One of the structural problems facing the UK economy is that people have been borrowing too much and saving too little. As a result, vast numbers of people have been living on credit and accumulating large debts, and many people have little in the way of savings when they retire.
So should the government or Bank of England be encouraging people to save? Not according to Charles Bean, Deputy Governor of the Bank of England – at least not in the short term. While acknowledging that people should be saving more over the long term, he argues that the main purpose of the historically low Bank Rate since the beginning of 2009 has been to encourage people to spend, thereby boosting the economy. In other words, if the purpose of a loose monetary policy is to increase aggregate demand and stimulate the economy, then what is needed is increased consumption and reduced saving, not increased saving.
In the following webcast, Charles Bean gives his views about interest rates and counters the criticism that savers are being pid too little interest. He argues that for many the solution is to start drawing on some of their capital – not a solution that most savers find very appealing!
Webcast
Bank of England: savers should eat into cash Channel 4 News, Faisal Islam (27/9/10)
Articles
Savers told to stop moaning and start spending Telegraph, Robert Winnett and Myra Butterworth (28/9/10)
Bean Says Bank of England Trying to Get Reasonable Economic Activity Level Bloomberg, Scott Hamilton and Gonzalo Vina (27/9/10)
Spend, spend, spend, demands Bank of England deputy governor Investment & Business News , Tom Harris (28/9/10)
Data
International saving data (see Table 23) Economic Outlook, OECD
AMECO on line (see tables in section 15.3) AMECO, Economic and Financial Affairs (European Commission)
Economic and Labour Market Review (see Table 1.07) National Statistics
Questions
- What is meant by the ‘paradox of thrift’?
- Reconcile the argument that it is in the long-term interests of the UK economy for people to save more with the Bank of England’s current intention that people should save less?
- Is there a parallel argument about fiscal policy and government spending (see the news item The ‘paradox of cuts’?)
- What are the determinants of saving?
- Look at the data links above and compare the UK’s saving rate with that of other countries.
- What has happened to the UK saving rate over the past four years? Attempt an explanation of this.
Most people, when asked, would like to earn more and many people are prepared to make sacrifices to do so. They may devote considerable time to obtaining qualifications; work much harder in order to gain promotion; work longer hours. What is more, when people do earn more, they take on extra commitments: a bigger house with a bigger mortgage; sending their kids to a private school; getting used to a more luxurious lifestyle. In fact, many people have to spend more on things such as home help, convenience foods and all sorts of labour-saving devices in order to cope with their longer hours.
Some people get so fed up with this pressurised lifestyle that they say ‘enough is enough; let me off this merry-go-round’. They may be happy to take a cut in income to live a simpler life and have more leisure time. Others, however, find that the merry-go-round just keeps going faster and faster and that they cannot get off; except, perhaps, if they make themselves ill, or worse still, die!
Now, if you are struggling as a student to make ends meet and find your debts are inexorably mounting, you may have little sympathy for people earning six-figure salaries! But are you in danger of trying to achieve this lifestyle for yourself? Do you see the main goal of your degree as getting you a better-paid job? What would count as ‘rational behaviour’ here and what would an economist advise you to do?
Then there is the question of whether the high paid are worth their high salaries. Are these salaries a reflection of the value of their output and the sacrifices they make? Or do they reflect economic power, custom and practice or asymmetry of information? And what do we mean by ‘worth’?
The following articles look at some of the highest paid people in the public sector. Some 38,000 public-sector employees earn more than £100,000. In the private sector the figures are much higher: some 545,000 people.
Articles
The perils of earning a £100,000 salary BBC News Magazine, Jon Kelly (22/9/10)
Ranking the pay packets of the public sector’s top dogs BBC Panorama programme, Vivian White (19/9/10)
Public Sector pay: The numbers BBC News (20/9/10)
Over 9,000 in public sector earn more than David Cameron, survey claims Guardian, Nicholas Watt (19/9/10)
On the inequality myth The Economist blogs (20/9/10)
Data
Portal to Annual survey of hours and earnings (ASHE) Office for national Statistics
Family Spending – A report on the 2008 Living Costs and Food Survey (see Chapter 3) Office for national Statistics
Income inequality Office for national Statistics (10/6/10)
The effects of taxes and benefits on household income, 2008/09 Statistical Bulletin (ONS) (10/6/10)
Data: The effects of taxes and benefits on household income, 2008/09 Office for national Statistics
Questions
- Use Gini coefficients to examine what has happened to income distribution in the UK in recent years.
- Are high-paid earners ‘worth’ what they are paid? How would set about establishing what they are worth?
- Is it rational to seek a higher paid job if it involves longer hours and more stress? Why may it be difficult to make a ‘rational’ decision?
- Should the Prime Minister be the highest paid public-sector employee? Explain your answer.
