The Causes of the Financial Crisis

INTRODUCTION: In a recent editorial (September 8th), the Economist suggested that  the financial crisis of September 2008 will be regarded as one of the defining  events of the early 21st century, alongside 9/11.Hence the importance of knowing  what caused it ten years ago and preventing another similar crisis

For most people, the story  started in August, 2007, when BNP Paribas, a major French bank, stopped customers withdrawing money from three sub-prime, largely US-based mortgage investment funds. (Sub-prime mortgages are those to less financially secure borrowers). By doing this, BNP Paribus was implying that money invested in these funds might not be repaid. Banks rely on borrowing from other banks via the inter-bank market. The BNP action cast doubt on the stability of the banking system and made banks less willing to lend in this market, causing increased interest rates and a lack of liquidity, despite central banks trying to offset this. As the inter-bank market froze, more financial institutions such as TSB, Bradford and Bingley, Lloyds, Alliance & Leicester and HBOS, found themselves in difficulties and confidence among banks fell further. A month later the reality of the crisis reached British high streets when Northern Rock suffered a “bank run” –  the first in the UK for 141 years – after doubts were cast on the BBC over its solvency. It had invested heavily in the sub-prime market and the value of its assets fell as house prices fell in the USA. Then, ten years ago on 15th September, 2008, Lehman Brothers, the fourth largest investment bank in the US collapsed and the world entered the worst financial crisis for decades.

THE CAUSES:

FUNDS SEEKING A HIGH RETURN – An early cause  can be traced back to  the late 1990s when vast quantities of money from Asian countries with large balance of payments surpluses were invested in the USA and Europe, seeking high returns. This increased the supply of money, reduced interest rates and  discouraged saving. It also encouraged banks and other financial institutions to look for areas with a high rate of return, particularly in the booming housing market and to lend to mortgage borrowers. This caused large increases in house and share prices and helped create the asset price bubble which preceded the crisis.

THE RISE OF NEW FINANCIAL PRODUCTS – As the quantity of loans increased, there was a huge expansion of new financial products particularly CDOs (collaterised debt obligations), which were intended to spread risk but ultimately made it worse. They work as follows: imagine a bank makes five loans of $200,000 each to housebuyers at 5%, guaranteed by the value of the houses. It finances this by bundling them together into a bond (called a CDO) and selling it for $1m (5 x $200,000), paying 3%, thus making a profit, and uses the money to lend again. This process is securitisation – transforming a stream of cash payments into an asset.  To understand the concept, think of a butcher taking different types of meat (mortgages), mincing them all together and making sausages (CDOs) from the mixture. In theory, the CDO was safer than individual loans since, if a bank made one loan and it failed, it lost all the money but, with a CDO, where it had a slice of many loans bundled together, one individual loan failing was relatively insignificant. The CDOs were involved in long chains – banks might buy CDOs, then re-bundle them into new CDOs and sell them to other financial institutions who sold them again with borrowed money (sometimes from the original institution) financing many of these transactions, like the butcher then taking the sausages and mixing them together to make different sausages from the mixture.

SUB-PRIME MORTGAGES – A significant component  of the CDOs were sub-prime mortgages  which had increased during the early 2000s since they provided a higher return. Although offered to low-income households, they were regarded as a safe investment since housing markets were booming and if the borrower defaulted, the lender would re-possess the property and sell it at a profit. There was a failure of ratings agencies to properly assess the risk of these new financial products in the USA, which were highly-rated, because they focussed on the credit risk (the risks arising from non-payment) rather than the liquidity risk (the risk of not being able to sell the CDO).  This was combined with a lack of awareness by government regulators of the possibility of a financial crisis since they focussed on CDOs spreading risks and did not anticipate the possible risk of a housing collapse.

When the US sub-prime market collapsed, due to rising interest rates, deemed necessary to reduce inflation, and falling house prices, the CDOs, despite their high rating, were seen to be risky and quickly depreciated in value. They  became illiquid since no one wanted to buy them, so their holders were unable to sell them to realise even part of their value. Simultaneously banks became reluctant to lend to other banks holding CDOs in their assets and first Northern Rock and then other banks failed. However because the original mortgages had been converted into CDOs and often re-bundled into other CDOs, it was not easy to tell which assets were safe and which were not, and therefore all such products were assumed to be risky, the institutions which held them were avoided by lenders and liquidity in the financial system evaporated. Because these products were bought and sold  by financial institutions in USA, Europe and Asia, the crisis spread quickly between the continents.

