In 1917, the US Government passed a law that set a limit on the total amount of debt that the government can incur – initially set at $11.5bn. However Government debt has increased under every President and now stands at $31.4trn. In January this year debt hit this latest level which means that the Government cannot legally borrow anymore money. In order to increase the debt ceiling it must be voted through the House of Representatives which the Republicans have a majority. Although the ruling party is the Democrats, the Republican majority can pressure President Joe Biden to agree on cuts to the budget. In the past, under the same scenario, there have been hastily arranged agreements at the 11th hour to avoid a default. Below is a good video from the WSJ explaining the debt ceiling and the consequences of it not being raised.
Paradox of Thrift – Great Depression & GFC
Although the paradox of thrift has been a regular part of the CIE A Level syllabus it is has only become more relevant since the Global Financial Crisis (GFC). It has its origins in the 1714 book entitled ‘The Fable of Bees’ by Bernard Mandeville but it was John Maynard Keynes who really popularized this concept during the Great Depression of the 1930’s. Classical economic theory suggests that greater levels of saving will increase the amount of loanable funds in the banks and therefore reduce the cost of money – interest rates. This allows people to put off consumption to a later date thereby avoiding the risk of taking on debt and thereby give people security if their jobs became threatened during a recessionary period
Keynes argues that saving was not a virtue from a macroeconomic view as he believed that negative or pessimistic expectations during the Depression would dissuade firms from investing. Cutting the rate of interest is supposed to be the escape route from economic recession: boosting the money supply, increasing demand and thus reducing unemployment. He also suggested that sometimes cutting the rate of interest, even to zero, would not help. People, banks and firms could become so risk averse that they preferred the liquidity of cash to offering credit or using the credit that is on offer. In such circumstances, the economy would be trapped in recession, despite the best efforts of monetary policy makers. The graph below shows a liquidity trap. Increases or decreases in the supply of money at an interest rate of X do not affect interest rates, as all wealth-holders believe interest rates have reached the floor.
All increases in money supply are simply taken up in idle balances. Since interest rates do not alter, the level of expenditure in the economy is not affected. Consequently, monetary policy under these circumstances is futile.
Keynes saw the 1930’s as a time when aggregate demand needed boosting – C+I+G+(X-M) – as the economy was in underemployment equilibrium. With the help of the multiplier, output and employment would increase – GDP. But with increased saving leading to reduced consumption and a fall in aggregate demand, a recession will worsen.
The fact that income must always move to the level where the flows of saving and investment are equal leads to one of the most important paradoxes in economics – the paradox of thrift. Keynes explains how, under certain circumstances, an attempt to increase savings may lead to a fall in total savings. Any attempt to save more which is not matched by an equal willingness to invest more will create a deficiency in demand – leakages (savings) will exceed injections (investment) and income will fall to a new equilibrium. In the graph below, the point of equilibrium is at E where the saving curve SS and investment curve II intersect each other. The level of income at equilibrium is OY and saving and Investment are equal at OH. When the aggregate saving increases, the saving curve shifts upwards from SS to S1S1. The new equilibrium point is E1 with OY1 level of income. Saving and investment are equal at point OT. As the level of saving increases, national income decreased from OY to OY1. Similarly, the volume of saving and investment also declined from OH to OT.
People save more → spend less → another’s reduced income → negative multiplier → reduces demand → unemployment ↑ → incomes ↓ → AD↓ therefore planned increase in savings makes a recession worse.
Paradox of thrift and the GFC
The relevance of the paradox of thrift today is different from that during the Great Depression in the 1930’s. Back then consumers weren’t in as much debt as they are today and the government played a much smaller role in the economy with little or no welfare state to provide automatic stabilizers. Also the financial system wasn’t an interconnected as it is today and the financial engineering that evolved in the 2000’s allowed for the creation of instruments that had no real value to the economy – CDO and CDS. But after the GFC the expectations of consumers became very negative and as workers became fearful of losing their jobs what followed was an increase in savings as they wanted less exposure to debt, which negatively affected consumption.
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The collapse of Silicon Valley Bank
Been covering banking and the bond market with my A2 economics class and we talked about the collapse of Silicon Valley Bank. Below is a video from the WSJ on the whole SVB saga and the history behind bank regulation under Obama but deregulation under Trump. What is interesting is the fact that 94% of SVB’s deposits (see graph) were above the $250,000 which is insured by the Federal Deposit Insurance Corporation – government corporation supplying deposit insurance to depositors in US commercial and savings banks. However you do wonder why depositors kept so much money in a bank when you would want to spread your risk. Although you may need cash for day-to-day transactions, money could be put into a market fund and brought back into a bank account when needed.
