Economic growth is closely linked to investment. In the short term, there is a demand-side effect: higher investment, by increasing aggregate demand, creates a multiplier effect. GDP rises and unemployment falls. Over the longer term, higher net investment causes a supply-side effect: industrial capacity and potential output rise. This will be from both the greater quantity of capital and, if new investment incorporates superior technology, from a greater productivity of capital.
One of the biggest determinants of investment is certainty about the future: certainty allows businesses to plan investment. Uncertainty, by contrast, is likely to dampen investment. Investment is for future output and if the future is unknown, why undertake costly investment? After all, the cost of investment is generally recouped over several months or year, not immediately. Uncertainty thus increases the risks of investment.
There is currently great uncertainty in the USA and its trading partners. The frequent changes in policy by President Trump are causing a fall in confidence and consequently a fall in investment. The past few weeks have seen large cuts in US government expenditure as his administration seeks to dismantle the current structure of government. The businesses supplying federal agencies thus face great uncertainty about future contracts. Laid-off workers will be forced to cut their spending, which will have knock-on effect on business, who will cut employment and investment as the multiplier and accelerator work through.
There are also worries that the economic chaos caused by President Trump’s frequent policy changes will cause inflation to rise. Higher inflation will prompt the Federal Reserve to raise interest rates. This, in turn, will increase the cost of borrowing for investment.
Tariff uncertainty
Perhaps the biggest uncertainty for business concerns the imposition of tariffs. Many US businesses rely on imports of raw materials, components, equipment, etc. Imposing tariffs on imports raises business costs. But this will vary from firm to firm, depending on the proportion of their inputs that are imported. And even when the inputs are from other US companies, those companies may rely on imports and thus be forced to raise prices to their customers. And if, in retaliation, other countries impose tariffs on US goods, this will affect US exporters and discourage them from investing.
For many multinational companies, whether based in the USA or elsewhere, supply chains involve many countries. New tariffs will force them to rethink which suppliers to use and where to locate production. The resulting uncertainty can cause them to delay or cancel investments.
Uncertainty has also been caused by the frequent changes in the planned level of tariffs. With the Trump administration using tariffs as a threat to get trading partners to change policy, the threatened tariff rates have varied depending on how trading partners have responded. There has also been uncertainty on just how the tariff policy will be implemented, making it more difficult for businesses to estimate the effect on them.
Then there are serious issues for the longer term. Other countries will be less willing to sign trade deals with the USA if they will not be honoured. Countries may increasingly look to diverting trade from the USA to other countries.
Video
Articles
- Trump’s erratic trade policies are baffling businesses, threatening investment and economic growth
Associated Press, Paul Wiseman, Anne D’innocenzio and Mae Anderson (6/3/25)
- The world is beginning to tire of Trump’s whiplash leadership
CNN, Stephen Collinson (6/3/25)
- US stocks slide and Nasdaq enters correction as chaos over Trump’s tariffs intensifies
CNN, John Towfighi (6/3/25)
- Trump’s Tariffs And Trade: Uncertainty, Chaos Or Brilliance?
Forbes, Mike Patton (6/3/25)
- How Trump’s second term might affect the market and your finances
The Conversation, Art Durnev (4/3/25)
- US corporate bond investors cautiously navigate trade war uncertainty
Reuters, Matt Tracy (6/3/25)
This week in Trumponomics: Playing chicken with marketsYahoo Finance, Rick Newman (8/3/25)
- Measuring fear: What the VIX reveals about market uncertainty
The FRED Blog, Aakash Kalyani (13/2/25)
- Trump shrugs off stock market slump, but economic warning signs loom
The Conversation, Conor O’Kane (17/3/25)
Data
Questions
- Find out what tariffs have been proposed, imposed and changed since Donald Trump came to office on 20 January 2025.
- In what scenario might US investment be stimulated by Donald Trump’s policies?
- What countries’ economies have gained or are set to gain from Donald Trump’s policies?
- What is the USMCA agreement? Do Donald Trump’s policies break this agreement?
- Find out and explain what has happened to the US stock market since January 2025. How do share prices affect business investment?
- Which sector’s shares have risen and which have fallen?
- Using the Data link above, find out what has been happening to the US Policy Uncertainty Index since Donald Trump was elected and explain particular spikes in the index. Is this mirrored in the global Policy Uncertainty Index?
- Are changes in the Policy Uncertainty Index mirrored in the World Uncertainty Index (WUI) and the CBOE Volatility Index: VIX?
On the day he came to office, President Trump signed a series of executive orders. One of these was to set in motion the process of withdrawing from the UN Paris climate agreement. Section 3(a) of the order reads:
The United States Ambassador to the United Nations shall immediately submit formal written notification of the United States’ withdrawal from the Paris Agreement under the United Nations Framework Convention on Climate Change.