LOW BANK RATIOS – Banks need a balance between the loans which they make and their share capital and liquid reserves which can be used in case any of their loans fail. In the approach to the crisis, their leverage ratios (loans:capital) increased greatly, meaning that they were supporting their loans on a much smaller base. Lehmann Brothers, for example, had a ratio of 35:1. When the housing market fell, the banks wished to build up their capital by selling the properties on which the loans were based. However the increased supply of housing onto the market further reduced house prices and the value of the sub-prime mortgages, making the crisis worse. It should be noted that it was much easier for a US mortgage borrower to abandon their property without a financial penalty than in the UK. What many sub-prime borrowers did when they could not afford the higher interest rates and house prices fell below the value of their mortgage  was to drop the keys back to their lender and move into rented accommodation. It was then up to the bank to try to sell the house and get their capital back.

POOR REGULATION – Another contributory factor was the level of regulation of the financial sector. Authorities such as the IMF focussed on how securitisation reduced risk and global bank  reforms aimed to make it easier for banks to lend. in the UK there was also a change in the financial regulatory framework. Previously the Bank of England had been responsible  for the regulation of the banking system and the operation of monetary policy. Following the election of the Labour Government in 1997, Gordon Brown, created a three-way structure involving the Bank of England, the Treasury and Financial Services Authority. The FSA was responsible for maintaining confidence in the financial system, preserving financial stability, protecting consumers and reducing financial crime. The move from a single body regulating the financial system to a tripartite arrangement possibly hindered a speedy response to the crisis.Subsequently, in 2013, the FSA was replaced by the Financial Conduct Authority which is responsible for regulating 56,000 financial services firms to protect consumers, protect financial markets and promote competition).

THE SOCIAL CLIMATE – There has been much media attention in the last ten years blaming the crisis on the greed of bankers, earning enormous salaries and bonuses from their activities. . The FT, in a series of articles on the crisis talks of “Massively leveraged investment banks engaged in socially useless trading of huge volumes of complex credit securities.” However it is not only bankers who were keen to make money. Housebuyers borrowed more than, in retrospect, was sensible and even everyday savers  used their savings to dabble in financial products they did not understand in a bid to obtain a higher return.

Then, on 15th Sept 2008 Lehman Brothers filed for bankruptcy protection. It was not the first chapter in the financial crisis but its size and the probability that it would be allowed to fail, can be regarded as the moment when the crisis became apparent. Within two weeks of Lehman’s collapse the global interbank money market had frozen, creating fear of economic collapse in the USA, Europe and Asia and the Dow Jones Index experienced its largest drop since the September 11 attack in 2001.

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A confusing week for economists

This week has seen a considerable amount of contradictory economic information. On the positive side, employment in Britain reached a record high in the three months to April, 2018, with an employment rate of 75.6%. Unemployment has remained at its current low of 4.2% and the inactivity rate, those people, such as students, of working age, but not in the labour force, is also at a record low. Retail sales grew by a record 4.1% in May

However the rate of increase in earnings, which we would expect to be high given the low unemployment figures (as suggested by the Phillips Curve), has dropped from 2.6% to 2.5%. In real terms, the rate of growth in real earnings was only 0.1%, implying that future consumption growth will be low.

Other disappointing news was an announcement from Land Rover that they are moving production of the Discovery from the UK to Slovakia and news that Poundland and House of Fraser have collapsed, putting thousands of jobs at risk. However even these news items are not clearcut. One of the reasons behind Land Rover’s actions is that, once production has moved out of the UK, the site will be used to produce new, more high-tech, more expensive hybrid and electric models and the decline in traditional retailing is happening as on-line purchases increase, creating delivery and warehouse jobs.

However possibly the most disappointing pieces of news were firstly the latest data on manufacturing output for April, showing the fastest fall for 6 years and secondly, the deterioration in the UK’s trade deficit which grew by £1.6bn to a deficit of £9.7bn, the worst monthly figure since October 2016.

