Activity in the housing market has remained robust despite the stamp duty relief ending on 30 September 2021. The latest Halifax House Price Index Report for April 2022 suggests that house prices increased by 10.8% year-on-year in April 2022. This means that the average price for a house in the UK is now £286,079 – up by £47,668 from a year ago. This is the tenth consecutive monthly rise, which is the longest streak since 2016.

Why have house prices surged?

House price inflation started to accelerate at the end of 2020. Prices then rose significantly following the end of the nationwide lockdown in the first quarter of 2021, with several factors contributing to this increase.

A lack of discretionary spending opportunities during the periods of lockdown helped to boost household savings by around £200 billion. This meant that people had more savings to spend on property once lockdown was over.

The increase in remote working led to greater demand for larger houses, as people looked for properties with extra rooms that they could use for offices. Halifax suggests that in April 2022, prices for detached and semi-detached houses had increased by over 12%, compared with 7.1% for flats, over the past year.

The extension of the job furlough scheme also helped to support income levels and confidence. And the generally low interest rates, together with the stamp duty holiday, made buying a house cheaper during the pandemic.

Figure 1: Annual percentage change in UK house prices

Source: Office for National Statistics (ONS)

Central banks have also played a part in driving up house prices. The loosening of monetary policy and the relaxation to 0% of the ‘countercyclical capital buffer’ (which requires banks to hold a specific percentage of capital as a buffer during times of high credit growth, so it can be released during a downturn when credit growth slows) during the pandemic prevented a sudden tightening of financial conditions and encouraged banks to continue lending to help the recovery.

This further supported housing demand, pushing up prices. In November 2020, mortgage approvals reached their highest level since before the global financial crisis of 2007-09, and housing transactions through 2021 were higher than the average levels seen in the decade before Covid-19. In line with this, there has been an increase in total mortgage lending by banks throughout the pandemic (see Figures 2 and 3).

Low (and even negative) real interest rates since 2008 have helped to boost house prices. Planning restrictions and supply chain bottlenecks over the past year have also limited the procurement of key materials for construction. This has had the knock-on effect of keeping the supply of new homes tight and prices elevated.

Figure 2: Total number of mortgage approvals and housing transactions

Source: Bank of England

Figure 3: Total outstanding value of residential mortgages

Source: Financial Conduct Authority

What about mortgages?

Commercial banks have supplied mortgages throughout the pandemic-induced recession, including through the government-backed 95% mortgage scheme, which helps buyers to secure a mortgage with a 5% deposit.

So, the question is whether higher interest rates will cause house prices to fall sharply and bring about defaults and a housing market crash. This is unlikely for four reasons.

First, it is expected that there will only be a gradual increase in borrowing costs, with the Bank of England’s Monetary Policy Committee anticipated only to increase its policy interest rate from 1% to around 2.5% next year.

Second, household credit growth in the three months to June 2021 was 3.7%. This is higher than the 2019 average of 2.8% but still low compared with historical standards (and almost five times lower than before the global financial crisis). This suggests that, lately, credit growth has continued to be better controlled, which may have limited the accumulation of systemic risk as housing costs rise.

Figure 4: Proportion of different loan-to-value (LTV) ratios

Source: NMG

Figure 5: Debt-to-income ratios

Source: ONS, UK Finance

Third, in the period before the pandemic and even following it, the proportion of high loan-to-value (LTV) and loan-to-income (LTI) mortgages has fallen (see Figures 4 and 5). Likewise, household total debt-to-income ratios (the proportion of debt taken relative to the applicants’ income levels) and mortgage debt-to-income ratios have remained stable throughout the period of the pandemic, and they are 10-20 percentage points lower than during the global financial crisis.

This fall in the proportion of risky mortgage lending since the financial crisis has limited the build-up of financial vulnerabilities.

In June 2014, the Bank of England’s Financial Policy Committee introduced more thorough affordability checks on potential mortgages, with banks calculating the debt service ratios of applicants based on an interest rate that is three percentage points higher than the current rate.

At the same time, banks have also faced limits on the number of very high LTI mortgages they are allowed to supply: specifically, no more than 15% of new mortgages can be at LTI ratios of 4.5 or greater.

This set of ‘macroprudential’ policies has helped to manage mortgage lending risks.

Figure 6: Proportion of residential lending to individuals – by type

Source: Financial Conduct Authority

Fourth, there has been an increase in the proportion of fixed rate mortgages in the UK. These now account for 90-95% of total mortgages taken out by homeowners (see Figure 6).

These homeowners are already tied into a mortgage product that offers, for example, a fixed rate of interest for either two years or five years. This means that an increase in the interest rate is not going to have an immediate effect on their monthly repayments.

New mortgage applicants may be affected by higher interest rates, but once they have had their rate locked in as part of fixed term deal, they will be cushioned from future changes.

On the other hand, variable rate mortgage owners will experience higher monthly mortgage payments in line with higher nominal interest rates. But given that only 5% of mortgage owners are on such a scheme, it is unlikely that the impact from higher rates on these borrowers will cause significant distress across the housing market as a whole.

Figure 7: Residential loans to individuals

Source: Financial Conduct Authority

Another factor that will help to prevent a meltdown of the housing market is the greater proportion of double income households with mortgages. Figure 7 shows that there has been a general increase in the number of mortgages supplied to joint income households over the last ten years.

Even though there was a slight reduction throughout 2021 (potentially because some people were more reluctant to take on the risk of purchasing mortgages and houses because of greater uncertainty around how the pandemic would affect their employment and income), they still account for 65% of the mortgages supplied in the regulated mortgage market.

A household managed by two individuals with two sources of income is likely to be better equipped to cushion themselves against higher living costs. The prevalence of these types of homeowners will therefore also reduce the probability of large-scale default. It is also possible that two employed and financially secure individuals may be more confident when purchasing a house, irrespective of the current climate, further supporting housing demand and underlying prices.

How might the cost of living crisis affect tenants in rental accommodation?

Outright homeowners and those with fixed rate mortgages are not the most vulnerable groups in this context. The worsening cost of living crisis is likely to have more of a direct impact on those renting, those in sheltered accommodation or borrowers on variable rate mortgages.

Landlords can increase rental rates as economic conditions change – for example, in response to rising utility bills or even in wake of lower property prices (see Figure 8).