The Paris Agreement is an international treaty on climate change. It was adopted on 12 December 2015 and came into force on 4 November 2016, 30 days after the point was reached when at least 55 countries accounting for at least 55% of global emissions had ratified the treaty.
Currently, all UN countries are signatories to the agreement and only Iran, Libya and Yemen are yet to ratify it. The agreement commits countries to limiting global warming to well under 2°C above pre-industrial levels and preferably to no more than 1.5°C. This would involve reducing greenhouse gas emissions and/or taking carbon absorbing measures.
Since 2020, each country has been required to submit its own emission-reduction targets, known as ‘nationally determined contributions’ (NDCs), and the actions it will take to meet them. Every five years each country must submit a new NDC more ambitious than the last.
Rich countries are expected to provide finance to low-income countries. This is required to help poor countries adopt green technologies and to adapt to the harmful effects of climate change (e.g. through irrigation schemes and flood defences).
Countries set target dates by which emissions would be fully offset by carbon absorption measures (‘net zero’). The UN’s goal is to reach global net zero by 2050. According to the UN Climate Action site:
As of June 2024, 107 countries, responsible for approximately 82 per cent of global greenhouse gas emissions, had adopted net-zero pledges either in law, in a policy document such as an national climate action plan or a long-term strategy, or in an announcement by a high-level government official. More than 9000 companies, over 1000 cities, more than 1000 educational institutions, and over 600 financial institutions have joined the Race to Zero, pledging to take rigorous, immediate action to halve global emissions by 2030.
The Paris Agreement has helped to cut emissions or slow their rate of growth in most countries. Although net zero by 2050 may be unlikely, warming will be less than without the agreement.
The USA and the Paris Agreement
In April 2016 the USA signed the Paris Agreement. As stated above, the Paris Agreement came into effect on 4 November 2016.
President Trump came to office for the first time in January 2017. In June 2017, he signed an executive order in which he announced that the USA would withdraw from the agreement, arguing that it undermined the US economy and put it at a competitive disadvantage. He claimed that global warming is a hoax concocted by China designed to undermine the competitive power of the USA.
However, despite Trump’s intention to withdraw from the agreement, its terms did not allow a country to begin a withdrawal procedure for at least three years after the agreement was ratified (i.e. not before 4 November 2019) and then a year’s notice has to be given. This notice was given on 4 November 2019. In the meantime, the USA had to abide by the terms of the treaty. During this period, US representatives at COP meetings used the opportunity to promote fossil fuels. Withdrawal took place on 1 November 2020, just one day after the presidential election and just over two months before the end of Trump’s first term of office.
On 20 January 2021, his first day in office, President Biden signed an executive order to rejoin the agreement, which took place on 19 February 2021. He committed to cutting total greenhouse gas emissions by at least 50% by 2030. To achieve this, his administration adopted a number of emissions-reducing measures, for example requiring all new passenger vehicles sold after 2035 to be emissions free, giving tax credits for clean electricity generation, providing federal funds for smart agriculture and setting greener appliance and equipment standards.
But, as we have seen, newly elected President Trump for the second time announced that the USA would withdraw from the Paris agreement and would prioritise fossil fuel production, under the mantra, ‘drill, baby, drill’.
The economics of climate change
Climate change is directly caused by market failures. One of the most important of these is that the atmosphere is a common resource: it is not privately owned; it is a global ‘commons’. Individuals and firms use it at a zero price. If the price of any good or service to the user is zero, there is no incentive to economise on its use. Thus for the emitter there are no private costs of using the atmosphere in this way as a ‘dump’ for their emissions and, in a free market, no incentive to reduce the climate costs.
And yet when firms emit greenhouse gases into the atmosphere there are costs to other people. To the extent that they contribute to global warming, part of these costs will be borne by the residents of that country; but a large part will be borne by inhabitants of other countries.
These climate costs are external costs to the firm and are illustrated in the figure. It shows an industry that emits CO2. To keep the analysis simple, assume that it is a perfectly competitive industry with demand and supply given by curves D and S, which are equal to the marginal private benefits (MPB) and marginal private costs (MPC), respectively. There are no externalities on the demand side and hence MPB equals the marginal social cost (MSB). Market equilibrium is at point a, with output at Qpc and price at Ppc. (Click here for a PowerPoint.)
Assume that the emissions create a marginal cost to society equal to MECc. Assume that the MEC increases as output and total emissions increase. The MECc line is thus upward sloping. At the market price of Qpc, these external climate costs are equal to the purple vertical line. When these external climate costs are added to private costs, this gives a marginal social cost given by MSC = MPC + MECc. The gives a socially optimal level of output of the product of Q* at a price of P*, with the optimum point of c.