Possibly the best way to evaluate the data is to look at what the markets thought and they were pessimistic, thinking that the weakness of the economy will make an interest rate rise less likely and therefore sterling fell in the foreign exchange markets.

A world trade war moves closer

President Trump has tweeted both  that “Protection will lead to great prosperity and strength” and that “We have a MASSIVE trade deficit with Germany. Very bad for U.S. This will change.”
He now seems to be taking steps to attempt to do this. On 1st June, the USA imposed a  25% tariff  on imports of steel  and a 10% tariff on aluminium  imports from the EU, Canada and Mexico with the aim of reviving the USA steel industry. However, the main public argument for the tariffs was of the need to protect the steel industry on the grounds of  national security since this is an acceptable argument for protection under World Trade Organisation rules.

The countries affected are planning to appeal to the WTO, arguing that the national security argument is false, and are also planning  possible retaliation on US products such as Levi jeans, bourbon whiskey and Harley Davidson motorcycles.

From an economic, as opposed to a political standpoint, the tariffs make little sense. Many US producers and consumers will suffer, not only from retaliation, but more importantly because the price of steel will increase, thereby increasing the price of anything, such as cars, made with steel. The US is also planning significant infrastructure works which will be come more expensive  since they have a significant steel content. The imposition of tariffs also goes against the logic of comparative advantage where one imports goods and services from countries which can produce them most cheaply while specialising in the products one is relatively most efficient at, thereby increasing world output and living standards.

Worrying for the UK where the steel industry employees approximately  31,000 workers and exports 7%  output to the USA, is the impact on areas where steel is a major industry. They will experience a strong local negative multiplier effect, with  shops, pubs, local suppliers and transport companies being affected. The measures will also do nothing to restrict world  steel over-capacity and the possibility that some steel which would have gone to the USA being sold in the UK at reduced prices, thereby reducing domestic steel production. Finally, if the EU does retaliate, UK consumers will face increased prices for  USA imports, with the size of the price rise  depending on the size of the tariff and how much is passed on compared to the amount absorbed by importers and retailers.

 

Economic Man meets the Royal Wedding

One of the features of being an economist, particularly in the internet age, is that one does not need a vast quantity of facts at one’s disposal; instead the study of economics is much more about learning how to apply economic principles to everyday situations. Although not an everyday occurrence, it is interesting to consider the wedding’s impact on economic objectives from an economist’s perspective.

Firstly, prior to the wedding we can speculate about the impact on the UK economy from the production of wedding memorabilia such as fridge magnets, tea towels, plates and mugs. The vast majority of these will be produced by companies already in the business, for example making similar products for beach shops in Southend or tourist shops in London and therefore all  we would expect to see would be an increase in profits and overtime, rather than in long-term employment, as these firms expand their production (and move along their SR supply curve). The extent of the rise in  profits will be determined by the additional costs incurred compared to the additional revenues received. Given the rarity of such events, it would be safe to assume that demand will be inelastic and therefore prices might be high. However not all products on sale are modifications of existing items. The Daily Mirror, Daily Mail and even Radio 4 reported on special royal wedding commemorative condoms which have a picture of Meghan and Harry on the outside and microchip inside and  play God Save the Queen and The Stars and Stripes when the box is opened! There will also be an increase in interest in the businesses making more traditional wedding essentials such as for the designer making the wedding dress.

The wedding itself will create an increase in activity in the Windsor area, leading to a regional multiplier effect, as tourists come in, stay in nearby hotels, eat in local restaurants and buy goods in the Windsor shops. However, judging by some newspaper articles, some visitors featured seemed to have ignored hotels and camped on the route of the Royal Wedding procession. If you were working in Windsor in the tourism industry, you would almost certainly have worked overtime this weekend and there would probably have been an increase in temporary employment. On a national scale, the impact will be much smaller than for William and Kate’s wedding which took place on a weekday which was made an additional bank holiday. Therefore their wedding had street parties with all the associated expenditure on food and drink which was offset against the loss of output from the extra bank holiday.

Finally we should consider the impact on the UK’s balance of payments with the influx of overseas visitors, particularly from the USA, who have come over specifically for the wedding. Not only does their spending in the UK counts as a UK export, it is possible that they might have flown over on a British plane or come over on a British boat, boosting the service section of the balance of payments accounts. However, given the economics is sometimes referred as the “dismal science” we ought to consider the offsetting impact on the balance of payments and UK economy of British citizens fleeing overseas in order to escape the wedding.