In February 2022, the Royal Institute of Chartered Surveyors (RICS) reported that over the next year, rental prices are forecast to increase by 4% on average across the UK. On a regional basis, the survey suggests that in relatively lower-income parts of the South East of England and the East Midlands, rental growth will be limited by the worsening cost of living crisis.

Rental tenants are more susceptible to fluctuations in disposable incomes, which can affect budgeting (unlike fixed rate mortgage owners who have clear foresight of their monthly repayments for the term of their mortgage). This means that surging food and energy prices are more likely to hit renters, reducing demand for rental properties rather than residential properties.

Figure 8: Annual growth in UK private rental prices

Source: ONS

Conclusions

Looking ahead, in the short term, increased demand for larger residential homes, together with tight supply because of planning restrictions, will continue to support UK house prices.

The prospects of higher nominal interest rates may start to slow the strong growth in house prices and demand towards the end of this year, as mortgage rates rise. But the increase in the Bank of England’s policy rate from around 1% this year to 2.5% next year is unlikely to lead to a collapse in house prices, especially as interest rates will be raised gradually.

The surging cost of living – which is squeezing disposable incomes – together with record high house price-to-disposable income ratios are more likely to affect those in rental accommodation or with variable rate mortgages compared with fixed-term mortgage holders.

The higher cost of living may even discourage risk-taking by prospective homeowners, particularly single applicants, especially if they are forced to run down savings to help to cope with the higher cost of living. This may in turn depress demand for new housing, slowing down price growth.

Where can I find out more?

• Housing transactions now rising but a substantial shortfall this year due to Covid-19: Barry Naisbitt analyses the trend in housing transactions during the pandemic.
• Planning to fail? Ian Mulheirn evaluates whether increasing supply would reduce house prices.
• Property millionaires: The growing housing divide: Paul Cheshire provides an outlook on how the housing market might evolve.
• There’s more to house prices than interest rates: Lisa Panigrahi and Danny Walker suggest that low interest rates were not the only driver behind surging house prices during the pandemic.

Who are experts on this questions?

• Barry Naisbitt
• Paul Cheshire
• David Miles
• Geoff Meen
• Christine Whitehead

Author: Urvish Patel

Photo by Andrew Michael from iStock

The post What next for the UK housing market? appeared first on Economics Observatory.

Midsummer’s day is here, but the UK economic news is unremittingly wintry. Food and fuel costs continue to push higher. National rail strikes presage a long season of industrial action as workers and their trade union representatives demand pay increases that keep up with rising prices. Higher interest rates, as the Bank of England tries to deliver on its central objective of returning inflation to an annual rate of around 2%, risk weakening a fragile economy and perhaps tipping it into recession. And on top of all that, there is the self-inflicted harm of Brexit – disrupting goods and services trade, business investment, the post-pandemic recovery, and much else.

We have covered many of these challenges at the Economics Observatory in recent weeks and months. Early in the year, Delia Macaluso (University of Oxford) and Michael McMahon (also Oxford and one of our lead editors) explained how Covid-19-induced shortages of goods and increases in labour, energy and transport costs in global supply chains were contributing to initial inflationary pressures around the world. Russia’s invasion of Ukraine and European efforts to move away from dependence on Russian oil and gas have led to even higher energy prices, as discussed in pieces by Erkal Ersoy and Christopher Aitken (Heriot-Watt University) and by Helen Thompson (University of Cambridge).

The war is also having a big impact on global food prices, as explored this week on the Observatory by Lotanna Emediegwu (Manchester Metropolitan University). As he describes in this and an earlier analysis of the effects on global food security, conflict in the ‘breadbasket of Europe’ is driving up food prices for the continent and the wider world. But developing and emerging economies are being hit hardest due to their reliance on the region for fuel and grain imports. Crop shortages and price hikes in these countries could spur further political turbulence and even violence.

Double trouble

Back in the UK, the consumer price index hit an annual inflation rate of 9.1% in May, the highest since March 1982, according to new data from the Office for National Statistics (ONS). Observatory manager Charlie Meyrick considers what this means for the cost of living crisis, particularly for lower-income households, as well as the industrial action by the National Union of Rail, Maritime and Transport Workers and potential strikes in other parts of the economy. These are issues to which we will return in the coming weeks.

Figure 1: CPIH, CPI and OOH inflation rates (May 2012 to May 2022)

Source: ONS
Note: CPIH – consumer price index including owner occupiers’ housing costs; CPI – consumer price index; OOH – owner occupiers’ housing costs

Elsewhere, there’s been some good coverage of the inflation data and their implications for monetary policy and public sector pay. Our colleagues at the National Institute of Economic and Social Research (NIESR) note the key role of rising food prices in keeping inflation at this historic high – and like the Bank of England, they expect the annual rate to reach double digits before turning down. Chris Giles at the Financial Times notes that just a year ago, inflation appeared under control, and blames central bankers for complacency about what was coming. And Soumaya Keynes at The Economist and Paul Johnson at the Institute for Fiscal Studies (IFS) separately anticipate some of the challenges for the government of trying to restrain public sector pay to curb inflation.

Looking much further back in history, another new piece this week gives a perspective on UK inflation over nearly a millennium. Jason Lennard of the London School of Economics (LSE) and Ryland Thomas at the Bank of England outline the challenges of measuring the rate of inflation facing different households, sectors and regions – and how past statisticians and commentators have sought to construct a price index. Gradual progress on measurement over the centuries by contemporaries and economic historians has improved our understanding of inflation over the long run, but much remains to be done.

Figure 2: UK consumer price level, 1086 to 2021

Sources: From 1209, the measure of consumer prices used in both charts includes housing costs (actual and owner occupiers’ rent) and is based on the aggregate expenditure weights of all households. From 1209 to 1830, it is based on the domestic expenditure deflator of Clark, 2015; from 1830 to 1949, it uses the consumers’ expenditure deflator based on Deane, 1968; Feinstein, 1972; and Sefton and Weale, 1995; and from 1949, it uses the long-run CPIH index recently produced by the Office for National Statistics. Between 1086 and 1209, the price index is a trend measure based on a more limited set of commodities based on Barratt, 1996, 2001, and Mayhew, 2013. Alternative measures of consumer prices such as the CPI and those based on the expenditure weights of the ‘working classes’ or wage earners can be found in Thomas and Dimsdale, 2017.