In other words, other things being equal, the free market overproduces products with climate externalities. If the output is to be reduced to the social optimum of Q*, then the government will need to take measures such as those advocated in the Paris Agreement. These could include imposing taxes on products, such as electricity generated by fossil fuels, or on the emissions themselves. Or green alternatives, such as wind power, could be subsidised.
Alternatively, regulations could be used to cap the production of products creating emissions, or caps on the emissions themselves could be imposed. Emissions permits could be issued or auctioned. Only firms in possession of the permits would be allowed to emit and the permits would cap emissions below free-market levels. These permits could be traded under a cap-and-trade scheme, such as the EU’s Emissions Trading Scheme. Again, such schemes are advocated under the Paris Agreement.
Effect of the USA’s withdrawal from the Paris Agreement
Withdrawal from the Paris Agreement and promoting fossil fuels will increase US emissions. Scientific consensus is that this will have a negative effect on climate change. Only part of these climate costs will be borne by the USA, although the severity of recent fires in California, fanned by strong Santa Ana winds, and more violent hurricanes are two examples of costs of climate change to the USA itself.
A bigger worry is whether the USA’s withdrawal will encourage other countries, such as Argentina, to do likewise. Then the climate costs of US withdrawal will be greater.
But all is not bad news. The transition to green energy is well advanced and the costs of solar and wind power are decreasing. Global investment in clean energy has increased by 60% since 2015. China is investing heavily in renewable energy technology, which is giving it a significant trade advantage. The EU has taken significant actions to promote green energy and technology. Similarly, industrial processes that economise on emissions are developing apace and it is becoming increasingly profitable for private companies to make climate-friendly investments without subsidies. In the USA itself, many Democratic states and local governments, and even some Republican ones, will continue to adopt climate-friendly policies.
In this environment, the Trump administration does not want to fall behind in the development of new technologies and markets. And with Elon Musk having a significant influence on Donald Trump, the USA’s investment in EVs and battery technology is likely to continue. This will help to reduce the price of green energy and transport.
Videos
Articles
- Trump vows to leave Paris climate agreement and ‘drill, baby, drill’
BBC News, Matt McGrath (20/1/25)
- What is the Paris climate agreement and why has Trump withdrawn?
BBC News, Esme Stallard and Mark Poynting (21/1/25)
- Six Trump executive orders to watch
BBC News (21/1/25)
- The real message behind Trump’s withdrawal of US from the Paris climate agreement
Sky News, Tom Clarke (21/1/25)
- Trump signs order to withdraw US from Paris climate agreement for second time
The Guardian, Dharna Noor (20/1/25)
- Explained: how Trump’s day one orders reveal a White House for big oi
The Guardian, Oliver Milman and Dharna Noor (22/1/25)
- Donald Trump can’t stop global climate action. If we stick together, it’s the US that will lose out
The Guardian, Bill Hare (6/11/24)
- Trump to pull US from Paris climate agreement: What could this mean for the environment?
ITV News, Martin Stew (21/1/25)
- 10 reasons why US president-elect Donald Trump can’t derail global climate action
The Conversation, Wesley Morgan and Ben Newell (8/11/24)
- Trump has rejected the Paris agreement again, but game theory shows how other countries can still lead by example
The Conversation, Renaud Foucart (27/1/25)
Information
Questions
- Summarise the Paris Agreement.
- Using a diagram similar to that above, illustrate how the free market will produce a sub-optimal amount of solar power because the marginal social benefit exceeds the marginal private benefit.
- How might game theory be used to analyse possible international decision making in the context of US climate policy?
- Is it in America’s interests to cease investing in green energy and green production methods?
- Go through each of the reasons (not specific to Australia) given in The Conversation article linked above why ‘Donald Trump can’t derail global climate action’. To what extent do you agree with each one?
In an interview with Joe Rogan for his podcast, The Joe Rogan Experience, just before the US election, Donald Trump stated that, “To me, the most beautiful word – and I’ve said this for the last couple of weeks – in the dictionary today and any is the word ‘tariff’. It’s more beautiful than love; it’s more beautiful than anything. It’s the most beautiful word. This country can become rich with the use, the proper use of tariffs.”
President-elect Trump has stated that he will impose tariffs on imports of 10% or 20%, with 60% and 100% tariffs on imports from China and Mexico, respectively. This protection for US industries, combined with lighter regulation, will, he claims, provide a stimulus to the economy and help create jobs. The revenues will also help to reduce America’s budget deficit.
But it is not that straightforward.
Problems with tariffs for the USA
Imposing tariffs is likely to reduce international trade. But international trade brings net benefits, which are distributed between the participants according to the terms of trade. This is the law of comparative advantage.
In the simple two-country case, the law states that, provided the opportunity costs of producing various goods differ between the two countries, both of them can gain from mutual trade if they specialise in producing (and exporting) those goods that have relatively low opportunity costs compared with the other country. The total production and consumption of the two countries will be higher.