The economy today

Current information about key areas of the economy is important for those taking exams this summer. The following highlights key areas.

Economic Growth – Manufacturing output rose by 1.3%in the last quarter of 2017 with Boeing announcing it will build a new factory in Sheffield.; It has also announced closer links with Sheffield University, guaranteeing to employ 19 apprentices trained at the Advanced Manufacturing Research Centre in Rotherham which is linked to Sheffield University.  At the other end of the scale, Alpkit, an outdoor equipment company in Nottingham, has increased its exports by 50% because of the EU recovery and the fall in the value of sterling. However UK car manufacturing fell by 3% in 2017, with part of the drop being caused by a reluctance to buy new diesel cars.

In global terms, the IMF has upgraded growth forecasts for the next two years for France, Germany and the USA while reducing the forecast for the UK to 1.6% this year and 1.5% next year. In terms of the forecast increases in real GDP per head, the UK is at the bottom of the G7. The IMF highlights weak investment, low productivity and Brexit uncertainty as causes for the UK’s relatively poor performance while the rest of the world benefits from US tax cuts, riding investment and increased international trade (presumably their forecast was written before concern over a US/ China trade war).

The poor figures for growth from Jan – March 2018 (only 0.1% up compared to the previous quarter) were below expectations and the worst for 5 years. While some of the blame for the poor figures can be attributed to the recent poor weather, the ONS was quick to point out that weather was not the cause of these figures and highlighted a slump in construction as a key factor. Sterling fell after the data was published since investors now think that an imminent interest rate increase is less likely. In addition, the Bank of England has now downgraded the UK’s growth forecast for this year from 1.8% (made in February) to 1.4%.

Productivity – April 2018: The latest productivity figures contain some good news for the UK since, between July and December 2017, output per hour rose by 1.7% – the fastest rise since 2005. Note that part of the rise is because of a fall in the number of hours worked. Output per person has hardly changed. The purchase of industrial robots in the UK rose in 2016, the first rise for 5 years.

The apprenticeship levy is a tax on companies (0.5% of their wage and salaries bill) with a turnover of at least £3m; they pay the tax and can then claim back money spent on training over the next two years. The scheme was introduced in 2015 and the aim is to create three million new apprenticeships by 2020 and raise the quality of training. While it has proved relatively easy to provide training in traditional industries such as construction or plumbing where apprentices can learn from current employees, designing courses in service industries has proved more difficult. In Jan 2018, 25,400 apprentices were in training, compared with 36,700 a year earlier with criticism that the scheme is too inflexible and some of the money is going to fund basic training for low-paid staff such as those working in hotels and coffee shops (labelled as apprenticeships to claim the training money).

Incomes, savings & living standards – March 2018: The Bank of England predicts that pay increases in the private sector are expected to reach 3.1% per annum, the highest rate since the financial crisis ten years ago. With inflation expected to drop below 3%, living standards should therefore rise. However pay increases for senior staff are only expected to be between 1 – 2%. The national living wage rose to £7.83 in April. In the three months to February, wages rose in real terms with earnings rising at 2.8% (at an annual rate) while inflation dropped to 2.7%. A recent OECD international comparison of real household disposable income growth since Brexit shows 1.8% growth in Europe compared with a fall of 0.3% in the UK .  The savings ratio fell to 0.9%, its lowest level since 2008, as consumers attempted to keep their consumption up as their REAL disposable income fell in 2017. (The same occurred in 2016). This is not as worrying as the situation between 2004 and 2007 when the savings ratio was negative – borrowing was greater than savings.

Unemployment – Between November and February, unemployment fell to 1.42 million, reducing the rate from 4.3% to 4.2%, the lowest it has been for 43 years. The activity rate reached 75.4% (those of working age in work or looking for work as a percentage of the potential labour force), the highest since 1971.

Inflation – The rate of inflation for March dropped to 2.5%, compared to 2.7% in February, the second consecutive month it has fallen (It was 3.1% in November). Falling inflation has cast doubt on when the next interest rate will occur. However oil prices have reached their highest level for almost four years to $77.32 a barrel,  because of increased demand from US drivers combined with an earlier cold spell in Europe reducing stocks, the long-term impact of OPEC production cuts and most recently, the recent political events in Iran where the threat of sanctions will reduce Iran’s oil sales.

