market policy. Training and education systems need to be overhauled to reflect the new set of skills needed by employers. However, we also need to sit back and think through the consequences that these developments have for our vision of the modern job market. What can be done to best prepare individuals for the new world of work? How can we make the distribution of work more equitable?

These are hard questions but a few things are self evident with little deep thought. Slowing the pace of public sector redundancies will slow the rise in unemployment. Creation of something like a small business bank would not have to add to the public sector debt and could help propel the recovery forward. The government cannot afford to be complacent. A slower recovery adds to the cost of fixing their finances and creates long term hardship for many in society. The UK economy is Desperately Seeking Stimulus. Plan B is for Bankruptcy? Bullshit.

Banking Reform: The Principles & Proposals

On Monday, a 358 page tome on financial sector reform was delivered to UK politicians and public, the outcome of an investigation into UK banks by the Independent Commission on Banking (ICB). What were the central recommendations and their motivations? Do they go far enough?

The ICB was set up by the Treasury in the aftermath of the financial crisis and is headed by Sir John Vickers, former boss of the Office of Fair Trading and Warden of All Souls College, Oxford. Achieving a stable banking sector is more important to the UK than many other countries. Britain is hugely exposed to turmoil in the financial sector. The balance sheet of banks is £6trillion. To put this in perspective, this is 4 times larger than the total value of our economic output. Incomprehensively huge. This is not the case in all Western countries. In the US banking liabilities are equivalent to ‘only’ 50% of GDP. It is thus of upmost importance that we get the structure of our banking industry right.

Some banking basics

There is a lot of jargon in this field. To help get to grips with what the reforms target, let’s briefly review the basics on the banking system.

In a simple world, one can think of banks as absorbing savings deposits and certain types of debt and transforming them into longer term investments, such as mortgages and corporate & government loans. This means that our savings do not just ‘sit in the bank’, they are re-lent out to generate profits. Banks suffer from a ‘maturity mismatch’; their liabilities are short term (we can demand our savings back right now), while their assets pay back in the long term (the flow of profits from mortgages and bonds might go far into the future).

But what happens if lots of people suddenly want their savings back? In ‘normal’ times banks satisfy the demands of their depositors by lending to each other in overnight inter-bank reserve markets. If you’ve heard the term LIBOR, this is the London Interbank Offer Rate, the interest rate charged in the London overnight reserve market. Banks short on liquidity (i.e. those that don’t have enough free cash to satisfy deposit demand) borrow from those with excess reserves. In this way, it doesn’t matter most of the time that savings don’t just stay in the vaults at the bank.

So what happens when loans go bad? When loans go bad, losses must be absorbed by past profits generated by good loans or depositors, i.e. savers, will take a hit and the bank will be judged insolvent. Thus, it is important that banks carefully monitor the loans that they make and set interest rates to properly reflect the risk they face. Regulators also require that a portion of loans are funded from equity capital. This is the stock of past profits accumulated by a bank. Then if a loan goes bad it is the bank shareholders that shoulder the loss. This is fair. They oversee the management who allowed the bad loan to be made.

Equity capital is thus a lovely safety cushion on banks’ balance sheets. The higher the equity capital relative to the total size of the bank, the safer it is. The Vickers’ report and the Basel III agreement are both concerned with increasing equity capital ratios. What they actually do is specify a minima for:

Equity capital/Loans*risk weighting

where the ‘risk weighting’ figure reflects the quality of the loans made. So, it will be high if all the loans you made were to unemployed teenagers for multi-million pound houses.

In brief, during the financial crisis banks made, or were at least expected to make, losses far in excess of their equity capital. This led to a run on savings deposits, a freeze in interbank lending (banks couldn’t tell if each other were solvent and so wouldn’t lend to one another to help meet high deposit demand), a credit crunch and severe recession. Nice.

The recommendations

The Treasury set up in ICB to help prevent a similar financial crisis from arising again in the future. One can group the ICB’s proposals under three main headings:

1. Ring fencing retail operations

This is the proposal that has gobbled up the most column inches. The ICB argues that we need to separate the retail operations of banks from investment banking. Retail operations are those which ‘normal’ people think of when you say “bank”, i.e. savings, current accounts and mortgages, while investment banking activities include things like the more exotic sounding derivative trading. Ring fencing effectively builds a sort of firewall around the crucial activities which we really care about and will result in our own savings funding the flow of domestic loans.

 2. Promote greater competition

The UK banking industry is dominated by a small number of very big players. To create greater effective competition in the sector, Vickers recommends that the Lloyds banking group be broken up in a way that creates a strong new challenger. Further, measures to make it easier for individuals to switch their accounts between institutions are outlined and the need for a greater amount of clear pricing information is pressed.