WSJ talk about bonds and below are some notes on how bond yields work. This is part of the A2 syllabus Unit 9 – interest rate determination: loanable funds theory and Keynesian theory.
How do Bond Yields work?
Say market interest rates are 10% and the government issue a bond and agree to pay 10% on a $1000 bond = annual return of $100.
100/1000 = 10%
If the central bank increase interest rates to 12% the previous bond is bad value for money as it pays $100 as compared to $120 with the a new bond. The value of the old bond is effectively reduced to $833 as in order to give it annual payment of $100 a year the price would have to be $833 to it a market based return.
100/833 = 12%
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How do we know when a current account deficit is bad?
A current account deficit (CAD) allows residents to consume more products that it produces. However the country needs to finance the deficit by attracting investment into the country or by borrowing. This will involve an outlow of money in the future in the form of investment income. An increase in a CAD may also reduce AD, which may slow down economic growth and may cause unemployment.
A CAD could be indicative of a lack of competitiveness but it could also mean an excess of investment over savings which could mean a highly productive, growing economy. Although there is a deficit an important question is what the deficit is made up of? If a country is importing a significant amount of capital goods then these can add value to the economy by creating jobs and growth. For example if Air New Zealand buy planes from Airbus these are part of the service that they offer which employs people and generates income. But if a CAD reflects low savings rather than investment, it could be caused by an irresponsible expansionary fiscal/monetary policy like we have seen in New Zealand post-covid.
New Zealand’s annual current account deficit was $27.8 billion for the year ended in the June 2022 quarter, equivalent to 7.7 percent of GDP. The annual current account deficit rose by $16.3 billion during the year, driven by increases in the goods and services deficits. Sea transport costs (which is a services import cost) rose by $2.2 billion during the year, and was a driver behind a $5.0 billion deterioration in New Zealand’s services balance. However the record-breaking deficit shows we’ve been living beyond our means, becoming more dependent on foreign capital in the process. However CAD reflect underlying economic trends, which may be desirable or undesirable for a country at a particular point in time.
Causes of CAD
- Overvalued exchange rate – If the currency is overvalued, imports will be cheaper, and therefore there will be a higher quantity of imports. Exports will become uncompetitive, and therefore there will be a fall in the quantity of exports.
- Economic growth – If there is an increase in national income, people will tend to have more disposable income to consume goods. If domestic producers cannot meet the domestic demand, consumers will have to import goods from abroad. In New Zealand there is a high tendency to import manufactured goods as we don’t have a comparative advantage.
- Drop in demand from trading partners – If there is a downturn in country A that normally buys another country B’s exports this will mean a loss of export revenue for country B. A current account deficit that results from the economic cycle is referred to as a cyclical deficit. Usually short-term and self-correcting
- Growing domestic economy – when demand increases in the domestic economy it may mean that companies now have to import more capital goods and raw materials from overseas. As well as imports increasing, producers may switch their sales to the domestic market and not overseas (exports). However in the long-term firms output might increase so that they can sell both at home and abroad.
- Higher inflation – if New Zealand’s inflation rises faster than our main competitors then it will make New Zealand exports less competitive and imports more competitive. This will lead to deterioration in the current account. However, inflation may also lead to a depreciation in the currency to offset this decline in competitiveness.
- Structural problems – a current account deficit that is persistent is concerning as it indicates that domestic firms are not internationally competitive and the country may have to borrow from overseas to fund the current account deficit. As well as an overvalued exchange rate (see above) the country might have low labour and capital productivity so finds it hard to compete internationally.
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UK Pound slumps as IMF advises against tax cuts
Below is a very good video from Al Jazeera that explains the Bank of England’s emergency intervention to calm the market after the UK’s government’s tax cut plans. Once these plans were announced the GB Pound slumped to it lowest level $1.035 against the US Dollar since 1985. The BoE announced it is buying up long-dated UK government bonds to bring stability to financial markets but even higher interest rates are still likely and that is worrying news for the country’s property market. Good coverage of this below from Al Jazeera.
What kind of recovery after coronavirus – L U V W
Like after the GFC in 2008 can China kick start the world economy? The FT’s global China editor James Kynge explains why China’s indebtedness means it is probably both unwilling and unable to launch a stimulus package like that of 2009. A lot depends on how quickly their own economy can bounce back and if it is a L U V W shaped recovery. Also can it act as a locomotive for the rest of the world. The video below contains some excellent graphs concerning China’s debt problem.
Although from 2011 the video below from the PBS Newshour shows reporter Paul Solman and Simon Johnson – former IMF economist and now at MIT. Johnson explains the different types of recoveries – L U V W shapes.