So if the USA has a comparative advantage in various manufactured products and a trading partner has a comparative advantage in tropical food products, such as coffee or bananas, both can gain by specialisation and trade.
If tariffs are imposed and trade is thereby reduced between the USA and its trading partners, there will be a net loss, as production will switch from lower-cost production to higher-cost production. The higher costs of less efficient production in the USA will lead to higher prices for those goods than if they were imported.
At the same time, goods that are still imported will be more expensive as the price will include the tariff. Some of this may be borne by the importer, meaning that only part of the tariff is passed on to the consumer. The incidence of the tariff between consumer and importer will depend on price elasticities of demand and supply. Nevertheless, imports will still be more expensive, allowing the domestically-produced substitutes to rise in price too, albeit probably by not so much. According to work by Kimberly Clausing and Mary E Lovely for the Peterson Institute (see link in Articles below), Trump’s proposals to raise tariffs would cost the typical American household over $2600 a year.
The net effect will be a rise in inflation – at least temporarily. Yet one of Donald Trump’s pledges is to reduce inflation. Higher inflation will, in turn, encourage the Fed to raise interest rates, which will dampen investment and economic growth.
Donald Trump tends to behave transactionally rather than ideologically. He is probably hoping that a rapid introduction of tariffs will then give the USA a strong bargaining position with foreign countries to trade more fairly. He is also hoping that protecting US industries by the use of tariffs, especially when coupled with deregulation, will encourage greater investment and thereby faster growth.
Much will depend on how other countries respond. If they respond by raising tariffs on US exports, any gain to industries from protection from imports will be offset by a loss to exporters.
A trade war, with higher tariffs, will lead to a net loss in global GDP. It is a negative sum game. In such a ‘game’, it is possible for one ‘player’ (country) to gain, but the loss to the other players (countries) will be greater than that gain.
Donald Trump is hoping that by ‘winning’ such a game, the USA could still come out better off. But the gain from higher investment, output and employment in the protected industries would have to outweigh the losses to exporting industries and from higher import prices.
The first Trump administration (2017–21), as part of its ‘America First’ programme, imposed large-scale tariffs on Chinese imports and on steel and aluminium from across the world. There was wide-scale retaliation by other countries with tariffs imposed on a range of US exports. There was a net loss to world income, including US GDP.
Problems with US tariffs for the rest of the world
The imposition of tariffs by the USA will have considerable effects on other countries. The higher the tariffs and the more that countries rely on exports to the USA, the bigger will the effect be. China and Mexico are likely to be the biggest losers as they face the highest tariffs and the USA is a major customer. In 2023, US imports from China were worth $427bn, while US exports to China were worth just $148bn – only 34.6% of the value of imports. The percentage is estimated to be even lower for 2024 at around 32%. In 2023, China’s exports to the USA accounted for 12.6% of its total exports; Mexico’s exports to the USA accounted for 82.7% of its total exports.
It is possible that higher tariffs could be extended beyond China to other Asian countries, such as Vietnam, South Korea, Taiwan, India and Indonesia. These countries typically run trade surpluses with the USA. Also, many of the products from these countries include Chinese components.
As far as the UK is concerned, the proposed tariffs would cause significant falls in trade. According to research by Nicolò Tamberi at the University of Sussex (see link below in Articles):
The UK’s exports to the world could fall by £22 billion (–2.6%) and imports by £1.4 (–0.16%), with significant variations across sectors. Some sectors, like fishing and petroleum, are particularly hard-hit due to their high sensitivity to tariff changes, while others, such as textiles, benefit from trade diversion as the US shifts demand away from China.
Other badly affected sectors would include mining, pharmaceuticals, finance and insurance, and business services. The overall effect, according to the research, would be to reduce UK output by just under 1%.
Countries are likely to respond to US tariffs by imposing their own tariffs on US imports. World Trade Organization rules permit the use of retaliatory tariffs equivalent to those imposed by the USA. The more aggressive the resulting trade war, the bigger would be the fall in world trade and GDP.
The EU is planning to negotiate with Trump to avoid a trade war, but officials are preparing the details of retaliatory measures should the future Trump administration impose the threatened tariffs. The EU response is likely to be strong.
