Over-financialisation of the economy

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Readers Question: I am also interested in Marxist economics and they seem to say the 2007-2008 crisis was a result of over-financialisation of the economy, and that investors/owners could not squeeze surplus out of other sectors in the economy as they once could.

Financialisation of an economy refers to the situation where the finance sector takes a bigger share of GDP and employment. The consequence of financialisation include the possibility that:

  • Financial markets have greater influence over firms and the real economy.
  • The economy is more dependent on the strength of the finance sector.
  • Widening inequality as the finance sector is often able to capture relatively higher salaries and profits.
  • Growth in financial instruments has increased the risk of unsustainable debt and lending levels.
  • The nature of the finance sector means that if it fails it is has a much wider knock-on effect to other industries. If coal mines close, it doesn’t really adversely affect other industries. But, if banks get into difficulties, it has severe adverse effects for every other industry.

Epstein (2001) defines financialisation as:

“the increasing importance of financial markets, financial motives, financial institutions, and financial elites in the operation of the economy and its governing institutions, both at the national and international level” (Financialisation and its consequences)

Growth of Financial sectors in developed countries

Between 1970 and 2008, most industrialised countries saw a growth in the importance of the finance industry.  The total share of finance in value added (GDP) to the economy more than doubled in 11 OECD countries. In terms of employment, economies have seen a growth in the share of financial sector employment.

finance-sector

source: Bank of England

UK Finance sector

UK finance sector growth

Source: Bank of England

UK financial sector growth – strong between 1995 and 2008, but experienced a deeper dip in the 2008 recession.

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Credit Policy

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Credit policy / financial policy is the use of the financial system to influence aggregate demand (AD). Monetary policy affects AD through the Central bank controlling interest rates and the money supply. Fiscal policy affects AD through the use of government spending and taxation.

Credit policy looks at factors such as:

  • Bank lending rates to firms and households in the economy.
  • The supply of credit and availability of loans from banks to firms and households.

In normal economic circumstances, it was felt the Central Bank could adequately control the economy through changing base rates.

When the Central Bank (e.g. ECB, Bank of England) changed interest rates, it had a strong influence on bank lending rates. When the ECB cut rates in 2001-03, bank lending rates fell, when the ECB raised rates in 2006-07, bank lending rates rose. Bank lending rates closely mirrored the Central Bank. Therefore, there was little attention paid to bank lending rates – there was no need.

However, since the credit crunch, the normal relationship between Central bank base rates has broken down. In particular, when the main base interest rate was cut, firms – especially small and medium sized firms (SME) didn’t see the actual interest rate they paid cut.

base-rates-bank-rates

See also bank and base rates in the UK

Implications of divergence between base rates and bank rates

This is very important for the effectiveness or not of monetary policy. Usually, if interest rates are cut from 5% to 0.5%, we would expect the loosening of monetary policy to boost lending, consumption and aggregate demand. But, that hasn’t been happening. Lending rates are still high, and credit tight. The base rate of 0.5% has become misleading to the actual reality of firms who face high borrowing costs.

Problems in the Eurozone

bank costs

Source: Economists – Central bank has lost control over interest rates

This problem of bank lending rates is most noticeable in the peripheral Eurozone countries. Since the crisis, small and medium sized firms have actually seen an increase in borrowing costs. Bank rates have increased, making the 0.5% ECB rate meaningless. The Economist reports

‘SMEs in Spain and Italy must pay over 6% to borrow; money is tighter there than it was in 2005, even though the ECB’s rate is far lower.’ (Woes for small business in Europe)

The problem for SME (small and medium enterprise firms) is that they are too small to sell their own bonds. They are reliant on bank lending. But, because of the credit crunch and fears over bank stability, they are finding their borrowing costs increase.

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Revising for economic essays

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Readers Question: how to revise for a possible exam question like: discuss the likely effectiveness of ‘expansionary fiscal and monetary policies as means of closing the output gap’

Firstly write down the question on a blank piece of paper. Then try and revise in three parts.

Part One – Knowledge  define terms

  • Expansionary fiscal policy – an attempt by the government to increase AD, through increasing government spending and cutting tax, (leading to bigger budget deficit)
  • Expansionary monetary policy – When the Central Bank cuts interest rates or increases money supply, through a policy like quantitative easing.
  • Output gap. This is the difference between potential output and actual output. A negative output gap means that current real GDP is less than potential and therefore there is spare capacity / unemployment.