The final new Observatory contribution this week draws our attention away from rising prices to focus on falling prices – specifically those of cryptocurrencies like Bitcoin and Ethereum, which have been plummeting in recent weeks. William Quinn (Queen’s University Belfast), who late last year wrote a punchy piece for us on why the price of Bitcoin has risen/fallen in the past day/week/month, now clarifies why the latest movements are steeply downwards. While the weak state of the global economy has triggered the crash, its root cause is that cryptocurrencies have always been fundamentally unsound long-term investments. They have no intrinsic value – and like pyramid schemes, they require a continuous flow of new investors to sustain prices. That flow has dried up.

Figure 3: Bitcoin price (dollars), June 2019-June 2022

Source: Yahoo! Finance

Safe European home

Another ill-advised scheme is also revealing serious signs of stress. It is six years this week since the referendum vote for the UK to leave the European Union (EU) – and our colleagues at the Centre for Economic Policy Research (CEPR) have marked the sad occasion with an ebook on what Brexit has meant for the UK economy. Next week here, we’ll have a piece by the publication’s editor Jonathan Portes (King’s College London and UK in a Changing Europe) on the impact of the post-Brexit immigration system. Overall migration numbers have not changed much since when the UK was an EU member, but the provenance, skills and sectoral mix of migrants is starting to look substantially different.

Previous Observatory articles on Brexit include explorations of its impact on Northern Ireland’s economy, Welsh ports, Scotland’s fishing industry, competition policy, Premiership football, hate crime, earnings inequality and the role of sterling in UK trade.

This week, our colleagues at the Centre for Economic Performance (CEP) at LSE have published evidence on the dramatic fall in the value of UK imports from the EU relative to the rest of the world after the Trade and Cooperation Agreement came into effect, as well as the destruction of many smaller trading relationships. A separate CEP study shows that leaving the EU’s single market and customs union has led to a 6% rise in food prices in the UK.

One final big news story this week has been European leaders’ approval of Ukraine as a candidate for EU membership. A recent Observatory piece by Richard Disney and Erika Szyszczak (both University of Sussex) considers the economic differences that EU membership would bring. They note that existing agreements between Ukraine and the EU have already promoted substantial trade flows. Accession would have bigger implications for freedom of movement of capital and workers – investment inflows and migration outflows – and these areas are where negotiations are likely to focus.

Young at heart

The Royal Economic Society (RES) young economist of the year competition closes next month. Essays of up to 1,000 words can address some of the big issues we discuss on the Observatory, including cryptocurrencies, the cost of living crisis and the ‘levelling up’ agenda for tackling regional inequalities – on which we will have a new piece by CEP’s Henry Overman and Helen Simpson (Centre for Evidence-Based Public Services, CEPS, University of Bristol) early next week.

If you have comments on any of the articles published by the Economics Observatory, please get in touch. We also welcome suggestions for questions that our contributors can answer. And do pass on the link to this newsletter to friends and colleagues who might be interested. Anyone can sign up here.

Author: Romesh Vaitilingam

Photo by solarseven from iStock

The post Summer of discontent appeared first on Economics Observatory.

Figure 1: Bitcoin price (dollars), June 2019-June 2022

Figure 2: Ethereum price (dollars), June 2019-June 2022

Figure 3: XRP price (dollars), June 2019-June 2022

Source: Yahoo! Finance

To appreciate what is happening, we need to understand the nature of cryptocurrencies as investments. In finance, we typically evaluate investments by assessing their associated future cash flows. For example, if we want to understand how much a share in a company is worth, we try to estimate how much money the business might make in the future.

A small number of investment assets, such as gold, are useful to investors despite producing no cash flows. This is usually because extensive historical data indicate that their price tends to rise when other assets are losing value. Including them in a portfolio of investments can therefore reduce the investor’s level of risk.

Depending on investors’ risk preferences, this may offset the reduced expected return arising from the absence of cash flows. These assets are also commodities: they would still be useful to their holder even if no one was willing to buy them.

When evaluated as an investment, cryptocurrencies are unique – and not in a good way. In the vast majority of cases, they do not entitle the holder to any cash flows; their price does not appear to rise when other investments are falling; and they have no value beyond the willingness of another person to pay for them.

In addition, the most popular cryptocurrencies incur substantial energy costs. Bitcoin’s ‘proof-of-work’ verification system gives investors incentives to use computing power repeatedly to guess a very large number, with the closest guess receiving newly minted Bitcoin. This burns through an estimated $6.5 billion of electricity per year. Since these electricity costs cannot be paid in Bitcoin, the system is negative-sum: more money will be lost by the losers than is gained by the winners.

Figure 4: The negative-sum cash flows of Bitcoin

This means that the cryptocurrency ecosystem requires a continuous inflow of new investment just to keep prices at the same level. Positive returns can only come from future investors who are willing to pay a higher price.

The only other class of ‘investment’ for which this is always true is Ponzi or pyramid schemes, two common forms of fraud in which money from late investors is used to pay unsustainably high returns to early investors. Similar to Ponzi schemes, crypto investors often advertise the coins they hold aggressively in an effort to attract newcomers (a practice commonly known as ‘shilling’).

Another way to increase the flow of cash into the system is via the use of debt. For example, rather than buy $1,000 worth of Bitcoin, an investor might use that $1,000 as collateral for a loan of $10,000 and buy $10,000 worth of Bitcoin (this is generally known as margin trading).

Since this generates ten times more demand, margin trading will cause prices to rise more quickly in a bull market – a period when an asset’s price rises continuously. But the lender typically retains the ability to force the borrower to sell if their investments fall below a certain level – the dreaded ‘margin call’. These forced sales mean that prices will also fall more rapidly on the way down.

Another significant form of debt in the crypto ecosystem involves stablecoins. These are cryptocurrencies that are ‘pegged’ to the value of a traditional currency, usually the dollar. They are often issued without being fully backed by underlying dollars, with the excess stablecoins invested in crypto assets.

Effectively, this means investing depositor money multiple times, in much the same way as a fractional reserve bank (where only a portion of deposits are backed by cash and therefore available for withdrawal). Since it incurs liabilities, it constitutes another form of debt.

At the time of writing, the largest stablecoin, Tether, had 67.9 billion Tethers outstanding. The quantity of dollar equivalents backing these assets is unknown but has previously been at levels as low as 6%. In other words, the Tether Corporation had at that time issued over 16 Tethers for every dollar it owed to depositors. This represents another significant source of debt, and the potential failure of the Tether peg is widely considered as a systemic risk to the crypto sphere.

Partially backed stablecoins can simply be used to buy other cryptocurrencies, increasing their price even when no new dollars are entering the system. More commonly, they are used to collateralise margin trading in the manner outlined above, layering one level of indebtedness on another.