Articles
- The Most Beautiful Word In The Dictionary: Tariffs
YouTube, Joe Rogan and Donald Trump
- The exact thing that helped Trump win could become a big problem for his presidency
CNN, Matt Egan (7/11/24)
- Trump’s New Trade War With China Is Coming
Newsweek, Micah McCartney (9/11/24)
- Trump tariff threat looms large on several Asian countries – not just China – says Goldman Sachs
CNBC, Lee Ying Shan (11/11/24)
- Trump’s bigger tariff proposals would cost the typical American household over $2,600 a year
Peterson Institute for International Economics, Kimberly Clausing and Mary E Lovely (21/8/24)
- More tariffs, less red tape: what Trump will mean for key global industries
The Guardian, Jasper Jolly, Dan Milmo, Jillian Ambrose and Jack Simpson (7/11/24)
- Trump tariffs would halve UK growth and push up prices, says thinktank
The Guardian, Larry Elliott (6/11/24)
- China is trying to fix its economy – Trump could derail those plans
BBC News, João da Silva (8/11/24)
- Trump tariffs could cost UK £22bn of exports
BBC News, Faisal Islam & Tom Espiner (8/11/24)
- Trump to target EU over UK in trade war as he wants to see ‘successful Brexit’, former staffer claims
Independent, Millie Cooke (11/11/24)
- EU’s trade war nightmare gets real as Trump triumphs
Politico, Camille Gijs (6/11/24)
- Will Trump impose his tariffs? They could reduce the UK’s exports by £22 billion.
Centre for Inclusive Trade Policy, University of Sussex, Nicolò Tamberi (8/11/24)
- Three possible futures for the global economy if Trump brings in new trade tariffs
The Conversation, Agelos Delis and Sami Bensassi (17/12/24)
Questions
- Explain why, according to the law of comparative advantage, all countries can gain from trade.
- In what ways may the imposition of tariffs benefit particular sections of an economy?
- Is it in countries’ interests to retaliate if the USA imposes tariffs on their exports to the USA?
- Why is a trade war a ‘negative sum game’?
- Should the UK align with the EU in resisting President-elect Trump’s trade policy or should it seek independently to make a free-trade deal with the USA? is it possible to do both?
- What should China do in response to US threats to impose tariffs of 60% or more on Chinese imports to the USA?
In many countries, train fares at peak times are higher than at off-peak times. This is an example of third-degree price discrimination. Assuming that peak-time travellers generally have a lower price elasticity of demand, the policy allows train companies to increase revenue and profit.
If the sole purpose of ticket sales were to maximise profits, the policy would make sense. Assuming that higher peak-time fares were carefully set, although the number travelling would be somewhat reduced, this would be more than compensated for by the higher revenue per passenger.
But there are external benefits from train travel. Compared with travel by car, there are lower carbon emissions per person travelling. Also, train travel helps to reduce road congestion. To the extent that higher peak-time fares encourage people to travel by car instead, there will be resulting environmental and congestion externalities.
The Scottish experiment with abolishing higher peak-time fares
In October 2023, the Scottish government introduced a pilot scheme abolishing peak-time fares, so that tickets were the same price at any time of the day. The idea was to encourage people, especially commuters, to adopt more sustainable means of transport. Although the price elasticity of demand for commuting is very low, the hope was that the cross-price elasticity between cars and trains would be sufficiently high to encourage many people to switch from driving to taking the train.
One concern with scrapping peak-time fares is that trains would not have the capacity to cope with the extra passengers. Indeed, one of the arguments for higher peak-time fares is to smooth out the flow of passengers during the day, encouraging those with flexibility of when to travel to use the cheaper and less crowded off-peak trains.
This may well apply to certain parts of the UK, but in the case of Scotland it was felt that there would be the capacity to cope with the extra demand at peak time. Also, in a post-COVID world, with more people working flexibly, there was less need for many people to travel at peak times than previously.
Reinstatement of peak-time fares in Scotland
It was with some dismay, therefore, especially by commuters and environmentalists, when the Scottish government decided to end the pilot at the beginning of October 2024 and reinstate peak-time fares – in many cases at nearly double the off-peak rates. For example, the return fare between Glasgow and Edinburgh rose from £16.20 to £31.40 at peak times.
The Scottish government justified the decision by claiming that passenger numbers had risen by only 6.8%, when, to be self-financing, an increase of 10% would have been required. But this begs the question of whether it was necessary to be self-financing when the justification was partly environmental. Also, the 6.8% figure is based on a number of assumptions that could be challenged (see The Conversation article linked below). A longer pilot would have helped to clarify demand.
Other schemes
A number of countries have introduced schemes to encourage greater use of the railways or other forms of public transport. One of these is the flat fare for local journeys. Provided that this is lower than previously, it can encourage people to use public transport and leave their car at home. Also, its simplicity is also likely to be attractive to passengers. For example, in England bus fares are capped at £2. Currently, the scheme is set to run until 31 December 2024.
Another scheme is the subscription model, whereby people pay a flat fee per month (or week or year, or other time period) for train or bus travel or both. Germany, for example, has a flat-rate €49 per month ‘Deutschland-Ticket‘ (rising to €58 per month in January 2025). This ticket provides unlimited access to local and regional public transport in Germany, including trains, buses, trams, metros and ferries (but not long-distance trains). This zero marginal fare cost of a journey encourages passengers to use public transport. The only marginal costs they will face will be ancillary costs, such as getting to and from the train station or bus stop and having to travel at a specific time.
