See my write up of Huw Pill’s talk at Oxford University, for OXONIA, here. Huw Pill is the Chief European Economist at Goldman Sachs.

This seminar for OXONIA, which took place on Wednesday 15th February, was made possible by the generous benefaction of Oxford Economics.

Martin Wolf presented the key ideas behind his third book entitled “The shift and the shocks: prospects for the world economy”. He described the exceptional, and unexpected current global economic situation, and explored how it might progress. In doing so, he exhibited an impressive understanding of the global macroeconomy.

The shift

The world economy has changed significantly in the last 200 years. In the 19th century there occurred what Kenneth Pomeranz called the “great divergence”, which saw the Western world advance ahead of Eastern countries. Japan and the east Asian “tiger countries” then saw converging growth in the early 20th century and more recently, in the late 20th/early 21st century, convergence spread to the Asian giants, like China. Today, growth across the globe is diverging again but in the mirror image to the 19th century.

The rate of growth in the emerging economies is staggering, suggesting that their GDP is going to double every 12 yrs. The most striking case is China, who since 2007 has seen aggregate GDP rise by 60%. Chinese GDP per head has continuously risen, as a share of US GDP per head (at PPP), since the 1980s from 3% to 16% today. This is in contrast to the other six largest emerging economies who have faced fluctuating or less rapid increases in GDP per head, relative to the US, during the same time period. What makes the situation so interesting, and unprecedented, is that, since 2007, the developed economies have been mainly stagnant.

In the long run, Wolf finds it hard to believe that this ‘catch up’ by the emerging economies won’t continue, provided the world avoids huge shocks. That’s not to say, however, that the process will be smooth because China is vulnerable to its excessive reliance on investment, and its high dependence on exports and property bubbles. If China’s growth did slow, the impact on commodity exporters could be substantial.

The impacts of the shift in global economic activity have so far been strong. The labour supply shock, which has lowered the relative wages of the relatively unskilled in high income countries is ongoing. Whilst there was initially a disinflationary shock as China lowered world prices for manufactures, an inflationary shock followed as demand for raw materials soared. 

The impact on the pattern of saving was unanticipated; emerging economies have increased savings whilst the richer countries have decreased the amount they save, and there have been huge flows of capital from poor countries to the West. Wolf argues that the “savings glut” is evident from the negative real interest rates in the UK and US. Unfortunately, the low interest rates distorted the price of risk and debt, and the financial sectors failed to use the capital productively, contributing to an almighty financial crisis. The emerging world now holds $10trn of investment in “borderline bankrupt states”.

The shocks

A large and enduring economic collapse has ensued and a dramatic rescue pursued: the liabilities of the core financial system have been nationalised, fiscal policy is on a war time footing and the extent of monetary policy, in the form of quantitative easing, is without parallel. Unfortunately, most of the Western countries’ GDP remains below pre-crisis levels, their public debt is set to increase until at least 2015, and whilst some countries’ 10 year government bond yields remain low, other countries’, like Italy’s and Spain’s, are high. 

The prospects

At the broadest level, the global situation can be described, according to Wolf, as the interaction of two huge events: 1) the secular shift in location of economic activity, and 2) the collapse of a generational expansion in private and public sector leverage in high income countries. 

Wolf sees the eurozone crisis as a microcosm of the global crisis; a currency union that fell where these two events intersected. For, whilst there are current account imbalances, Europe (like the world) is roughly in balance as a whole, and the core of the eurocrisis is not fiscal but the result of the interaction of a balance of payments problem with financial crises. Huge debt stocks did played a part in creating liquidity problems for sovereigns though. 

At the moment the situation looks dire. Across the world countries are facing falling growth, and in Europe some countries face negative growth, which raises doubt that the countries of Europe can help each other. Wolf identified four immediate global challenges:

1) Accelerating de-leveraging in private sectors of over-leveraged countries,

2) Rebalancing the world economy to give over leveraged economies export led growth, which is necessary when their private sectors run huge financial surpluses, 

3) Reducing fiscal deficits without killing recovery, 

4) Avoiding excess in emerging countries despite easy financial and monetary conditions.

The question everyone wants to know the answer to is: How’s it going to play out? Wolf’s prognosis is mixed, and lamentable for Europe. He envisions that the US will be the most dynamic of the big economies. In high income countries, inflation will fall, growth will remain weak, and the short term official interest rates will remain low for a long time. Countries with their own central banks will have low long term bond rates but many eurozone countries will not and the chance of the eurozone breaking up is significant. Emerging countries are likely to grow quickly but the chance of crises exists there too.