Importantly, the fundamental negative-sum nature of cryptocurrencies is not changed by all of this debt. More leverage can postpone the crash, but it cannot prevent it, and it is likely to make it more sudden and painful. Research shows that debt-fuelled bubbles tend to be much more economically destructive than other bubbles (Quinn and Turner, 2020).

The current drop in the price of cryptocurrencies is simply the result of this debt-fuelled, negative-sum system unwinding. As a result of the increasing cost of living, rising interest rates and post-pandemic return to normality, the flow of new money entering the system has dried up.

Falling prices are leading to margin trader liquidations, financial difficulties at major crypto firms and stablecoin collapses. These events impose losses on other participants in the crypto economy, who may themselves default on debt, creating a vicious downward spiral. This momentum can only be stopped by finding a way to generate a new influx of dollars or to prop up prices temporarily with more debt.

The trigger for the crash was a change in the economic environment, but its root cause is that cryptocurrencies have always been fundamentally unsound long-term investments. History tells us that negative-sum assets with no use value cannot hold their value indefinitely. As is often the case during a bubble, the promise of ‘getting rich quick’ appears to have blinded many participants to the economic reality.

The big question for policy-makers now is whether this poses a threat to financial stability. Fortunately, the extent of institutional investment in crypto has been heavily exaggerated, and systemically important banks are unlikely to have much direct exposure to the crash.

The main risk to stability comes from the possibility that the banks are indirectly exposed in a way that they themselves do not fully understand. This was the case during 2021’s Archegos scandal, when the collapse of an investment company triggered banks and other investors to lose billions of dollars.

The bad news is that money lost in crypto investments is almost certainly gone forever. Investments with regulated UK financial services firms are often partially covered by the Financial Services Compensation Scheme, and deposits at banks are covered by deposit insurance. But since crypto is largely unregulated, money held at crypto exchanges or investment platforms is not covered. Although the crypto crash is unlikely to cause the next great recession, the losses to individual investors could be severe.

Where can I find out more?

• The latecomer’s guide to crypto crashing – Amy Castor and David Gerard – an outline of the crypto firms and stablecoins that have collapsed so far, and those that appear to be in distress.
• Are Bitcoin and other digital currencies the future of money? An assessment of the strengths and limitations of Bitcoin as a currency.
• Why has the price of Bitcoin rise/fallen in the past day/week/month? An assessment of the factors that drive short-term fluctuations in the price of Bitcoin.
• Web3 is going great – a continually updated timeline of failures, hacks and lawsuits affecting cryptocurrencies and other associated projects.

Who are experts on this question?

• Frances Coppola
• John M. Griffin
• John Paul Koning
• David Gerard
• Andrew Urquhart
• Eric Budish

Author: William Quinn

Photo by solarseven from iStock

The post Why are cryptocurrencies crashing? appeared first on Economics Observatory.

According to econometric estimates now and at the time, the full effect of monetary policy – in the guise of changes in interest rates – on inflation is achieved after about two years. So, our interpretation of the mandate was that we should vary the path of interest rates now, to achieve the forecast inflation targets two years down the line. That same interpretation has, I believe, been generally accepted among most other major central banks. 

There were other considerations that the initial MPC had to discuss. The first was the degree of individualism that the separate members of the committee should be allowed, even encouraged, to maintain. One reason for having external members was to avoid ‘group think’. And the then governor, Eddie George, encouraged us to stand up for our own individual views, and be prepared to present and defend them in public. 

There are a variety of arguments for and against a more individualistic committee, and there was an exchange of views on the subject in published articles between Willem Buiter and Otmar Issing at the time. In my view, the decision then to maintain an individualistic MPC was, and remains, correct. 

In conjunction with that decision, there was an associated need to decide on the precise procedure for reaching a decision on interest rates. If the governor was to speak first, a dissent from his views would be more challenging than if he had not yet revealed his hand. So, the governor then chose to speak last. Similarly, to support fairness and individuality, the procedure for choosing the order of members to give their views was adjusted randomly from meeting to meeting.

Another early decision related to the units of change. There was nothing to stop the committee adjusting interest rates in any number of basis points, as is sometimes done in China. But fairly early on, it was agreed that the unit of change should be 25 basis points. Since then, an asymmetry has seemingly crept into the maximum amount of change depending on whether the perceived crisis is deflationary or inflationary. 

In deflationary crises, such as at the onset of the global financial crisis of 2007-09 or the Covid-19 pandemic, there is now seemingly no particular limit to the extent that interest rates may be cut. But in inflationary crises, such as now, there seems to be a limit of 50 basis points to any increase.

Finally, there was a discussion on the role and position of the external committee members. Although initially it seemed that these members might have continued with their ordinary day jobs, it soon became clear that with a very few exceptions, like me, the requirements both of the job and of confidentiality required them to become continuously based in the Bank of England during their period of office. 

But if they were to be there permanently, what should they do? They were there initially completely on their own, with no support staff. Although it was felt that they could call on the regular staff at the bank, working for an external committee member would naturally be given less priority by the staff than working for their internal bosses.

So, the external members felt that they did not have enough support to do their allocated jobs as they thought appropriate. The decision was then made to allocate to each external two full-time members of staff: one a more senior economist and the other a more junior official.

I had one main surprise during my period in office. This was that each time we made a current step change in interest rates, this appeared, according to the forecast, to be sufficient to achieve the inflation target two years later. But the very next quarter, it often appeared that an exactly similar change would again be required. 

I concluded that for some reason the forecasting process underestimated the effects of various underlying, but changing, trends. The long sequence of similarly sized interest rate changes may have been put in place to avoid large, surprise changes in interest rates. But they demonstrate the inherent limitations, and perhaps constraints, on the forecasting process itself.

Author: Charles Goodhart

Photo by VictorHuang from iStock

The post How did the first Monetary Policy Committee members pursue their mandate? appeared first on Economics Observatory.

In 1998, Russia experienced a major currency crisis when the rouble lost over two-thirds of its value in three weeks, as well as a default on its sovereign debt and a banking crisis. Are there any lessons from that crisis that are relevant today?

Figure 1: USD/RUB exchange rate, January 1995-April 2022

Source: Bloomberg

Background and causes of the 1998 rouble crisis

The fall of the Soviet Union in 1991 preceded several years of economic reform, privatisation and macroeconomic stabilisation policies in Russia. A central element of this was the adoption of a currency peg – a type of exchange rate regime in which a currency's value is fixed against the value of another currency.