Articles
- Why a pilot scheme removing peak rail fares should have been allowed to go the distance
The Conversation, Rachel Scarfe (8/10/24)
- Return of peak rail fares a costly blow for commuters and climate, Scottish Greens say
Bright Green, Chris Jarvis (6/10/24)
- Commuters react to return of peak train fares in Scotland
BBC News (1/10/24)
- Perth peak rail fares to Edinburgh rise by almost 60 percent as pilot scheme ends
Daily Record, Alastair McNeill (4/10/24)
- Ditch peak-time rail fares across UK, campaigners say
iNews, Adam Forrest (30/9/24)
- Train fares reduced by up to 20% in East Yorkshire
Rail Advent, Roger Smith (26/9/24)
- Deutschland-Ticket: Germany’s popular monthly transport pass will soon be more expensive
Euronews, Angela Symons (24/9/24)
- Fare Britannia: a new approach to public transport ticketing for the UK
Greenpeace report, Leo Eyles, Tony Duckenfield and Jim Steer (19/9/24)
- Ministers urged to trial monthly ‘climate card’ in North of England to save rail commuters money and cut emissions
About Manchester, Nigel Barlow (20/9/24)
Questions
- Identify the arguments for and against having higher rail fares at peak times than at off-peak times
- Why might it be a good idea to scrap higher peak-time fares in some parts of a country but not in others?
- Provide a critique of the Scottish government’s arguments for reintroducing higher peak-time fares.
- With reference to The Conversation article, why is it difficult to determine the effect on demand of the Scottish pilot of scrapping peak-time fares?
- What are the arguments for and against the German scheme of having a €49 per month public transport pass for local and regional transport with no further cost per journey? Should it be extended to long-distance trains and coaches?
- In England there is a flat £2 single fare for buses. Would it be a good idea to make bus travel completely free?
Recently, US regulators have decided not to impose further increases in capital requirements on US large and mid-sized banks. The increased requirements, proposed in late 2023, would have been stricter than required under the Bank for International Settlements’ Basel framework1 and provoked a fierce backlash, involving public statements by senior bank executives, aggressive lobbying and extensive media campaigns, including an ad-spot during the Superbowl.
Following bank insolvencies in the USA during 2023, such as Silicon Valley Bank (SVB) and First Republic, which required bailouts from US banking authorities, many commentators argued that the failures were caused by the institutions having insufficient capital to cover losses on their portfolios of US Treasuries. The implication was that banks, particularly mid-sized ones (which were exempt from the Basel framework), needed to have more capital.
US regulators duly responded by proposing what was officially known as ‘the finalisation of Basel III’, but was commonly referred to as ‘the Basel Endgame’. The proposed system-wide reforms involved more conservative calculations of the risk-weighted value of assets such as mortgages, corporate loans and loans to other financial institutions. Further, the proposals also sought to subject banks with $100bn to $250bn of assets to Basel capital adequacy requirements for the first time. Previously they applied only to banks with over $250bn of assets.
The issue focused attention on the capital banks hold to protect against insolvency and provoked discussion about how much of a capital buffer these institutions should have.
Critics argued the changes would lead to significant increases in the capital required to be held by all US banks compared to international rivals and have an adverse effect on their profitability and international competitiveness. Further, critics pointed out that problems at SVB and First Republic were down to confidence issues and it was argued that more capital would not have saved those institutions from insolvency.
This blog examines these issues. It analyses the role of capital in banks and discusses the trade-off that banks face between profitability and security in their activities which underpinned their resistance to the proposed increases. I will also discuss the other trade-off that banks face – between liquidity and profitability – and how liquidity is just as important an influence on bank’s survival in times of crisis.
The role of capital in banks
As with any limited company, a bank’s capital is the difference between total assets and its liabilities. It is the funding provided by long-term investors. These are primarily shareholders, but also long-term debtholders. Bank capital acts as a buffer to prevent insolvency. Capital represents the amount that the value of assets have to fall before the bank is insolvent (value of assets is below liabilities). Higher capital provides a greater buffer. Lower capital provides a smaller buffer.
Capital is uniquely important for commercial banks compared to non-financial companies because of the nature of the assets banks hold – financial securities and loans. Banks are susceptible to losses from financial securities and ‘bad debts’, which are directly reflected in the value of their capital. Further, unlike non-financial companies, the failure of a bank has a significantly negative impact on wider economic activity.
The trade-off between profitability and security
As limited companies, banks face a trade-off between profitability and security in lending. The more profitable a loan, the more risky (less secure) it is likely to be. This creates the potential for the interests of deposit holders and regulators on the one hand and bank executives and shareholders on the other to diverge.