Covid-19 – The economic recession is a public health measure
No doubt you will have heard in most government press conferences the aim of flattening the curve. In trying to flatten the epidemic (epi) curve there will be a trade-off with reduced economic activity. By having a lockdown you reduce the exposure of people to the virus but it also means less employment and consumption.
The graph above shows the following:
- steep red curve shows – (medical outcome) without some sort of lockdown
- latter blue curve – impact on cases of the virus with a lockdown
- flatter red curve shows – the impact on economic activity if there was no lockdown
- steep blue curve shows – impact on economic activity if there was a lockdown
Therefore if you flatten the infections curve you steepen the recession curve.
This unavoidable trade-off is surely behind some leaders delaying containment policies – not wanting to experience a severe recession especially in US as it is election year. It seems that if you don’t act to contain early you pay for it later
These desperate times call for desperate measures – a version of shock therapy. Society has a pressing need for a massive increase in government spending but what we don’t want to happen is a COVID-19 recession gradually turning into a COVID public debt crisis.
Source: Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes. Edited by Richard Baldwin and Beatrice Weder di Mauro
Covid-19 and Global Debt
Below is an informative video by CNBC which covers the history of debt waves and brings us up to date with regard to government spending and Covid-19. The have been 3 previous debt waves since the 1970’s
- 1970s and 1980s, with borrowing by governments in Latin America and in low-income countries in sub-Saharan Africa. This wave saw a series of financial crises in the early 1980s.
- Ran from 1990 until the early 2000s as banks and corporations in East Asia and the Pacific and governments in Europe and Central Asia borrowed heavily, and ended with a series of crises in these regions in 1997-2001.
- Private sector borrowing in Europe and Central Asia, which ended when the global financial crisis disrupted bank financing in 2007-09 and tipped several economies into sharp recessions.
The latest wave of debt accumulation began in 2010 and has already seen the largest, fastest, and most broad-based increase in debt. Add in Covid-19 and these are very worrying times for government budgets. Global debt has topped $US250 trillion, or 322% of global GDP – a record level. But more debt has been used to acquire expensive assets, rather than on developing productive capacity with capital investment. Lower interest rates, have also made it possible to borrow more, leading to more debt and less equity being deployed to buy these assets. Furtermore Covid-19 will only increase this debt by a significant amount.
Global Debt – 225% of GDP
The New Zealand Parliamentary Library publish a very good monthly economic review and in the July edition the topic of the month was The International Monetary Fund’s Global Debt Database.
The IMF publish their Global Debt Database which provides the gross debt levels since 1950 for 190 advanced economies, emerging market economies and low-income countries. It covers 99% of global GDP in 2016. Currently, total debt levels have reached a new high, standing at around US$164 trillion, or 225% of global GDP with USA, China and Japan accounting for more than half this figure – $92trn out of $164trn – see table.
The big change is China with debt having gone from $5trn to $26trn in the space of 10 years – this equates to 3% of global debt in 2007 to 15% in 2016. Private debt has nearly tripled since 1950.
Government vs Private Debt in New Zealand
New Zealand government debt has been on its way down which is in contrast to its private debt – see figures and graph below. Not surprisingly the IMF is concerned about private debt and the effects of the country’s inflated housing market despite the strong economic outlook. They said “Household debt remains high under the baseline outlook and would amplify the impact of large downside shocks, notwithstanding recent improvements in its risk structure after macroprudential policy intervention. Such shocks could also trigger a disruptive housing market correction,” The main risks to New Zealand are an economic slowdown amongst developed countries and China, the fallout from increasing protectionism and the Mycoplasma bovis cow disease.
Source: New Zealand Parliamentary Library – Monthly Economic Review – July 2018
Dairy debts make NZ Banks vulnerable
New Zealand dairy farmers are making banks worried about their ability to keep up with their mortgage payments. Four recent issues haven’t helped the cause:
1. Falling produce prices making it harder for farms to service debt
2. Mycoplasma bovis cutting productivity and profitability of the sector
3. Regulatory changes – restrictions on foreign ownership and therefore reducing the value of dairy farms
4. Environmental regulations – increasing operating costs for farms
Whilst the last two might improve the long-term sustainability of the dairy sector they could reduce the profitability of highly indebted farms and their equity buffers.
Banks are closely monitoring about 20% of their dairy farm loans because of concerns about the borrowers’ financial strength. Although a dairy downturn is unlikely to threaten the solvency of the banking system, it does weaken their position if there is another external shock like another GFC. Bank lending in the dairy sector has been consistent over the last few year years but the proportion of loans on principal and interest terms has increased from 6% in January 2017 to 12% in March this year.