This meant that the value of the rouble relative to the dollar was constant and only allowed to fluctuate within a narrow band. The Bank of Russia would intervene by buying and selling the rouble as necessary to maintain the exchange rate.

The Russian economy was also supported by financial aid from the World Bank and the International Monetary Fund (IMF), while negotiations to repay foreign debt inherited from the Soviet Union improved investor confidence (Chiodo and Owyang, 2002).

In the first quarter of 1997, foreign investment in Russia rose sharply with the relaxation of restrictions on foreign portfolio investment. But investor expectations soon changed following the Asian financial crisis, which began with the collapse of the Thai baht in July 1997. This crisis quickly spread to other Asian currencies and by November, the rouble also came under attack by speculators (Chiodo and Owyang, 2002).

Despite the reforms introduced since 1991, fundamental institutional weaknesses remained in Russia (Sutela, 1999; Chiodo and Owyang, 2002). These weaknesses were highlighted and exacerbated by the financial crisis in Asia.

A global recession and a fall in commodity prices compounded weak tax enforcement in Russia and an expensive war in Chechnya. This led to fiscal imbalances and raised questions about the government’s ability to pay its sovereign debts and maintain a fixed exchange rate (Desai, 2000; Kharas et al, 2010). This increase in default and exchange rate risk made capital flight from Russia and a devaluation of the rouble more likely.

In an attempt to encourage investors to hold rouble-denominated assets and support the fixed exchange rate, the Bank of Russia increased interest rates to 150%.But this meant that by July 1998, interest payments on Russia’s debt were 40% higher than the country’s tax collection. This had the effect of further eroding investor confidence and creating downward pressure on the currency.

In early August 1998, driven by fears of a default on domestic debt and a rouble devaluation, the Russian stock, bond and currency markets all came under severe pressure. Trading on the stock market was suspended for 35 minutes due to sharp falls in prices.

Then on 17 August, the government announced a devaluation of the rouble’s pegged exchange rate, a default on its domestic debt and a 90-day suspension on payments by commercial banks to foreign creditors.

Two weeks later, on 2 September, the Bank of Russia abandoned its efforts to maintain a fixed exchange rate and allowed the rouble to float freely. In three weeks, the currency had lost about two-thirds of its value (Kharas et al, 2010).

Consequences and recovery

There were significant domestic and international consequences of these events. The currency crisis and associated financial market turmoil contributed to a recession and contraction of the Russian economy by 5.3% in 1998, with GDP per capita reaching its lowest level since the formation of the Russian Federation in 1991.

Inflation in 1998 was 84% because of rouble depreciation, contributing to a dramatic fall in real wages and social unrest. Workers staged strikes and large scale protests, including demonstrations in front of the Russian White House. 

Increased political instability followed: both the prime minister and central bank governor were replaced; the new prime minister’s first budget was rejected; and the president’s popularity collapsed (Desai, 2000). In August 1999, within a year of the crisis, Vladimir Putin became the fifth prime minister in 12 months.

The crisis also had a significant effect on financial markets globally. Russia’s sovereign default was the largest in history at the time and contributed to the collapse of the LTCM (Long Term Capital Management) hedge fund in the United States, which required a $3.6 billion bailout. This led to substantial spillover effects in international markets (Dungey et al, 2002).

The Russian economy recovered relatively quickly from the 1998 crisis, growing by 6.4% in 1999 and 10% in 2000. The sharp depreciation of the rouble made Russian exports attractive internationally and, combined with an increase in oil income, helped to stimulate the economic recovery. Sovereign debt restructuring and an IMF loan of $4.8 billion helped Russia to regain access to international financial markets.

Lessons for today

It is important to note that the forces driving the 1998 crisis and today’s crisis are very different, both politically and economically. Yet there may be fundamental lessons about how crises evolve and their implications.

First, currency crises can be triggered by events that increase a country’s risk, reduce investor confidence and change expectations of a country’s economic outlook, causing capital flight.

As in 1998, the devaluation of the rouble in 2022 was fundamentally triggered by a large increase in Russia-related risk, although the source of this was very different in each case.

Second, currency crises often go hand-in-hand with other financial crises, such as sovereign debt defaults, stock market crashes and banking crises, and can lead to higher inflation and interest rates. These have important implications and in 1998, they culminated in a sharp increase in the cost of living, recession, social unrest and political instability in Russia.

The full extent of financial market difficulties in Russia today has, so far, been moderated by extensive government restrictions. Nevertheless, interest rates have already increased from 9.5% to 20%, before being reduced to 14%, and inflation had accelerated to 16.7% by March.

Further economic difficulties may still unfold in Russia, particularly as there is currently no sign of political risk abating as the war continues and sanctions increase. But a default on Russian foreign debt seems increasingly likely and a deep recession appears certain.

As in 1998, this may have implications for social and political stability. It has been shown that approval ratings of political leaders in Russia have tracked citizens’ perceptions of the state of the economy since 1991 (Treisman, 2011).

The 1998 crisis illustrates that economic shocks can reverberate throughout global financial markets. Today, many countries are experiencing rising inflation and weaker growth as a direct result of the war in Ukraine, with rising interest rates likely to follow. Numerous international companies have written down investments in Russia.

In contrast to 1998, Russia has adopted a floating exchange rate in recent years, which means that capital flight from the country should immediately be reflected in the exchange rate. Despite this and in contrast to 1998, the rouble exchange rate has recovered rapidly from its initial fall in early March 2022.

Rather than a reflection of reduced risk or increased investor confidence in the Russian economy, this recovery highlights Russia’s success at supporting the rouble with government interventions. These include trading restrictions, capital controls, increased interest rates and government requirements for business to hold 80% of overseas revenue in roubles.

This means that the rouble is no longer freely convertible and its value now tells us little about the reality of the Russian economy.

Notably, Russia was able to recover quickly from the 1998 crisis thanks to the stimulatory effect of the weaker rouble, increased oil revenue and help from the West in the shape of IMF loans. The rapid recovery of the rouble exchange rate in March 2022 combined with increasing international sanctions means that the expansionary forces that enabled a quick recovery from the 1998 crisis seem extremely unlikely today.

These lessons suggest that the full economic effects of recent events in Russia are yet to unfold, and without a move towards peace and geopolitical normalisation, the impact will be longer and more severe than in 1998.

Where can I find out more?

