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Ec 111 week 5(2)


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Ec 111 week 5(2)

  1. 1. EC-111 British EconomyRecent UK MacroeconomicTrendsDr Catherine RobinsonF26, Richard Price BuildingOffice Hours: Mondays 10.30-11.30 and Thursdays 9.30-10.30Appointments:
  2. 2. Outline for this week‟s lectures… Macro policy and the financial crisis What 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 problem Also, increased globalisation means the UK cannot belooked at in isolationWeek 5:12
  3. 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 projectsWeek 5:13
  4. 4. The Financial Crisis of 2007 The economic slow down began in 2006..and in the US Relatively high risk borrowers in the US lost their jobs Unable 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 5:14
  5. 5. Contagion By 2010, house prices (and share prices) in the US hadfallen by 29% from their peak in 2007 Reducing economic growth Caused a big drop in UK inter-bank lending, withknock-on effects on other sectors such asmanufacturing Contagion as there was more and more scrutiny on the lendingpractices of financial intermediariesWeek 5:15
  6. 6. Causes: Financial„innovations‟ The Big Bang led to deregulation… Deregulation of the financial sector led to innovations inproducts: Short selling Over the counter derivatives Securitisation Proprietary trading Speculation SHADOW BANKINGWeek 5:16
  7. 7. Structured Investment Vehicles(SIVs) innovative ways to package debts In such a way as to obscure the risks associated bycreating a portfolio of liabilities some of which were the sub-prime mortgages Some of which were short term debts (with comparativelylittle risk)Week 5:17
  8. 8. Slide 30.8Griffiths and Wall, Applied Economics 12th Edition © Pearson Education Limited 2012ABS other, 2.2%Studentloans, 4.4%RMBS(Residentialmortgage backedsecurities) , 23.2%Other, 3.3%Financialdebt, 42.6%Credit cards, 5%CMBS(Commercialmortgage backedsecurities), 6.1%CDO, 11.4%Autoloans, 1.1%Sector composition
  9. 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 incurdefaults Bear Sterns lost 90% of its sub-prime loans and filed forbankruptcy 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 lossesWeek 5:19
  10. 10. And the bad newscontinued…2008 Further write-downs and losses announced, interest ratesslashed to record low levels Northern Rock nationalised In July in the US Indy Mac Bank collapses, the secondlargest bank failure ever Lehman Brothers attempts to sell 50% of its shares to southKorea or China. Fails. In September enters bankruptcy, thelargest in USA history In the same month US Government takes control of FreddieMac and Fanny Mae Merrill Lynch, Bank of America, Bear Sterns and LehmannBrothers have all by now ceased to tradeWeek 5:110
  11. 11. Bank Bailout Events unfolded in such a way as to the extent to which variousbanks 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 UKbank 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 forcountries to save them Aggressive, orchestrated policy required by US, UK and EU.Week 5:111
  12. 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 debtguarantees (up to £250bn) Record low interest ratesWeek 5:112
  13. 13. So, the UK policy response•To emphasise international co-operation and co-ordinatedfiscal and monetary policy responses to help move the UKand world economies out of recession•a number of levers during the recession:Bank base rate reduced to 0.5 per centBailing out of some banks and finance to support the balancesheets of the banksValue Added Tax temporarily reduced from 17.5% to 15%Quantitative easing of £200billion – Asset Purchase Facility bywhich the Bank of England can buy corporate bondsCar scrappage schemeWeek 5:113
  14. 14. Into 2009…heading intodouble dip… But the market is still jittery (Flash crash of the NYSE inMay 2010) International organisations meeting to define standardsin banking BASEL III Contagion means that currencies are suffering Euro problems in Ireland, Greece and now Portugal andItaly… Cyprus problems in the news recentlyWeek 5:114