Marloes Nicholls, seminar coordinator

I recommend this beautiful and fascinating meditation on money that combines anthropological and economic analysis. 

Start the week with Andrew Marr focused this week on the financial system. There are some interesting ideas in there. Do paper money systems always fail? 

We’ve all heard about Germany’s world class manufacturing industry and strong export trade. Two events that took place earlier this year in July  highlight just how far Germany is ahead of the UK. 

1) Cameron’s pride at signing a £1.4bn trade deal with Chinese premier Wen Jiabao was quickly knocked when two days later Angela Merkel signed a £9bn deal and agreed on a target to increase trade with China to £178bn over the next five years. 

2) The last remaining train maker in the UK, Derby based firm Bombardier, lost a UK government contract to the German group Siemens resulting in 1400 job losses, and this was just four months after Cameron visited the plant to boost morale.

Less well known is the fact that the German banking system is also radically different. Here in the UK, most people bank with the familiar high street banks (Barclays, HSBC, Lloyds TSB, Nationwide and RBS), but in Germany there are many smaller banks from which people choose to banks with. David Boyle has written about this in a recent report for the new economics foundation on local banking: “In the UK, over 80 per cent of mortgages are in the hands of the top five banks, as are over 80 per cent of Small and Medium Enterprises (SME) accounts. In comparison, 70 per cent of the German banking sector is in small or community banks.” 

The benefits of the German system are strikingly apparent from the graphs below (excuse the poor pictures) which show that the small community banks were able to provide stable returns and access to credit during the financial crisis. Figure 2 shows that their return on savings remained fairly constant during the period of the financial crisis, whereas the rates commercial banks offered were much more volatile and plummeted in 2008. The big banks that most of us use in the UK are commercial banks. Figure 3 shows how local Swiss banks continued to provide credit at a constant rate throughout the crisis, whereas the commercial banks reduced lending considerably. This stability helped to shelter small businesses and individuals from the crisis. To be clear, they aren’t untouchable by economics crises but as David Boyle says, they “represent a stability and usefulness to the real economy that is almost entirely lacking in the UK”. In the UK small businesses are struggling to get loans.

I think the difference in performance between commercial banks and local community banks can largely be explained by their different structures of ownership and decision making. Commercial banks are usually public limited companies listed on the stock market  driven to make profits for their owners, the shareholders, who can be anyone in the world. Decisions are often made by computers or sent to remote regional offices. Local community banks in Germany, on the other hand, are mutually owned which means that, instead of having shareholders, they have members who collectively own the business and are also its customers. The members are entitled to information on the business and to vote on important issues. Decision making is decentralised so that the branch manager has the authority to back his or her judgement (rather than obeying a computer algorithm). Furthermore, these banks are not purely profit driven, but have explicit social as well as economic objectives. 

There are a large number of financial institutions (over 450) called credit unions all over the UK that could form the basis of a flourishing local community banking sector in our country too.

Credit unions are not-for-profit cooperatives owned and run by their members that focus on providing savings accounts and loans. Their main purpose is to provide credit at competitive rates and their social benefit lies in tackling financial exclusion (the fact that many people cannot get loans from the big banks) and liberating communities from loan sharks. They are by no means just for the “poor” though - apparently there is a credit union for people who work in the City! As a saver, you can put your money in a credit union and know that it will be used in the local community. About 25 credit unions also offer current accounts. Rest assured that credit unions offer precisely the same government guarantee as the high street banks.

In North American and Canada 40% of people are members of a credit union, whereas in the UK about 1% of the population are. Hopefully new legislation that comes into effect in early January will begin to broaden the services they can provide and help credit unions to compete with other banks. 

Each credit union is slightly different because it is run by its members and for their particular local community. You can find out more about credit unions, and search for your local one and the services it offers on the Association of British Credit Unions’ website. 

Figure 1:

Figure 2:

“Like an organ ofthe human body, the financial system calls most attention to itself when it malfunctions. But in normal times, is the financial system like the human heart, circulating essential capital throughout the economy? Or is it like the appendix, doing little when healthy but devastating when ill?”(Christina Wang)

Conventional measures of how much the financial sector contributes to the economy indicate that the financial sector contributes up to twice as much to the economy than the average of all US firms. These measures, one might say, portray finance as being the heart of the economy.

Christina Wang explains why these measures are misleading, mainly because they fail to discriminate between the cases when a bank is providing a service and when they are just taking on more risk. She discusses her research that tries to measure the risk-adjusted value-added of the financial sector to the economy. She finds that the conventional measure overstates the ‘true’ value-added of banking by 100%, and by her measure “banks look like the average of all US firms. In fact, banks appear to generate slightly lower returns”! 