Depositors place their funds with banks and will want the bank to be secure, holding lots of capital to prevent insolvency. However, bank executives and shareholders have a strong incentive to lower the capital buffer, particularly equity, because it produces a higher return for shareholders.
Let’s analyse the implications of different capital buffers on profitability and return, particularly the return to shareholders. A performance measure used to analyse the return to shareholders is Return on Equity (RoE) – the amount of profit each pound of equity capital generates, expressed as a percentage. It is calculated by dividing net profit by equity capital and multiplying by 100.
If a bank has a net profit of £1m and holds £10m of equity capital, the RoE is:
If it has a net profit of £1m and holds £5m of equity capital, the RoE is:
In the first case, the capital buffer generates a 10 per cent RoE. In the second case, the lower capital buffer generates a higher RoE of 20 per cent. This provides a simple illustration of the trade-off banks face. The lower the amount of capital they hold, the higher the return to shareholders but the lower capital buffer, which increases the risk of insolvency.
In different time periods, banks have held varying percentages of capital. For much of the 20th century, banks had capital ratios of around 20 per cent, generating a return on equity of between 5 and 10 per cent. Bank lending was restricted, with shareholders accepting a lower return on equity, while holding a higher amount of capital to cover potential losses from financial assets. Indeed, in the 19th century, banks typically held even more capital, amounting to about 50 per cent of their assets, making bank lending even more restricted.
However, starting from the 1960s, but accelerating during the 1980s, banks began to change their view of the trade-off between profitability and security. This coincided with the liberalisation of credit markets and a greater emphasis on ‘shareholder value’ in business. Average capital ratios fell from over 20 per cent in the 1960s to below 10 per cent in the early 2000s. The return on equity went in the opposite direction. In the 1960s, it was typically between 5 and 10 per cent; by the decade before the 2008 financial crisis it had risen to above 20 per cent. The trade-off had shifted in favour of profitability.
However, the dangers of this shift were exposed during the 2008 financial crisis. The capital held by banks was very thin and not designed to cope with extremely stressful economic circumstances. Banks found they had insufficient capital to cover losses from big decreases in the value of their securitised debt instruments like CDOs (collateralised debt obligations) and struggled to raise additional capital from worried investors.
After the crisis, the Bank of International Settlements (BIS) determined that banks needed to hold sufficient capital, not just to cope with the ebbs and flows of the business cycle but also as a buffer in the rare, yet extremely stressful, economic circumstances that might arise. Therefore, international bank regulations were redrafted under the auspices of the BIS’s Basel Committee. The third version of these regulations is known as ‘Basel III’. It was agreed in 2017, with the measures being phased in from 2022. Basel III significantly raised the capital buffers for large global banks, known as ‘globally systemically-important banks’ (G-SIBs) and the use of stress-tests to model the robustness of banks’ balance sheets to cope with severe economic pressures.
Figure 1 shows the changes to the average return on equity (RoE) and average tier 1 capital ratios for a sample of 10 G-SIBs as a result of Basel III. By 2022, all the banks had capital buffers which were well above the minimum required under Basel III for tier 1 capital – 8.5 per cent. The trade-off was that banks’ average return on equity was much lower – around 8 per cent in 2022, compared to 16 per cent in 2007.
How much capital is enough capital?
Ever since the Basel III agreement, there had been discussions around tightening capital requirements further but no agreement had been reached. One aspect of Basel III was that increased capital was only required of the largest banks. Mid-sized and smaller banks, which are a significant part of the US market, were exempt. The failures of the mid-sized US Silicon Valley Bank (SVB) and First Republic Bank provoked unilateral proposals by the US authorities through the ‘Basel Endgame’. This would raise capital requirements for large banks and extend capital requirements to mid-sized institutions.
But large US banks resisted these proposals, arguing that the authorities were pushing the trade-off too far in favour of security, attempting to make banks very safe but offering a poor return for investors and decreasing the amount of lending banks would conduct.
The furore raises the question as to what is an adequate amount of capital. One reference point is non-financial institutions. These typically hold much more capital relative to the value of total assets – in the range from 30 per cent to 40 per cent. If banks had capital ratios at that level, or even higher, they would be perceived as extremely safe, but might not offer much return to shareholders, impinging on the ability of banks to raise additional capital when they needed it.
Further, other critics argue that there is too much emphasis placed on capital adequacy. Focusing on capital ignores the other significant trade-off banks face in their activities – between liquidity and profitability. Indeed, recent bank failures were not due to insufficient capital but other problems relating to the management of the institution, which led to a loss of confidence by not only by investors, but primarily, deposit-holders.