  15. 15. How can we ensure this mistakedoesn‟t happen again? Regulate the financial sector more effectively Commission a report – the Independent Commission on Banking Sir John Vickers Report published in September 2011 recommendations on ring-fencing domestic retail banking, 1/6th to1/3rd of banking assets to be within the ring-fence Competition in banking sector needs to be improved “Future of Finance”, 2010 Report by LSE stars – Adair Turner, Andy Haldane and lots ofothers Highlights that central banks and governments should shouldersome of the responsibility for the failure – argue as yet, this hasn‟thappenedWeek 5:115
  16. 16. Management of the financialsystem Increasingly understood that the financial system hadchanged beyond recognition from the 1980s Many banking investments were obscured, borderingon illegal (Barclays fined £500m by the UK treasury)Week 5:116
  17. 17. Why are banks regulated in thefirst place? Goodhart (2010) Market failures: Monopoly control Asymmetric information Externalities (social costs to bankruptcies)Week 5:117
  18. 18. What has happened to our macrovariables?Source: Gregg and Wadsworth(2010)Week 5:118
  19. 19. International variations• Gregg and Wadsworth (2010) group countries into 5categories on the basis of changes in the GDP andunemployment over the recession: Those with small falls in employment relative to GDP (UKand Sweden) Those with small falls in employment relative toGDP, 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, Spainand Ireland) Those with little fall in GDP (Australia)Week 5:119
  20. 20. Why did the UK labour market holdup?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-timersrisen Workers accepted nominal wage moderation early on in therecessionincreased chances of finding work if they are made redundant• The impact on productivity (and international competitiveness) andpublic finances has been large; hence the cutsWeek 5:120
  21. 21. Cost of crisis The level of debt in most Western Economies is adirect result of bank bailouts Severe recession Bank of England policy of “quantitative easing” Exchange rate system in Europe under threat Greece most obviously Irish IMF loan and the austerity measures Italy, Spain and Portugal also under pressureWeek 5:121
  22. 22. Slide 30.22Griffiths and Wall, Applied Economics 12th Edition © Pearson Education Limited 2012CountryNationalDebt 2009NationalDebt 2014Budgetdeficit 2009Budgetsurplusrequired* in2014US 88.8 121.0 -12.3 4.3Japan 217.4 239.2 -9.0 9.8Germany 79.8 91.4 -2.3 2.8France 77.4 95.5 -5.3 3.1Britain 68.6 99.7 -10.0 3.4G20 100.6 119.7 -8.6 4.5*To bring respective national debts back to a maximum of 60% of GDP by 2014Source: IMF, World Economic Outlook (various)
  23. 23. And now the Euro… Weaker countries within the Eurozone have suffered –especially Greece No longer considered to be a good debtor Agreed to a range of austerity measures for theforeseeable future in exchange for Euro bailout to preventnational bankruptcy A wider EU problem The ECB issued €530bn of cheap loans for Banks toease liquidity concernsWeek 5:123
  24. 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 existingnew Keynesian macro modelsWeek 5:124
  25. 25. There will be othermistakes… Macroeconomic models will not cover all eventualities Abstractions from the real world Simplifications BUT still powerful tools A new focus on risk? The role of credit ratings are also under scrutinyWeek 5:125
  26. 26. Road to recovery Osborne: Treat the recession Tighten the fiscal belt – balance the budget Reduce government spending – rebalance the UK economy Encourage growth through private sector enterprise and growingexports Regulatory reform of the financial sector Balancing the need for reform against the footloose nature of financialintermediaries Balls: Treat the depression Looser fiscal policy to encourage growth Short term increase in government spending to get the economy backon track Tougher stance on financial sector reformIs the second policy approach viable?Week 5:126
  27. 27. References Griffiths and Wall (2012) Applied Economics, Chapter 30 for the basics Crafts and Fearon (2010) ‘Lessons from the 1930s Great Depression’, OxfordReview of Economic Policy, 26(3), 285-317 Drinkwater, Blackaby and Murphy (2011) ‘The Welsh Labour MarketFollowing 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: Deeper understanding in the current debates going on: Finance for the Future, LSE Report of 2010, available at This is really tough stuff though, so just read the summary!Week 5:127