This research uses US data but Andrew Haldane from the Bank of England has conducted similar research for the case of the UK (The contribution of the financial sector: miracle or mirage?). 

Christopher Ferguson’s oscar winning documentary doesn’t just scrutinise the banking and finance industry, it pieces together the events that led to the financial crisis of 2008 with a gripping narrative and all the drama of a Hollywood blockbuster. 

I thoroughly recommend it and am so pleased that you can currently watch it on iplayer. Find it here.

The gift of this film is that it offers the layperson an understanding of the financial crisis, and there’s no need to be put off by the finance. The sprinkling of explanations about financial instruments like “collatoralised debt obligations” are clear and simple, and are dispersed among striking panoramic scenes of Iceland’s natural beauty and the modern industry of the New York skyline, and intimate interviews with players from the upper echelons of the economics and finance profession. Ferguson cleverly includes outcuts from the interview tapes, catching the interviewees off guard. There are some particularly intimate moments where his frank questioning leaves certain guilty parties embarrassingly (and sickeningly) exposed. 

It is unfortunate that the film could only be made after the event, as the opacity of the finance industry was part of the problem that led to the crisis: “The real tragedy of this story, in other words, was that most of the folly was not due to a plot; instead, it was hidden in plain sight.” (Gillian Tett, Financial Times) The boom years were so fruitful and apparently indestructible that the public didn’t think to question the financial system driving it, and those that were able to understand the risks had reason to keep schtum (namely, profit). 

“Inside Job” reveals the stark corruption and cronyism within the top tiers of the banking system. It is entrenched, and so despite the best interests of regulators and policy makers who are currently devising new reforms and regulations to avoid another crisis and mitigate the mess should another hit, politics and lobbying will again play a major role in determining which policies are implemented. It is worrying that over half of the donations made to the Conservative party in 2009 and 2010 stemmed from the City. 

In a world where those in power are not benevolent or omniscient, we need to be clued up so that we can retain democracy and rebalance the power influencing those whose job it is to ensure that banks are well regulated. 

Further reading (in case you’re interested!):

Ferguson failed to explain the role of Globalisation in contributing to the financial crisis: low interest rates in Western economies (stemming from cheap import prices which led to low inflation expectations) gave rise to the “search for yield” that made risky assets with high returns like CDOs so attractive. If you want more on that I recommend Robert Peston series, “The party’s over: How the west went bust”.

I recently finished “Where does money comes from?”, a book written by researchers at the new economics foundation. It’s great at explaining how money is made in the UK, if a bit text booky (great for those studying economics).

Right now I’m reading Fools Gold by Gillian Tett and despite its focus on credit default swaps it is a real page turner!  

This seminar, held on Friday 25th October, was hosted by OXONIA and was made possible through the generous benefaction of Oxford Economics.

The Rt. Hon. John Redwood developed an argument he first made over a decade ago in “Our Currency, Our Country” (1997), which stated that the entry criteria and stability pact put in place by the founders of the European Union (EU) would not be sufficient, and that more and more powers would have to become centralised. Without this, he foresaw that some countries would free ride on the common interest rate and borrow too much at relatively low interest rates. 

When John Redwood presented a seminar at All Souls College in February earlier this year the calamitous outcome of the situation he had predicted had become a reality. Certain member states had borrowed so much because of the induced hike in interest rates they could no longer afford their debt. The highly indebted (so-called) peripheral eurozone economies began facing painful adjustment processes in aim to restore their competitiveness and the stronger member states created expensive loan packages to bailout profligate members. The markets have not regained confidence and in the nine months that have passed the crisis has escalated. The dramatic change, as Sir John Vickers, chair of the seminar, pointed out, is evident from comparing the cost of debt for certain European governments now and earlier this year in February: the cost of borrowing for the Italian government has risen from 4.8% to 7%, and from 12% to 30% for the Greek government. 

John Redwood began this seminar by explaining the difference between the common model of a single currency and the European model. Usually, a single currency is backed by a single country and government, and decisions are made by a sovereign. In the UK, for example, the conventional model applies. The elected central government works with the central bank to control monetary policy and inflation targets. The government sets out aims for the economy and is effectively the “sovereign” (although technically it is the Queen), and the central bank has power to buy bonds, lend to banks and set rates. It is the government’s job to keep broad consent for the institutions, and if trust breaks down the electorate can exert power to change the government, institution, or policy. 