There has been discussion about whether the 2% CPI target for inflation is still appropriate. Some economists are suggesting a higher target would be more appropriate to ensure faster growth and continued low unemployment while others suggest that it should be scrapped and replaced with a nominal GDP target (combining both inflation and growth), which would involve a much greater focus on the components of AD.

Government debt: Between 2007 and 2017, total government debt (the national debt) rose from £560bn to £1760bn which, as a share of GDP, was a rise from 36% to 85%. It is currently at 76.4% of GDP and predicted to fall to 75.3% by 2025. The latest figures (for the last year to March) show that the UK government ran a surplus of £112m on the current budget (day-to-day services such as pay for soldiers, NHS nurses and civil servants, and welfare payments such as JSA and pensions) FOR THE FIRST TIME IN 15 YEARS. What this means is that the only borrowing undertaken by the government last year was for investment in infrastructure, such as roads, schools, airports and railways. George Osborne, when Chancellor, aimed to achieve this in 2016 but, because of the slow recovery and low productivity, it has taken until 2018. The overall budget deficit was £42.6bn, a drop of £3.5bn compared to last year and the lowest since 2007.

Monetary Policy update: In 2016, post the Brexit vote, base rate was cut from 0.5% to 0.25% and a further £60bn of QE took place. In November 2017, the rate rise was reversed. The BofE introduced the Term Funding Scheme (TFS) to replace the Funding for Lending Scheme. Under the scheme, which will last until 2022, banks are able to borrow up to 5% of their loan book at a very low rate of interest. The BofE has also amended the leverage ratio (equity:assets) by removing central bank deposits from the asset side and increasing the ratio from 3% to 3.25%. Overall, this is seen as making the requirement less onerous.

At the start of 2017, household debt was increasing at its fastest rate since 2006 and the BofE financial Policy Committee (which is responsible for financial stability) was concerned by the increase and has instructed high street banks to add £10bn to their balance sheets in case of default and £11.4bn in case of an economic downturn. The latest figures (March 2018) show a fall in credit provided by high street lenders (overdrafts, credit card borrowing and car finance) from £1.7bn the previous month to £300m, the smallest figure since 2012, creating fears of a significant slowdown in growth. The slowdown in lending is partly the result of reduced consumer confidence but also due to lenders strengthening their balance sheets following warnings from the Bank of England.

Interest rates were expected to be increased on 10th May but, because of the UK’s sluggish economic performance, the Bank of England has left them on hold at 0.5%. However a rate rise later this year is still predicted by the Governor of the Bank of England.

House Prices: The Halifax announced a fall of 3.1% in house prices last month, the largest monthly fall since September 2010 and the second largest since they started their house price index in 1983. Mortgage approvals fell 10% in March. However house price data is extremely volatile.Reasons for this included a loss of confidence in the housing market, foreign demand slowing, and a feeling that the peak of the boom has been reached.

Foreign Trade: UK ran a service sector surplus on the BofP from Oct – Dec 2017 of £20bn with exports of £43.3bn and a service surplus of £80bn for the whole year. The main area of service exports was the EU (40%), hence the importance of obtaining a suitable free trade agreement, post Brexit, which includes services. The USA, at 20%, was the single largest country.  Banking, insurance, travel and business services were the main surplus categories. Trade in goods was negative so overall, in the last quarter, there was a deficit of £11bn.

Given that balance of payments figures are particularly inaccurate, it is no surprise that the 2016 deficit is likely to be revised down in next month’s data by £10bn (£30.9bn v an original estimate of £40.7bn), down from 2.1% of GDP to 1.6%., because of under-estimated earnings from financial traders in the Uk.

The US trade (goods and services) deficit has risen to its largest for almost a decade, rising to $57.6bn in February.

 

What does the future hold?

“Accurate predictions” and “economists” are not words which always go together and the longer the time period, the less accurate are predictions likely to be. Last year, it was predicted that driverless cars would soon be with us and we would be summoning our driver-free Uber with as little worry as ordering a take-away via Deliveroo. However, following the death of a 49-year-old woman in Arizona, as a result of a collision with an Uber vehicle being driven in autonomous mode, (with a human behind the wheel), both Uber and Toyota have suspended trials and a number of American states are reviewing their attitude to trials of driverless vehicles.