• Currency crises in emerging markets: Council on Foreign Relations explainer on currency crises.
• Has financial collapse saved Russia?: Anders Åslund on Russia’s 1998 crisis and recovery.
• The price of war: Macroeconomic effects of the 2022 sanctions on Russia: Anna Pestova, Mikhail Mamonov and Steven Ongena on the economic effects on the Russian economy.
• Economic spillovers from the war in Ukraine: The proximity penalty: Jonathan Federle, André Meier, Gernot Müller and Victor Sehn on stock market reactions to the invasion of Ukraine.
• Russian consumers are already feeling the cost of war: The Economist compares current Russian inflation with the 1998 crisis.
• The economic consequences of the war in Ukraine: The Economist on the geopolitical risk and economic consequences.

Who are experts on this question?

• Paul Krugman
• Maurice Obstfeld
• Sergei Guriev
• Daniel Triesman
• Anders Åslund

Author: Christopher Coyle

Photo by ArtemSam from iStock

The post Russia’s 1998 currency crisis: what lessons for today? appeared first on Economics Observatory.

While the MPC has recently started to increase interest rates, they will remain very low by historical standards and substantially below the rate of inflation. This article aims to help us understand what rising inflation will mean in this low interest rate environment.

What are the links between inflation, interest rates and real economy activity?

Economics textbooks usually say that there is a key difference between anticipated inflation (inflation that was expected beforehand) and unanticipated inflation. When inflation is anticipated, transactions can be agreed, with future changes in prices taken into account. In this case, the levels of output, employment and the quantities of goods and services produced remain unaffected by the exact level of inflation.

As inflation rises, so too does the rate of lending/borrowing before considering inflation – what’s known as the ‘nominal interest rate’. This change accommodates the additional growth in prices to maintain the same overall (or real) interest rate. In simple terms, the real rate of interest is simply the nominal rate minus the inflation rate.

With anticipated inflation, if all wages and prices are perfectly flexible (meaning that they can be changed with no additional cost), then they can also be raised together with general inflation. In this case, the relative prices of goods, services and real wages will be unaffected by inflation.

In economics, this idea is known as the ‘classical dichotomy’, and it represents a theoretical benchmark that indicates conditions under which inflation will have no effect on the real economy in terms of things such as output and employment.

If this theory were applicable to the UK economy, we would expect to see the real rate of interest (the nominal rate minus the inflation rate) vary only a little – due to productivity shocks and other factors. In contrast, the nominal interest rate would vary a lot with inflation.

But in fact, at certain times, we observe the exact opposite: the real interest rate varies a lot while the nominal interest rate varies less. This has certainly been the case in the UK since 2009, when the nominal interest rate was first fixed at just above zero (with slight variation) and the real interest rate essentially mirrored this.

In this case, the real interest rate is simply the negative of the inflation rate. For economists, it is this real interest rate that matters for households and firms when they make their savings and investment decisions.

This means that the MPC policy of near zero interest rates will result in notable effects on the real interest rate as inflation varies. Even when fully anticipated, inflation will have real effects on the economy, altering consumption, investment and employment. In the period since 2009, there have been big swings in the real interest rate – from almost -5% in 2011 to just above zero in January 2015-March 2016 (see Figure 1).

Figure 1: Nominal and real interest rates, from 2009 to 2022

Source: Bank of England

This is the longest period of sustained negative real interest rates in UK history, having lasted over a decade. This has had a variety of effects on the economy, but it is the effect on the redistribution of income and wealth that is most important. Since the Second World War, there have only previously been two brief periods of negative real rates: from 1950 to 1953; and from 1974 to 1978.

What role does the central bank play?

The policy rate of interest set by the MPC is essentially a short-run interest rate, captured in the price of short-term government bonds. The other big policy used by central banks since the global financial crisis of 2007-09 has been quantitative easing (QE). This enables the central bank to influence long-term interest rates.

One of the main ways this has affected the economy is via large-scale central bank purchases of longer-term bonds. This has raised the prices of these bonds, which means that the corresponding longer-term interest rates have also fallen.

To illustrate this, Figure 2 compares the yield curves in 2010, 2018 and 2021. The yield curve shows how the interest rate (yield) on government bonds varies with the length of the bond (also called the ‘maturity’). The vertical axis shows the (nominal) return on government bonds and the horizontal axis shows the length of maturity in years.

For all three yield curves, the ‘short end’ at half a year is roughly equal to the policy rate (0.5% in 2010 and 2018, 0.1% in 2021). But the large amounts of QE undertaken between these years has ‘flattened the curve’, bringing down longer-term returns on government bonds. This has led to the real interest rates on longer-term bonds becoming negative as well as at the short end shown in Figure 1.

This means that QE has helped to bring long-term nominal interest rates down closer to zero and below the inflation rate, at least in more recent years. The combination of the MPC interest rate decisions and QE has been to make both short- and long-term real interest rates negative.

Figure 2: UK yield curves in 2010, 2018 and 2021

Source: Bank of England

Note: Since 2010, QE has 'flattened' the yield curve. While the 'short end' is around 0.5 for both 2010 and 2018, the longer end has gone down. 20 years maturity went from 4.5% in 2010 to 2% in 2018, and 1.2% in 2021

One of the major effects of flattening the yield curve has been to boost asset prices, including the stock market and house prices. In general, there is an inverse relationship between the rate of interest and the value of financial assets: lower interest rates mean higher asset prices.

For example, if an asset yields £10 per year, its market value is approximately equal to £10 divided by the interest rate, which gives the amount you would need to invest at that interest rate to give you an income of £10. Using this approximation, if the interest rate was 10%, you would only need to invest £100 to give you an income of £10 per year. If the interest rate is 0.5% – as it has been most of the time – the income of £10 per annum is worth £2,000. Whether the income is from rent, dividends or bonds, the income generated by the asset is worth more when interest rates are lower.

This also has real effects, since the ownership of assets is highly skewed with a small proportion of households owning most of the wealth. Wealth inequality has increased in the UK in recent years.

What are the effects of inflation when there are near zero or fixed interest rates?

So, how does inflation affect the economy in an environment where nominal rates are fixed, as they have been since 2009? There are several effects, even when inflation is anticipated.

First, higher inflation redistributes from lenders to borrowers. With a fixed nominal interest rate, inflation reduces the amount that borrowers have to repay to lenders overall (in real terms). If one person has borrowed £100 from another, and promised to repay £105 in 12 months’ time, the actual value of the eventual £105 will depend on inflation (if prices have gone up, £105 is less valuable).