3. Raise banks’ ability to absorb losses

This proposal relates to the amount of equity capital banks hold. From above, this is key in determining how safe a bank is as it sets the degree of loss it can sustain. The ICB feels that the proposals achieved by Basel III do not go far enough and want higher equity capital ratios for retail operations.

Intended effect

Lots of our problems in the financial crisis stemmed from two main things: 1) Banks made bad loans and 2) Banks weren’t holding enough equity capital to cover the bad loans. So ideally the reforms will:

1)       Reduce the likelihood that bad loans will get made

Ring-fencing retail services should work to discourage reckless risk taking and promote more sensible lending. The ‘too big to fail’ problem is often mentioned in this context. During the financial crisis, it was felt that the government had no option but to intervene to bail out the banks. The costs of not doing so were unfathomable. However, this created a “moral hazard” problem. Banks knew that, when push came to shove, the taxpayer had little choice but to bail them out and cover their losses. This reduced their incentive to make good loans and monitor the amount of risk they took on, encouraging the dodgy lending and trading practices at the heart of the crisis. If the government could have credibly promised to stand back and watch banks fail, it is likely that many of the bad loans would never have been made.

The reforms should make it easier for the government to do just this. Stand back and allow banks, or certain parts of banks, to fail, reducing this moral hazard problem. Ring fencing allows for better targeted bailout policies making it easier to force the creditors of failing investment banks bear the consequences of their investment decisions. Not just the good ones. The government can choose if it wants to support the investment banking arms of banks rather than being compelled to do so because of the risk to the retail services it really cares about.

2)       Make banks better able to cope with losses

Raising the capital requirements of banks enhances their ability to shoulder losses and ring fencing should also help insulate the banking of the layman from international troubles as much of the complex international exposures of UK banks relate to their investment banking divisions.

Answering some criticisms

There have been noises made on the cost that these reforms will impose on the already fragile banking industry. Critics also mention that the proposals will damage the global competitiveness of the UK banking industry. Neither criticism is particularly strong.

Vickers estimates that banks will face costs in the region of £4-7billion per year as a result of the proposals. So, actually, given the total size of the industry these costs are relatively trivial. Also, these costs are nothing compared to the bill the government is footing: The New Economics Foundation argues that the 5 biggest UK banks received a £46bn government subsidy in 2010 alone. Furthermore, these costs are the result of returning risk bearing to where it should be, i.e. with investors rather than taxpayers, and so are not wholly bad. One can argue that the cost of capital has been artificially low for banks because of the implicit government bailout promise outlined above. Banks have been able to borrow at lower cost than they should have been able to because lenders have known that it is highly unlikely that they won’t get paid back. In the past it was known that the government would step in if things got bad. Therefore, interbank interest rates and borrowing costs have been lower than those which actually reflect the social risks.

On the issue of global competitiveness, the proposed regulations largely apply to high street business. By definition, the high street has to stay where it is (!), reducing the international ramifications of reform. The ICB estimates that only a relatively small portion of investment banking activity will be affected and all operations outside the ring-fence will continue to be regulated according to international standards. The enhanced equity capital ratios also only apply to the retail operations of banks. Operations outside the ringfence will continue to be policed by international standards.

Is it enough? Short answer: No. 

This is where I’m sceptical. Yes, the proposals are relatively wide reaching but they are also moderate. Meek even. The fact that there has been relatively little fuss and bother in the aftermath of the report is strong evidence that nothing really challenging has been put forward. Furthermore, implementation is far on the horizon. 2019 to be precise. That is a long time in the future. Who knows what issues will have arisen by then and this also gives the banks a long time to work out every way to minimise the impact of the proposals on their activities.

What Britain can achieve on its own is limited with respect to banking reform. Sadly, an international solution is needed. This is I think why Vickers’ proposals are not going to bring the radical change we need. The ‘sadly’ qualification is because the terms international, agreement and radical are not often found together in this environment.

I want more sensible debate and research on an international financial transaction tax. Such a tax would bring in revenue, which could then be directed to helping those in need at home and round the world, and would help to curb certain types of destabilising financial activities. For example, the growth of ‘High Frequency Trading’ (HFT), identified by the Bank of England as a serious systemic risk, could be reduced by a minimal tax on each transaction as these trades all rely on minuscule margins. However, such a tax does need to be international. The UK could not implement this on its own.

In summary, the Vickers’ report outlines sensible but mild reforms to the UK banking industry which certainly won’t make anything worse. However, they are not enough and their implementation is too far on the horizon. Creative, serious thinking on a challenging international solution is required. Sadly, I’m sceptical about what will be achieved.