A worry which has been with us for longer is the impact of technological progress and more recently AI, on employment prospects. Keynes, in 1930, during the Great Depression, wrote an article predicting a 15 hour working week by 2030. For him, this was not a worry since he suggested that the average person would be significantly richer in 2030 than in 1930, since businesses would still be producing goods and services and workers enjoying their increased leisure. However, he did raise the possibility of technological unemployment where the fall in demand for labour from technological progress was greater than the increased demand for labour needed to produce new goods and services. Trying to estimate the costs and benefits of new technology in terms of employment has been a problem since the Luddites in the 19th century – English textile workers and weavers who destroyed machinery which they thought would take their jobs away. On the other hand, technological optimists see the arrival of robots as an advantage since they will allow tedious, repetitive jobs to be undertaken by machines while the humans focus on rewarding, creative areas.

Examples support both views. The rise of online shopping is a cause of the decline in high street retailers. However internet shopping has created jobs in warehouses for workers to fulfil orders and among van drivers. But, in the future, will the goods ordered be collected from the shelves by robots and delivered by drones? What will happen to the number of workers in supermarkets if the technology used in Amazon’s cashless store becomes more widespread? There is a consensus that the types of jobs most at risk are those which are routine and repetitive while the safest are those which involve creativity, judgement and manual dexterity. An area which should be secure, and in which the UK is currently strong, is the creative sector, which covers such things as advertising, film and television programme making, architecture, and fashion, employing two million people and contributing over 5% to GDP. One might also think that teaching is a safe occupation since, so they tell me, it involves judgement, empathy and creativity. But if the school of the future is based round individualised learning with students working in large open-plan spaces, supported by “facilitators”, will so many people be needed? How long before we get the department blog generated with no human involvement? How do we take account of the jobs which have not yet been created?

What is clear is that there will need to be resources put into re-training existing workers to allow those who have lost their jobs to move into new areas and, more importantly, those entering school in September, will need to be taught to be adaptable and creative so they can learn new skills, rather than being trained in the skills in use today.

Are apprenticeships a solution to the UK’s low growth rate?

Last month, in case you missed it, we had National Apprenticeship Week. In 2015 the government set a target of creating three million apprenticeships by 2020 to improve the skills of the labour force and, in 2017, they established an apprenticeship levy which made businesses with a wage bill of £3m or more pay 0.5% of their labour costs into a fund to pay for training.

Apprenticeships are not new, dating back to medieval times, and, in the 1960s, about 1/3 of school leavers took this route into employment. However the raising of the school leaving age, the desire of governments to promote university education and a view that they are inferior to university degrees, have caused a decline in the importance of apprenticeships. More recently, as the cost of university education has risen and the UK’s productivity growth has fallen below our competitors, the government has seen apprenticeships as an alternative to university, which would meet the skill shortages which have plagued the UK economy in recent years and boost productivity.

A survey in March 2018 suggests that the target will not be met and businesses have called for a review of the apprenticeship levy which is intended to fund the scheme. Part of the problem is the low wage offered to apprentices in the first year of training compared to those in work (£3.70 versus £4.20 per hour for those under 18, £5.90 for those aged 18 – 20 and £7.38 or over for those aged over 21). In some cases, apprentices were paying more to travel to work and other expenses than they were receiving and complaints were also received that they were being used as a form of cheap labour, doing the same work and having the same responsibilities as non-trainees.  Poor mathematical and linguistic skills are also a bar to completing an apprenticeship and, despite a desire to help younger workers into employment, there is evidence that some firms are using their apprenticeship fund for re-training older workers or providing management training.

We are still a long way from the success of the German vocational training programme which is seen as an attractive alternative to higher education, catering for about 60 per cent of the country’s young people. Their programmes are three-year schemes, either school-based with work placements or more business-based with training also undertaken in school and result in nationally-recognised qualifications which have the same status as academic qualifications and are not regarded as being second-class and more suitable for the less academic.  Although their schemes are not the only reason, it is worth noting that the German unemployment rate for those under 25 has averaged approximately 1/3 of the EU average.