In contrast, in the European model there is no agreed sovereign, individual governments set targets for growth specific to their countries (although there is a common inflation target), and the central bank has limited powers which it must decide to use subject to conflicting pressures from member states. These unconventional characteristics can account for both the crisis and why it so difficult to resolve. The eurozone has a constrained set of tools with which it can overcome the crisis (e.g. it has no legal powers to print its way out of debt and the less competitive countries in the south cannot devalue to promote growth) and since there is no agreed sovereign to make decisions actions must be decided on an EU or euroland level between national ministers. It is proving difficult to keep on top of the fast pace of events as, in addition to the time needed for states to reach an agreement, meetings are sporadic. 

As a result, despite numerous negotiations, several key problems remain. Firstly, there needs to be control over the debts and deficits of member states, which John Redwood believes is at the core of the unhinging of the euro. It is not only that some countries borrowed at too low an interest rate, but that from the very beginning every country (excluding just Luxembourg) exceeded the limits set by the founders on how much states could borrow. Reductions are particularly challenging for countries like Italy with a large stock of national debt. 

Secondly, the solvency of the banks needs to be ensured. John Redwood scorned the fact that Europeans had been “kidding themselves” when they described the financial crisis of 2008 as an anglo saxon problem. In fact, banks across the West were all equally weak. The boom in lending to the Spanish property market, for example, was no more prudent than subprime mortgages in the US.  Unfortunately, this became apparent later on and so when the euro crisis hit it compounded the solvency problem of Europe’s already weak banks. 

Thirdly, a route to economic growth needs to be found. If growth returned, then inflation and rising government revenue could reduce debts. John Redwood was pessimistic because he does not think Europe is competitive enough globally to achieve growth through exports and he does not think that it has the means to do it internally. Furthermore, public spending cuts which are necessary to increase confidence and reduce the chance of default will not help to promote growth. Some states will cut wages and other costs to compete in the absence of the ability to devalue but he said that, whilst Germany considers this a lesson to spendthrift states, he doubts that the people of those countries, like Greece, will accept it. He revealed that austerity was leading to things he would “not want to mention in polite public” and that he expected to see more rioting and strikes, as well as a rise of far right and left parties. 

John Redwood is unconvinced that the solutions advocated in Europe will work. He declared that requiring banks to hold more capital will lead to less lending by weaker banks, and that increasing tax and regulation to raise government revenue is proving counterproductive. In Greece, for example, entrepreneurs only accept cash in order to avoid taxes and the rich are going one step further by taking their money out of the country completely (apparently there are queues to buy flats in London). 

The European Financial Stability Facility is a large new fund designed to provide subsidised loans to distressed banks and states but, in John Redwood’s opinion, it is hardly the confidence building measure it is supposed to be. He explained that the fund is a Luxembourg based company that has AAA rating only because the countries backing it are currently AAA, and how the trillion euros the fund is supposed to have come from borrowing 440 billion euros that will then be geared by guaranteeing member state debt tranches (e.g. if Italy can only pay 80 cents on its debt, the fund will pay the remaining 20 cents). It is fortunate, John Redwood quipped, that the fund has only managed to borrow 16 billion euros so far. A previous measure that also did not boost confidence was the debt default that led to private banks, who already had weak capital cushions, being cajoled into accepting just half of the money back that they lent to Greece. 

John Redwood believes that the euro crisis would be surmountable if there were a sovereign to lead and enforce a resolution; “a single currency works best if they have a single country to love them”. Asked what he would do if he were sovereign of the EU, he replied that he would i) immediately order capacity to print and buy bonds ii) enforce urgent reform to single country budgets across EU, and iii) directly bolster banks. 

Without a sovereign, a role that John Redwood does not expect the eurozone is ready to create, the ‘easiest’ solution according to him is the swift exit of weaker member states which will allow them to devalue. He thinks that other possible ways of breaking up the eurozone are worth considering too. He is circumspect of estimates that a break up would lead to catastrophic loss in output if it was properly organised and planned, and claimed that 87 countries have left a single currency since 1945 in an orderly way. Economics aside, John Redwood rejected the suggestion that a break up could have terrible political ramifications, namely that they could give rise to the conditions that once led to war. 

John Redwood believes that the consensus among the political and business elite to hold onto the EU stems from an ideology. He is concerned that democratic values are slipping and that the “EU project” is being implemented by stealth as the politicians do not believe that, given the the opportunity to choose, people would vote in favour of it. He suggested that Berlusconi’s departure illustrated the serious power in the hands of those pressing for the strengthening of the EU.

Marloes Nicholls

Seminar Coordinator

The Oxford Institute for Economic Policy (OXONIA)