Although the average mortgage for most farm types has decreased in dollar value over the past six months, the average mortgage amount increased in the dairy farms – see graph below. The average mortgage for dairy farms is the highest at $5.1 million for the first time since the survey began in August 2015.
The table below shows the average current mortgage by sector over the years shown. Dairy farmers continue to hold the largest proportion of mortgages in excess of $2 million. They are also more likely to have a mortgage over $2 million – 62.5% of all dairy farms – and $20 million – 3.4% of dairy farms.
Source: Federated Farmers of New Zealand – Banking Survey – May 2018
Central Banks could cause next financial crisis
A Buttonwood piece in the Economist (30th September 2017) looked at how central banks can trigger the next financial crisis. Deutsche Bank have looked into long-term asset returns in developed markets and suggest that crises have become much more common. They define a crisis when a country suffered one of the following:
- a 15% annual decline in equities;
- a 10% fall in its currency or its government bonds;
- a default on its national debt; or
- a period of double-digit inflation.
Pre the Bretton Woods system of fixed exchange rates and a central bank’s limited ability to create credit, very few countries suffered a shock in a single year. But since 1980 there have been numerous financial crisis of some kind. Under the Bretton Woods system a country that expanded its money supply too quickly would encourage an increased demand for imports which would ultimately lead to a trade deficit and pressure on its exchange rate; the government would react by slamming on the monetary brakes. The result was that it was harder for financial bubbles to inflate.
But with a floating exchange rate a country has more flexibility to deal with economic crisis as they don not have to maintain a currency that is pegged to another. A weaker currency makes exports more competitive and imports more expensive. But it has also created a trend towards greater trade imbalances, which no longer constrain policymakers—the currency is often allowed to take the strain. See flow chart below.
As well as companies and consumers taking on debt, government debt has also been rising as a proportion of GDP since the mid-1970’s:
- Japan – a deficit every year since 1966
- France – a deficit every year since 1993
- Italy – only one year of surplus since 1950
This has resulted in significant credit expansion and collapse – by allowing consumers to borrow more money the cost of assets (esp. houses) is pushed higher. However when lenders lose confidence in borrowers ability to repay they stop lending and mortgage sales follow. This is then reflected in the credit rating of borrowers. In order to try and rectify the problem the central banks intervene and reduce interest rates or buy assets directly. This may bring the crisis to a temporary halt but results in more debt and higher asset prices.
Deutsche Bank suggest that could mean another financial crisis especially if there is the withdrawal of support from central banks who saved the global economy when the GFC started. Indicators suggest that this may be the case:
- US Fed – has pushed up interest rates and cut back on asset purchases
- ECB – likely to cut asset purchases next year
- Bank of England – has recently pushed up interest rates
However rates are still at a stimulatory level and developed economies have been growing for several years. According to Deutsche Bank any kind of return to “normal” asset prices from their high levels would constitute a crisis. This would then force central banks to once again lower interest rates again but they will not want to appear to be the ambulance at the bottom of the cliff every time this happens. Remember the bailouts of AIG and the investment banks. It seems that the investment banks are happy to privatize the reward but socialise the risk – when it all “turns to custard” they need to be bailed because they are too big to fail. The question that people are now asking is what is the vulnerable asset class? Mortgage-backed securities was the cause in 2008.
Functions of Money – the easier it is to buy things the more you spend
Money has taken various forms over the ages – whether it be tokens on a tree made of pewter (soft metal which comes from Malaysia) to the stone currency from the island of Yap in Micronesia. There was a problem with the stone currency in that one of the essential characteristics of money is portability and a 5 meter high stone with a hole in it doesn’t fit the bill let alone the wallet. Money that comes in small coins and notes became a much more efficient medium of exchange and facilitates more transactions but it still gives you a sense that you are spending it as your wallet becomes lighter and less bulky.
Today the vast majority of transactions are done without cash and there is a tendency not to feel the cost of the transaction, by physically taking money out of your wallet, when paying by credit card. This ease of payment encourages us to spend more. Research has shown that credit cards make people spend 12-18% more, on average, than they would using cash. But lets go further, you can now wave your card over the credit card terminal with no need for a security pin number or a signature. In fact a smartphone is able to carryout a similar transaction which further erodes the sense of parting with money. I recently received an updated airpoints card from a national airline which enables you to accumulate points that can be redeemed for flights. However reading the letter I was interested to see that the card was also offering me $10,000 credit limit. Credit was also offered from a petrol station and a supermarket card – the means of a deferred payment is a popular function.
For the AS level course remember the following:
The Functions of Money
There are 4 traditional functions of money.