Part Two – Explain effect of fiscal and monetary policy on output gap

Expansionary monetary policy could involve cutting interest rates. If the Bank of England cut interest rates, this should stimulate aggregate demand. Firstly, lower interest rates reduce the cost of borrowing and therefore encourage consumers to spend on credit. Lower borrowing costs will also encourage firms to invest because it is cheaper to finance investment. Secondly lower interest rates will reduce the amount householders have to spend on mortgage interest payments and therefore they will have more disposable income; this should increase consumer spending. Overall, with higher C and I, we should see an increase in AD.
ad

This increase in AD should lead to higher real GDP and reduce the output gap. At Y1, there is a significant negative output gap, Y1 is less than potential AS. Therefore, increasing AD does reduce the output gap.

Expansionary fiscal policy

The government could decide to borrow from the private sector and use this to spend on capital investment, such as building new roads and railways. This increase in government spending will increase AD and have a similar effect in increasing GDP. Alternatively, the government could cut the rate of VAT, this lower tax will give consumers greater spending power and should hopefully increase consumption; this should also increase AD, leading to great real GDP and reduce the output gap. There may also be a multiplier effect with the initial investment causing a bigger final increase in real GDP.

Part Three evaluation

For evaluation we need to discuss

  • Will these policies actually  be successful?
  • What could determine with monetary and fiscal policy actually close the output gap?
  • What might different economists say?

Evaluation for macroeconomics could involve several factors, such as:

  • Other factors affecting AD
  • Time lags
  • It depends on the state of the economy
  • It depends on side effects of policies implemented.

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What economic lessons can we learn from Latvia and Estonia?

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The Latvian and Estonian economies have recently experienced – an economic boom, a spectacular bust, and recovery. Their experience is a chance to evaluate the merits of fixed exchange rates, austerity and the issues of an economy based on trade and capital inflows.

estonia-latvia-growth

Aspects of the Baltic economies

  1. Boom period between 2000 and 2007
  2. Great recession of 2008-2010
  3. Readjustment policies of fiscal contraction whilst maintaining fixed exchange rate.
  4. Economic recovery from 2011

Lessons from the boom

Both Latvia and Estonia experienced rapid economic growth in the early 2000s. This was helped by various policies and economic factors

  • Free market reforms enabled growth of efficiency and productivity. From 1991, the economies became more market oriented with policies of privatisation and deregulation, enabling greater incentives to be efficient.
  • Latvia and Estonia are both small, open economies where free trade has contributed towards economic growth. In Latvia, exports account for 33% of GDP, including raw materials, such as timber, agriculture and manufacturing products.
  • The open nature of the economy attracted significant capital inflows from Europe. These capital inflows helped to finance a growing current account deficit, which reached 20% of GDP in Latvia and 16% of GPD in Estonia.

latvia

Source: Latvia report, EU

Record levels of economic growth in Latvia, led to a corresponding rise in the current account deficit.

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OCR F585 Stimulus material on Estonian economy

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This years OCR F585 global economy pre-release stimulus material is about Estonia and its economic performance. This post gives a few extra graphs about the state of the Estonian economy and considers important issues and questions, related to Estonia.

Brief synopsis

From the early 2000s Estonia experienced rapid economic growth as it benefited from joining the EU (in 2004) and receiving greater inward investment from Europe.

Estonia’s economic growth since 1991 has been based on its transition to a market economy, e.g. policies such as privatisation. It also benefited from low inflation and macro-economic stability. It has also encouraged inward investment through low taxes. In the boom period of 2000-2007, Estonia was able to borrow on European capital markets to finance investment, which spurred strong growth in exports and international trade.

However, the credit crunch and EU crisis of 2007-11 harmed Estonia’s economy. It’s reliance on EU loans meant that it saw investment drying up and GDP contracted by 5% in 2008 and by 14% in 2009. In the recession, the Estonian government embarked on a controversial austerity programme, which saw spending cut by up to 20%, to try and reduce the budget deficit. After a deep recession, the Estonian economy has shown a strong recovery, though unemployment is still over 10%.

Firstly, these are some elements of the Estonian / Latvian economy not mentioned in the extract. In particular, the extract gives little mention of unemployment. Knowing the unemployment rate, helps give a wider perspective on Estonia’s economic situation.

Unemployment in Estonia

After falling to less than 5% in 2007, during the economic crisis unemployment in Estonia increased rapidly reaching a peak of 17%.

estonia-unemployment

EU unemployment rates at Eurostat

However, unemployment in Estonia has now fallen to just below the EU27 level, but it is still high at over 10%.

latvia-eu

Unemployment was even higher in Latvia. This suggests that Estonia achieved a more successful recovery than Latvia. Estonia has been much successful than Greece.