If inflation over the 12 months is equal to 5%, then the £105 that the borrower has to repay has the same purchasing power as the £100 initially borrowed a year ago. This implies a zero real interest rate. If there had been no inflation, then the real interest rate would have been 5%. If interest rates were operating normally, this effect would be present only if the inflation was not fully anticipated.

Second, the government is the biggest borrower in the UK, with debt equal to almost 100% of GDP. There is therefore a big ‘inflation tax’. The real value of the governments’ liabilities declines, which is in effect a tax levied on the holders of government bonds. If I own bonds that promise to pay me £1,000 next year, the purchasing power of that £1,000 will be less as a result of inflation.

For example, if inflation was 5%, my purchasing power available from the £1,000 will be 5% less (because the items I consume have gone up in price). I will be in exactly the same position as if there had been no inflation and I had been taxed directly on the bond payment.

Due to QE, a large proportion of the UK government debt is held by the Bank of England. But the Bank’s bond purchases are ultimately funded by the creation of reserves at the Bank held by commercial banks. These are liabilities of the public sector to commercial banks, so that inflation erodes their value in the same way as it does bonds held by the private sector and households.

The size of the inflation tax is very large given the high level of debt relative to GDP. The Bank of England expects inflation to reach over 10% in 2022, so the inflation tax will be equivalent to about 10% or more of GDP.

Note that the inflation tax on bonds relies on the fixed interest rate policy. If interest rates were free to adjust, then they would rise with inflation so that the real return on bonds was not affected: the additional interest payments on the bonds would compensate for the extra inflation.

Third, this inflation tax does not fall on financial intermediaries such as banks, because both their assets and liabilities will generally be defined in nominal terms: inflation will reduce the value of their assets (bonds, reserves at the Bank of England) and their liabilities (deposits of firms and households).

Exceptions to this are defined benefit pension schemes, where the liabilities are defined in real inflation-indexed terms and the bonds held are nominal. Any assets or liabilities that are indexed to inflation will not be subject to the inflation tax.

Ultimately, the bulk of the inflation tax is levied on households indirectly, even if they do not directly own government bonds. This is because the broad measure of money (known as M4) takes the form of household deposits at commercial banks. The value of this money held by households is eroded by inflation.

So, in the fixed interest rate environment that has been in place since 2009, inflation has big effects even if fully anticipated. It redistributes purchasing power from savers to borrowers. Savers are hit as the real return on their savings declines and becomes negative. Households with mortgages will benefit as the real cost of their loans falls. But the biggest beneficiary of all is the government, since the value of its debt will decline in real terms and there is in effect an inflation tax.

What are the other effects of inflation?

There are several more standard costs to inflation, even when interest rates are not fixed. The most important ones in the current situation are the following.

Eroding purchasing power

Inflation erodes the real value of wages and benefit payments. If these are set in nominal terms, the process is obvious. Over time, the fixed nominal income is able to buy less if prices are going up. Now, benefits and the minimum wage may be indexed to inflation, in the sense that each year they are updated as a result of last year’s inflation. An increase in inflation will still have an effect: since the indexation is lagged and not instantaneous, real income will be falling until the minimum wage or benefit is updated.

For example, if I have an income of £100 per week, if inflation is 5%, then each month my income will fall by about 0.42% (5% divided by 12 months). But at the end of the year, if it is indexed it will be updated by 5% to take it back to its original level in terms of purchasing power. But in the intervening months, the real value of that income has been declining.

Wages may in principle rise faster than inflation, leading to a rise in real wages. But if inflation is higher than was expected when the wages were agreed, the unexpected inflation will still reduce real wages below the expected value. Where nominal wages are inflexible downwards, inflation might be the natural method of reducing real wages in response to some negative effect.

Informational costs

Inflation reduces the information conveyed by prices in terms of the relative costs of different items, and so may lead to a misallocation of resources. Prices are going up and down all the time. The Consumer Prices Index (CPI) measures the inflation of a basket of over 700 items covering most household expenditures. When inflation is low, most of the changes reflect real changes in relative prices.

But when inflation is higher, the public may confuse nominal price changes and real (relative) changes. People may be put off buying a good or service when its price goes up because they think it has gone up relative to other goods when it has not.

Further, if inflation leads to more uncertainty about relative prices, it will lead households to devote more time to researching prices – sometimes called the ‘shoe leather’ cost of inflation.

Higher costs of holding money

Inflation introduces a cost of holding money (at least for non-interest bearing deposits). This means that it erodes the ability of money to act as a store of value. When inflation is very high, households may be driven to holding other assets that are more volatile, such as gold or Bitcoin, or substituting foreign currency (for example, the US dollar) for the domestic currency. It should be noted that this flight from money usually only happens in a hyper-inflation.

Indeed, in his theory of the optimal quantity of money, Milton Friedman argued that to encourage people to hold money, the inflation rate should be negative (so that there was a real return to holding money). The role of money as a store of value is very important and encourages savings. This role is undermined by inflation.

Great uncertainty

Inflation creates uncertainty, which discourages investment by firms since the returns to investment become less predictable. This uncertainty also makes households worse off. In essence, higher inflation can lead to households and firms putting a higher probability of a bad outcome.

History tells us that when inflation is prolonged, it becomes entrenched and then it is hard and costly to reduce it. If higher inflation becomes part of firms’ and households’ expectations, then inflation can become hard-wired into wage and price decisions.

The costs of curbing these inflationary expectations will come in the form of low growth and unemployment, as illustrated by the big recessions of the 1980s in the UK and the United States when the ‘Great Inflation’ of the 1970s was reversed.

What are the implications for monetary policy?

Prior to 2009, the MPC set interest rates above the rate of inflation nearly all of the time. Inflation almost always remained in the target range of 1-3% from 1993 onwards, with average inflation at exactly 2%.

This was a period of active inflation targeting, where the nominal interest rate was kept above the inflation rate and varied to keep inflation on target. Inflation expectations settled down at 2% from the mid-1990s as the private sector came to trust that the Bank of England was willing and able to keep inflation at this long-run average.

Since 2009, the priorities of the MPC have shifted away from inflation and more towards supporting the recovery. Inflation has swung around more wildly: from 0% to 5%, but still with an average around 2%.