1. Medium of exchange.
This is very important in a specialised economy as barter would be very inefficient. It also makes possible a great extension of the principle of specialisation.
The desirable qualities of money are as follows:-
- Acceptable: Must be sure somebody will accept your money for goods & services
- Scarce: Should be, if there’s too much, then no one would value it, hence gold was always good money.
- Portable: Convenient to carry around
- Divisible: Can be divide up into different denominations
- Durable: Money (physical) that can last
2. Unit of Account
A unit of account is a way of placing a specific value on economic goods and services. Thus, as a unit of account, the monetary unit is used to measure the value of goods and services relative to other goods and services. It thus enables individuals to compare, easily, the relative value of goods and services. A firm uses money prices to calculate profits and losses: and a typical household budgets its regular expenses daily using money prices as its unit of account.
3. Store of Value.
Once a commodity becomes universally acceptable in exchange for goods and services, it is possible to store wealth by holding a stock of this commodity. It is a great convenience to hold wealth in the form of money. Consider the problems holding wealth in the form of wheat. It may deteriorate, it is costly to store, must be insured, and there will be significant handling costs in accumulating and distributing it.
4. Standard of Value/Standard of Deferred Payment.
An important function of money in the modern world, where so much business is conducted on the basis of credit, is to serve as a means of deferred payment. When goods are supplied on credit, the buyer has immediate use of them but does not have to make an immediate payment. The goods can be paid for three, or perhaps six, months after delivery.
PBS: Mervyn King and the future of global finance.
Another good video from Paul Solman of PBS ‘Making Sense of Financial News’.
In his new book, “The End of Alchemy,” Mervyn King still worries that the world banking system hasn’t reformed itself, eight years after its excesses led to collapse. He states that it’s easy with hindsight to look back and say that regulations turned out to be inadequate as mortgage lending was riskier than was thought. Furthermore, you are of the belief that the system works and it takes an event like the GFC to discover that it actually doesn’t.
Paul Solman asks the question that a large part of the problem that caused the GFC was the Bank of England and the US Fed were not able to keep up with the financial innovation that was going on in both of these countries. King refutes this by saying that there were two issues that were prevalent before the GFC:
- Low interest rates around the world led to rising asset prices and trading looked very profitable.
- Leverage of the banking system rose very sharply – Leverage, meaning the ratio of the bank’s own money to the money it borrows in the form deposits or short-term loans.
Central banks exist to be lenders of last resort. Problem: Too big to fail. And that’s what began happening in England, just like America, in the ’80s and ’90s. There needs to be something much more robust and much more simple to prevent the same problem from happening again. King makes two proposals:
- Banks insure themselves against catastrophe by making enough safe, secure loans so they have assets of real value to pledge to the Central Bank if they need a cash infusion in a hurry.
- Force the banks to keep enough cash on hand to cover loans gone bad as during the crisis banks didn’t have enough equity finance to absorb losses without defaulting on the loans which banks have taken out, whether from other bits of the financial sector or from you and I as depositors.
He finally states that the Brexit vote doesn’t make any significant difference to the risks facing the global banking system. There were and are significant risks in that system because of the potential fragility of our banks, and because of the state of the world economy.
Low oil prices fuel debt worries
Below is a video clip from the FT outling the reasons for the debt build up in the energy industry which is making investors nervous. Fracking has been partly responsible for the increase in oil output in the US by 400m barrels a day between 2010-2015. It was encouraged by high oil prices and also meant the sector took on a lot more debt – assuming that oil prices would stay above $100 a barrel. However as oil prices collapsed to around $30 a barrel oil extraction companies are finding it increasingly difficult to service their debt. Worth a look and with some very informative graphs.
How much wriggle room do countries have?
The Economist has devised a composite measure of interest rates, deficits and debt which are mechanism that tend to be used by a country’s policymakers to cope with a recession.
They assign a value of 100 which is maximum wriggling room – that is interest rates that are 10% or above. A value of 0 means there is no room to drop interest rates i.e. interest rate are 0%.
They assign a value of 100 to those countries that have budget surplus of 5% of GDP or above. A value of 0 is given to deficits of 15% of GDP or more.
They assign 100 to a country that, in the IMF’s view, can borrow a further 250% of GDP or more and 0 to those, including Greece, Italy and Japan, that it judges to be testing markets’ faith.
The chart below shows how countries rank. Norway, South Korea and Australia are top and have all kept their interest well clear of 0% and have very low debt levels. On average the rich world’s wriggle room has fallen by about a third since 2007. The leeway of hard-pressed countries such as Italy and Spain has shrunk by nearly half.