- What factors will you take into account when deciding what jobs to apply for?
- To what extent can imperfect information explain people’s choices about work-life balance?
- To what extent can marginal productivity explain the huge salaries and bonuses paid to top executives in both the public and the private sectors?
The price of gold has hit a record high of over $1282 per ounce. By contrast, in 2007 it was trading at under $700 per ounce and in 2001 at under $300 per ounce. Various uncertainties in the world economy have led to large rises in the demand for gold by both central banks and investors in general.
But why has the gold price risen so dramatically and what is likely to happen to the price in the coming days and months? Some commentators are saying that the gold price has further to rise. Others are saying that it is already over priced! The following articles look at the explanations and the arguments.
Articles
Monetary easing fears lift gold to record high Financial Times, Javier Blas (17/9/10)
Five-fold rise in gold price ‘is not a bubble’, claims industry body Independent on Sunday, Mark Leftly (19/9/10)
Gold Prices Today Are Increasing to Record Levels Business and Finance News, Aidan Lamar (18/9/10)
Gold hits new peak of $1,283 Telegraph, Richard Evans (17/9/10)
Gold hits new record high Guardian, Julia Kollewe (17/9/10)
Gold prices – the highs and lows since 1971 Guardian, Julia Kollewe (17/9/10)
Gold is overpriced, so be wary of those ads to buy it Idaho Statesman, Peter Crabb (17/9/10)
Data
Gold prices World Gold Council
Commodity price data (including gold) BBC Business: Commodities
Questions
- Why has the price of gold risen? Illustrate your arguments with a demand and supply diagram.
- How are these demand and supply factors likely to change in the near future?
- What is the role of speculation in the determination of the gold price? What particular factors are speculators taking into account at the moment?
- Why have actions by the Bank of Japan (see A Japanese yen for recovery) influenced the gold price?
- Why have possible future actions by the US Federal Reserve Bank influenced the gold price?
Rising costs of cloth and a rise in VAT could mean that clothes prices are set to rise. Does this spell the end of cheap fashion from the likes of Primark and H&M? Or can they absorb the cost increases?
The following articles look at the causes of the rise in costs of clothing and what the cheap fashion chains can do about it.
Articles
Primark follows fashion rivals as it warns of rising costs Guardian, David Teather and Zoe Wood (13/9/10)
Primark warns on costs as growth slows Telegraph, James Hall (14/9/10)
Is this the end of cheap clothes era? Price of cotton has rocketed because of floods, Primark warns Mail Online, Sean Poulter (14/9/10)
Fashion chains far from cheerful about future of cheap chic Observer, Zoe Wood, David Teather and Julia Finch (19/9/10)
Data
Commodity prices (including cotton) Index Mundi
Cotton futures BBC Business: Commodities
Questions
- Why have cotton prices been rising? Illustrate your arguments with a demand and supply diagram.
- Would you expect a rise in the price of cotton of 45% to lead to a rise in the price of cotton clothes of 45%, or of more than 45% or of less than 45%? Explain.
- For what other reasons are the prices of clothing rising?
- How did the process of globalisation keep the price of clothing down?
- Next’s chief executive, Lord (Simon) Wolfson said that if prices of Next’s clothes go up 8% then the number of units sold will fall by 10%. What is the value of the price elasticity of demand that he is assuming?
- Why is the ‘Fairtrade system so important’?
- “Some retailers have already increased prices but there is more to come. The products most under threat are T-shirts, underwear and socks. More complicated garments such as heavy jeans will be less affected.” Why are the prices of more complicated garments likely to rise by a smaller percentage than those of simple garments?
- What has been happening to the demand for cheap fashion clothing and why? Combine this effect with those of costs on a demand and supply diagram.
- What type of market structure is the market for fashion clothing? What are the implications of this for the profits of retailers?
Under the Basel II arrangements, banks were required to maintain particular capital adequacy ratios (CARs). These were to ensure that banks had sufficient capital to allow them to meet all demands from depositors and to cover losses if a borrower defaulted on payment. Basel II, it was (wrongly) thought would ensure that the banking system could not collapse.
There were three key ratios. The first was an overall minimum CAR of 8%, measured as Tier 1 capital plus Tier 2 capital as a percentage of total risk-weighted assets. As Economics 7th edition page 509 explains:
Tier 1 capital includes bank reserves (from retained profits) and ordinary share capital, where dividends to shareholders vary with the amount of profit the bank makes. Such capital thus places no burden on banks in times of losses as no dividend need be paid. What is more, unlike depositors, shareholders cannot ask for their money back. Tier 2 capital consists largely of preference shares. These pay a fixed rate of interest and thus do continue to place a burden on the bank even when losses are made (unless the bank goes out of business).
