Financial Economics

The Bank of England is sending some serious messages to the financial markets - and pension funds in particular - that they see significant risks to the financial stability of the UK economy. The Governor of the Bank of England has told pension funds - which manage more than £1.3 trillion worth of assets - that they have three days to sort themselves out before the Bank’s current intervention window - when it commits to buying £ billions of long-dated government bonds - comes to an end. The pension funds want the central bank to carry on buying government ‘gilts” until the Chancellor’s financial statement at the end of October. But this is by no means certain. Today, the Bank of England announced that it will be buying up index-linked (eg inflation proof) gilts as well as conventional ones as part of a wider strategy to keep gilt prices from falling further and threatening the viability of many pension schemes. The wider problem is that bond markets have concluded that the UK government’s fiscal approach is not sustainable. Announcing un-funded tax cuts of £35 billion in the “mini budget” was a huge mistake and has led to a sharp rise in government bond yields which in turn has driven up the cost of mortgage loans. The IFS reckon that the “credibility gap cost” for the government is in the order of an extra £10 billion worth of interest payments on debt each year. This has a huge opportunity cost - think of the new hospitals and schools that could be built with that money. And, it seems unlikely - on current growth projections - that the Chancellor will be able to announce a credible plan to reduce GDP as a share of the UK’s GDP without making some painful cuts in real government spending. A growing number of Conservative MPs will potentially vote against this. There is no certainty that the government will be able to get the bulk of their tax and spending proposals through Parliament.  One of the leading ratings agencies Fitch has said Britain will  probably face a deeper recession “following extreme volatility” in UK financial markets and the prospect of sharply higher interest rates. The economic woe continues - a recession will increase the debt-to-GDP ratio because the denominator is shrinking. And an economic downturn will lead to reductions in consumer spending which in turn will reduce direct and indirect tax revenues flowing into the Treasury. The government has a major job on its hands to persuade the financial markets that they have a credible growth and fiscal stability plan. 

The European Central Bank has raised their main monetary policy interest rate by 0.5% - the first increase for eleven years.

This IMF blog suggests that a dual currency system involving e-money and cash might give central banks for more freedom to cut interest rates below zero as a policy response to a future economic shock. Few central banks at present have moved nominal interest rates back towards previously normal levels (for the UK that might be between 4-5%) to allow themselves some wriggle room when there is an economic downturn. In countries where cash in circulation is a significantly smaller percent of GDP (such as Sweden and Norway) it would - in theory - be relatively straightforward to impose negative interest rates on e-cash held in deposit accounts. However "cash is a free option on zero interest, and acts as an interest rate floor." The accompanying chart shows the large differences in the use of cash across developed OECD countries - in Sweden, currency in circulation is around 1 percent of GDP,  whereas in Japan is it closer to 20 percent.

The inside scoop on the fixing of LIBOR ten years ago.

A reminder that the scope of financial markets extends well beyond the lending of commercial banks. Oxford University is seeking to raise funds by issuing a 100 year (long-dated!) bond. Their credit rating is good and they are likely to be around in a century to repay the loans. 

John Kay on fine form and posing some important questions including: What do people who work in the finance sector, in those large office blocks and in the City of London and Canary Wharf, actually do?

A timely Newsnight report on the impact that financial technology (FinTech) is having on competition / contestability in the UK financial sector. The UK government is trying to encourage competition, innovation and investment in FinTech and we are starting to see the emergence of challenger banks in certain sectors. Some small businesses for example are using card readers using the Square platform. Mono has just been awarded a banking licence. Once people get hold of their own financial data following an EU directive in 2018 we can expect more companies to get involved in financial technology. Apple, Google and Facebook are likely to be big players in the financial markets in years to come.

If you are looking for extra contextual examples of financial market failure then this BBC article will provide grist to the mill. 

A superb short case study on financial market failure in Cyprus.

Many students will be exploring aspects of financial market failure as part of their A level economics course. This article from Kamal Ahmed is a useful primer on the importance of credible regulation in banking and other financial services. The Deputy-Governor of the Bank of England fires a warning shot that a return to light-touch (aka lax) regulation of the financial sector increases the risks of another systemic financial crisis. It reminds me of the most dangerous five words in economics ... "this time it is different".

The cost of living crisis might be causing people to hold (if they can) higher cash balances as a way of keeping greater control of their day-to-day living expenses. New data from Post Office Counters has shown a sharp rise in people withdrawing cash from their accounts. This is perhaps a small blip in the march towards a cashless society. The use of cash money in the UK decreased significantly since 2016, especially during the coronavirus pandemic. Many pubs for example now do not accept cash payments, likewise concessions at sports grounds. But paying with a debit card, according to some behavioural economists, can lead to higher spending overall since swiping the card seems one step removed from handing over hard cash whereas with the latter approach, the amount spent is tangible and easier to monitor. Of course cash pays no interest so the real value of cash is falling sharply as inflation heads towards 10 per cent. But deposit accounts pay a paltry nominal rate of interest - try finding a savings account that offers anywhere near 3 per cent. So the opportunity cost of using cash for transactions is limited.

The veteran economics journalist William Keegan reflects on the key events of the eight financial crises involving the UK that he has covered, This is an engaging journey down memory lane for those of us who have been teaching economics for well over thirty years. For contemporary students, it might be a handy reminder that financial crises are nothing new and are perhaps becoming more frequent in a world of financialisation and external economic shocks.

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A useful infographic from the Bank of England on how they plan to prevent a bank being too big to fail. The key is to bail-in investors so that they bear some of the costs of debt write-offs rather than taxpayers if and when a financial institution is saved.

Excellent for revising some of the benefits and costs of moving from a floating currency to a fix against the Euro 

A classic example of an unintended consequence of the decision by the Swedish central bank to cut their policy interest rates below zero. 

A ninth straight year of losses for Royal Bank of Scotland - the legacy costs of managerial failure on an epic scale. Gains are privatised but losses are socialised - discuss.

A stunning Newsnight piece on two of the "heroes" in Flash Boys written by Michael Lewis  who have now started a new stock exchange to protect investors from being picked off by the speed merchants - the high speed traders looking to exploit minute differences in the speed of access to stock markets to make money.

Struggling for several years this news is not unexpected, but who will consider buying the Co-Operative Bank?