Estonia recession and recovery

Since the recession of 2008-09 Estonia has posted stronger recovery than other countries within the EU. However, if you have a deep recession, it is easier to recover lost output.

estonia-latvia-growth

EU economic growth at Eurostat

It also depends which way you look at real GDP.

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Will the Eurozone Breakup?

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No one doubts the commitment of many in the EU to seeking a way to prevent the Euro breaking up. The Euro project is deeply embedded in the European establishment. But, are they fighting a lost cause? Are the structural problems with the single currency so severe, they would be better off pursuing an orderly break-up? Or would the break-up of the Eurozone lead to an even worse period of instability and economic crisis?

Reasons Why the Eurozone is heading for a Break-up

1. There has been no Economic Harmonisation

Harmonised competitive indicators in the EU (2011 Q1), source: ECB Stats based on unit labour costs indices for the total economy:

Since 1998, Germany (DE) has seen a reduction in labour costs of 18.5%. By contrast, Italy and Ireland have seen an increase of 6.6% and Greece of 9.7%.

The Eurozone is not an optimal currency area. There is a huge difference between northern European economies (Germany) and Southern European economies. This is not a difference in debt levels. It is a difference in productivity and relative wage costs.

In normal circumstances, this would not be a problem because the German currency would appreciate due to its hyper-competitiveness – and the exchange rate of Italy, Greece e.t.c. would devalue, but this has not happened because the Euro permanently locks in exchange rates. See also: (competitiveness in Europe) | Two Speed Europe

2. Current Account Deficit

eurozone current account

  • This divergence in labour costs, productivity and inflation is reflected in the current account statistics within the Eurozone. In particular, it shows that Germany has had a persistently large current account surplus, which is matched by a current account deficit in other Eurozone economies.
  • With a fixed exchange rate, German goods have become more competitive in the Eurozone. Southern Eurozone goods have been uncompetitive. The exchange rate imbalance is a significant factor in the persistently low economic growth in Southern Europe.
  • Without a mechanism for exchange rate adjustment within the Eurozone, the current account imbalances will persist.
  • Furthermore, this issue rarely gets much attention. The EU and Germany frequently talk about the need for internal devaluation for countries to regain competitiveness. But, internal devaluation is causing economic misery of unemployment and falling GDP.
  • Economic Imbalances in the Euro by Christian Schoder 2011

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Finding economic stats and data at ONS and Bank of England

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Quick links for main economic statistics

My page with graphsMain ONS datasetUseful direct links
Economic growthNational income accReal GDP | % quarterly
Inflationinflation seriesCPI annual %
UnemploymentLabour market ILO %
Current account b of ppnbpC.A % GDP
Budget deficitpsf at ONS | psf at HM TPSNB % GDP
Public sector debtpsf at ONSPSND % GDP
Labour productivityprdy datasetlab. prod. % change
Saving RatioNat.l inc. acc: J3household savings %
Business investmentBusiness investment
Housing marketNationwide datahouse price index ONS
UK wage growth average earnings S.A % change
Industrial + manuf outputindustrial productionindex of output

Bank of England data
UK Bond yieldsBank of England 10 year bond yields
Exchange ratesSterling exchange rate
Money supply (BM4 at B of E)

Other data

Readers Questions: I’m pretty good at finding data at FRED. But I have no luck finding what I want at ONS. Do you have a post on that? Or some guidelines that might help me? Would be great!

It’s a good question. I’ve spent the past four years finding my way around the ONS database and website (and updating links the last time they changed URLs). I’ve spent many hours looking for certain statistics. The good news is that nearly all the important ones are there, if you dig hard enough. Though some data like exchange rates, bond yields, interest rates and money supply you will need Bank of England database.

Sometimes it’s frustrating because all you want is the % change in real GDP, and you have to wade through statistics on S.A Output in fishing and forestry.

A few points.

  1. If you get stuck, ONS have been very helpful in pointing out to me the relevant page. So it might be worth using the contact page, if you do get stuck
  2. Sometimes, the hardest thing is knowing where to find a statistic. For example, finding the savings ratio was difficult, because it’s not intuitive you need to look in National accounts – Household sector – saving ratio
  3. In some cases, other sources of data are better, e.g. for housing I still think Nationwide is better than the ONS, though the ONS seem to be giving housing more importance.
  4. It’s also worth checking out:

Tips on getting data

I subscribe to the ONS RSS feed so I can see when new publications come out.

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