The other trade-off: liquidity and profitability
While banks have to be solvent, they have to manage their trade-off between liquidity and profitability carefully too. A commercial bank’s basic business model involves maturity transformation – transforming liquid deposits into illiquid assets, such as government bonds and loans, to generate profit. This requires balancing the desire for profitability with the liquidity needs of depositors. If banks get it wrong, then it can lead to a loss of confidence and a ‘run’ on deposits. This is what happened to both Silicon Valley Bank (SVB) and Credit Suisse. The failures of both institutions were not due to insufficient capital but poor liquidity management, which eventually caused a loss of confidence.
Silicon Valley Bank (SVB) demonstrated poor liquidity management, involving a narrow depositor base which was very responsive to changes in interest rates, and an illiquid asset portfolio. During the coronavirus pandemic, tech start-ups received substantial venture capital funding and deposited it with SVB. SVB did not have the capacity or inclination to lend all of the extensive deposits which they were receiving. Instead, the management decided to invest in long-term fixed rate government debt securities. Such securities represented 56 per cent of SVB’s assets in 2020.
Since SVB’s depositors were businesses, unlike retail depositors they were more sensitive to changing interest rates. As rates rose, businesses moved their funds out in search of higher rates, creating a liquidity problem for SVB. The bank was forced to sell $21bn of its long-dated bonds to provide liquidity. However, it endured losses when it sold the bonds as bond prices had fallen, reflecting higher interest rates. Therefore, it needed to raise capital to replace the losses from those sales.
Investors baulked at this, however, particularly when they observed the accelerating deposit outflows. It was the ‘run’ on deposits that was the problem ($42 billion on 8 March 2023 alone), not the unrealised losses on government bonds relative to capital. It was only when the losses were realised that the problem arose. Indeed, Bank of America was in a similar situation with a substantial portfolio of long-term government debt. However, it did not have to realise its ‘paper losses’ since its deposits were more ‘sticky’.
Once confidence is lost and there is a run on deposits, even a bank which has a capital buffer deemed to be more than sufficient is doomed to fail. Take Credit Suisse. It was subject to the Basel framework and had capital ratios similar to its ultimate acquirer UBS. However, it had a risky business culture that pushed the trade-off too much towards profitability. This led to repeated scandals, fines and losses, which caused investors to lose confidence in the institution.
But, once again, it was not the financial losses that was the problem. It was the loss of confidence by depositors. The institution suffered deposit withdrawals of CHF 67 billion in the first three months of 2023. Attempts to stem the outflow with a ‘liquidity backstop’ provided by the Swiss National Bank on 15 March 2023 failed to reassure investors and depositors. Instead, the bank run intensified, with daily withdrawals of demand deposits topping CHF 10bn in the week afterwards. Credit Suisse failed and the Swiss banking regulators quickly forced its acquisition by UBS.
Conclusion
Bank capital is important. After the financial crisis, banks needed to redress the trade-off between profitability and security in lending. However, while the US authorities desire to improve the security of their banking system is laudable, the focus on capital is misplaced. Ever-increasing capital is not the solution to every banking crisis.
Ultimately, banks depend on confidence. Once that confidence is lost, there is little an institution can do to prevent failure. More emphasis needs to be placed on better management of assets and liabilities to maintain sufficient profitability, while at the same time being both liquid and secure. This will maintain confidence, not only by investors, but particularly by deposit-holders.
1 See Economics 11e, section 18.2; Economics for Business 9e, section 28.2; Essentials of Economics 9e, section 11.2.
Articles
- Basel III: The US has started a race to the bottom
Financial Times, Daniel Davies (14/9/24)
- Basel III: What It Is, Capital Requirements, and Implementation
Investopedia, Peter Gratton (22/6/24)
- BofA: dumb, or just unlucky?
Financial Times, Robert Armstrong (30/6/24)
- Why America’s banks need more capital
The Economist (19/10/23)
- The Fed gets ratioed, bank capital edition
Financial Times, Steven Kelly (31/8/23)
- The US pushback against ‘Basel Endgame’
Financial Times, Laura Noonan, Claire Jones and Joshua Franklin (19/3/24)
- SVB is not a canary in the banking gold mine
Financial Times, Robert Armstrong (10/3/23)
- Basel Endgame stumbles at the finish line
The Banker, Farah Khalique (16/7/24)
- Why did Silicon Valley Bank fail?
Economics Observatory, John Turner (17/3/23)
- Why did Credit Suisse fail and what does it mean for banking regulation?
Economics Observatory, Rebecca Stuart (13/4/23)
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Questions
- Explain the role of capital for a commercial bank.
- Research the ‘Basel Endgame’ proposals. Why would US regulators want banks to hold more capital?
- Explain the trade-off between profitability and security that banks face.
- Explain the trade-off between profitability and liquidity that banks face.
- Research Silicon Valley Bank’s failure and trace the ‘run’ on deposits in the bank. Explain why investors baulked at injecting more capital.
- Research Credit Suisse’s demise and trace the ‘run’ on deposits in that bank. Explain why investors baulked at injecting more capital.