Risk-weighted assets are the value of assets, where each type of asset is multiplied by a risk factor. Under the internationally agreed Basel II accord, cash and government bonds have a risk factor of zero and are thus not included. Inter-bank lending between the major banks has a risk factor of 0.2 and is thus included at only 20 per cent of its value; residential mortgages have a risk factor of 0.35; personal loans, credit-card debt and overdrafts have a risk factor of 1; loans to companies carry a risk factor of 0.2, 0.5, 1 or 1.5, depending on the credit rating of the company. Thus the greater the average risk factor of a bank’s assets, the greater will be the value of its risk weighted assets, and the lower will be its CAR.
The second CAR was that Tier 1 capital should be at least 4% of risk weighted assets.
The third CAR was that equity capital (i.e. money raised from the issue of ordinary shares) should be at least 2% of risk weighted assets. This is known as the ‘core capital ratio’.
Before 2008, it was thought by most commentators that these capital adequacy ratios were sufficiently high. But then the banking crisis erupted. Banks were too exposed to sub-prime debt (i.e. debt that was excessively risky, such as mortgages on property at a time when property prices were rapidly declining). Much of this debt was disguised by being bundled up with other securities in what were known as collateralised debt obligations (CDOs). On 15 September 2008, Lehman Brothers filed for bankruptcy: the largest bankruptcy in history, with Lehmans owing $613 billion. Although its assets had a book value of $639, these were insufficiently liquid to enable Lehmans to meet the demands of its creditors.
The collapse of Lehmans sent shock waves around the world. Banks across the globe came under tremendous pressure. Many held too much sub-prime debt and had insufficient capital to meet creditors’ demands. As a result, they had to be bailed out by their governments. Clearly the Basel II regulations were too lax.
For several months there have been discussions about new tighter regulations and, on 12 September 2010, central bankers from the major countries met in Basel, Switzerland, and agreed the Basel III regulations. Although the overall CAR (Tier 1 and 2) was kept at 8%, the Tier 1 ratio was raised from 4% to 6% and the core Tier 1 ratio was raised from 2% to 4.5%, to be phased in by 2015. In addition there were two ‘buffers’ introduced.
As well as having to maintain a core Tier 1 ratio of 4.5%, banks would also have to hold a ‘conservation buffer’ of 2.5%. “The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. While banks are allowed to draw on the buffer during such periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distributions.” In effect, then, the core Tier 1 ratio will rise from 2% to 7% (i.e. 4.5% minimum plus a buffer of 2.5%).
The other buffer is a ‘countercyclical buffer’. This will be “within a range of 0% – 2.5% of common equity or other fully loss absorbing capital and will be implemented according to national circumstances.” The idea of this buffer is to allow banks to withstand volatility in the global economy. It will be phased in between 2016 and 2019.
The Basel III agreement will still need to be ratified by the G20 countries meeting at Seoul on 10 and 11 November this year. That meeting will also consider other elements of bank regulation.
So will these extra capital requirements be sufficient to allow banks to withstand any future crisis? The following articles discuss this question.
Articles
Global bankers agree new capital reserve rules BBC News (12/9/10)
Q&A: Basel rules on bank capital – who cares? BBC News, Laurence Knight (13/9/10)
Basel III and Sound Banking New American, Charles Scaliger (17/9/10)
Wishy-washy rules might come back to haunt regulators Financial Times, Patrick Jenkins (18/9/10)
Basel III proposal released Newsweek, Joel Schectman (17/9/10)
New Bank Rules May Not Prevent More Meltdowns FXstreet, Henrik Arnt (16/9/10)
Basel III CBS Money Watch, Mark Thoma (14/9/10)
Basel III: To lend or not to lend Investment Week, Martin Morris (16/9/10)
Taming the banks The Economist (16/9/10)
Basel’s buttress The Economist (16/9/10)
Do new bank-capital requirements pose a risk to growth? The Economist, guest contributions
Myners: New rules ‘ignore bank liquidity’ BBC Today Programme, Robert Peston and Lord Myners (18/9/10)
Official press releases and documents
Group of Governors and Heads of Supervision announces higher global minimum capital standards Bank for International Settlements Press Release (12/9/10)
The Basel iii Accord Basel iii Compliance Professionals Association (BiiiCPA)
Details of the new capital requirements Bank for International Settlements
Details of the phase-in arrangements Bank for International Settlements
Questions
- What impact will a higher capital adequacy ratio have on banks’ behaviour?
- For what reasons may the Basel III regulations be considered too lax?
- When there is an increase in deposits into the banking sector, banks can increase loans by a multiple of this. This bank deposits multiplier is the inverse of the liquidity ratio. Is there a similar bank capital multiplier and, if so, what determines its size?
- Why will Basel III be phased in over a number of years? Is this too long?