Until 2020, inflation expectations have remained anchored. But now there is something of a moment of truth for the MPC. Inflation looks set to rise to 10% or possibly more in 2022. If the Bank of England keeps interest rates at these very low levels, then the private sector will lose faith in the Bank’s willingness and ability to control inflation and keep it low.

But the Bank may be a prisoner of circumstances. It is ultimately subordinate to the elected government and the chancellor faces a very high level of government debt. If the Bank were to raise interest rates, this would have a negative effect on government finances. Also, low interest rates have led to high asset prices, not just in bond markets but also in the housing and stock markets.

Raising interest rates might well lead to a decline in the values of these assets, which would be very unpopular with the wealthy and homeowners. This means that the Bank may be unwilling and unable to raise interest rates significantly.

Indeed, although current expectations for inflation are close to or above double digits in Europe and North America, markets expect interest rates to stay at levels well below inflation and below their levels before the global financial crisis of 2007-09.

Such a situation is sometimes referred to as ‘Japanification’, in reference to Japan’s experience since 1990. Given the testing fiscal situation of many economies, perhaps inflation will be the inevitable outcome of an inability of central banks to raise interest rates and governments to raise taxes or cut expenditures.

The war in Ukraine and ensuing sanctions imposed by the West have only made matters worse in terms of policy choices of central banks and governments by making the supply side of the economy worse.

Where can I find out more?

• What may happen when central banks wake up to more persistent inflation: Charles Goodhart and Manoj Pradhan.
• NIESR Monthly Inflation Blog by Huw Dixon.

Who are experts on this question?

• Jagjit Chadha
• Huw Dixon
• Michael McMahon
• Richard Davies

Author: Huw Dixon

Picture by Thinglass on iStock

The post How does inflation affect the economy when interest rates are near zero? appeared first on Economics Observatory.

Today, we mark the Silver Jubilee of that victory and look back at a successful track record. The UK’s annual rate of inflation – as measured by the Consumer Prices Index (CPI) – has averaged 2% from that date to this.

But with inflation now set to nudge double digits for the first time in over 30 years, the Bank’s Monetary Policy Committee (MPC) faces its sternest test as it seeks to engineer a return to price stability without prompting a sustained contraction in economic activity - a recession.

Why an independent central bank?

After the end of the Bretton Woods regime of fixed but adjustable exchange rates in 1971, the UK had long sought a credible nominal anchor for domestic prices – and failed.

From prices and incomes policies through monetary targeting to shadowing an external currency and then finally joining the exchange rate mechanism (ERM) of the European monetary system, it had not proved possible to adopt a workable nominal objective for domestic monetary policy to pursue.

Exit from the ERM in September 1992 led to the adoption of an inflation target the following month. But the choice of policy instrument for achieving the target was retained by the then Chancellor of the Exchequer, Ken Clarke. This meant that decisions on interest rate-setting remained subject to trade-offs against other economic and/or political judgements that would, over time, undermine the public good of price stability.

A growing body of evidence from economic research suggested that a rules-based policy pursued by a central bank with no other direct objectives, such as the need to get re-elected, would not only ensure more operational focus on the question of price stability but would also be credible in the eyes of firms and the public, who would then condition their own plans on that stated objective.

As long as there was a social consensus on the importance of price stability (which by the mid-1990s there was), it made sense to hand the month-to-month decisions on Bank rate to an independent committee of experts and officials. (Bank rate is the main policy instrument of the Bank of England as it is the rate at which it deals with commercial banks and, as such, influences the interest rates that banks pay or charge for transacting with them.)

The questions of detail to consider were: what should be the level of the inflation target? Should it be a band or a point? Should it be a symmetrical target, with equal concerns about inflation being too low as it being too high? And what form of ‘punishment’ should be introduced should the target be missed?

The answers to those questions were and still are: around 2%; a point; symmetrical; and an open letter to the Chancellor explaining the reason for the target being missed and when we can expect to return to target.

What is the structure of Bank decision-making on monetary policy?

The MPC was established with four ‘external’ experts and five ‘internal’ Bank officials. It was formalised under a new Bank of England Act of 1998.

The Bank was charged with producing its own publicly available economic forecasts with which to guide its judgement on policy decisions according to a published timetable. The minutes from the meetings would be published, along with the voting record of the MPC members.

Although under observation by a Treasury official, the MPC would be free to choose whatever level of policy instruments it thought fit at its meetings. Each meeting would be chaired by the Governor who would have a casting vote if required.

By and large the structure of the MPC has remained stable since 1997, which implies some large degree of success. The MPC’s credibility is generally felt to have been supported by the transparency of the process and the accountability of its members to the media and the public, but also to Parliament via regular evidence sessions.

Ultimately, MPC members are accountable to the Chancellor of the Exchequer who sets out, at least once every 12 months, ‘how price stability will be defined and the government’s economic policy objectives’. (I leave the story of how the Bank dealt with the global financial crisis of 2007-09 and extended its policy instruments to include quantitative easing, QE, and macro-prudential instruments to another time.)

What is causing the current inflation surge?

The current rise in inflation has its origins in the stoking of global demand by monetary authorities around the world to help stabilise economic activity during the Covid-19 lockdowns.

As we approached the end of restrictions on our day-to-day freedoms, we faced supply chain disruptions. In the case of the UK, these were amplified by Brexit, which acted to raise prices further. These have now been ratcheted up by surging prices in world food and energy markets, because of the Russian invasion of Ukraine.

In the language of economists, not only did the Phillips curve – which is the relationship between inflation and the balance of demand and supply – get steeper but it also shifted in. This meant that a given level of excess demand was more inflationary that it might otherwise have been.

To some commentators, the combination of booming demand and supply constraints is strongly reminiscent of the 1970s. But unlike then, because of the Bank of England’s operational independence, we have a monetary policy regime that is not only credible but also has a good track record. That may be critical in managing a disinflationary path without excessive output volatility – in other words, reducing inflation without a deep recession.

Indeed, in pursuing a flexible inflation targeting approach and in the face of sufficiently large shocks and/or considerable uncertainty, the MPC can choose to delay the horizon over which inflation is brought back to target. In other words, as long as the public believes the MPC will bring inflation back to 2%, it can decide how long it takes to do this.

Is it broke enough to fix?

The UK’s poor economic performance since the global financial crisis, which has involved low rates of real growth but also Bank rate stuck near to zero (or what economist call the zero lower bound or ZLB), has built up some momentum for the remit to be changed by many influential commentators.

Although I argue here that we should put a stop to this momentum for changing the MPC’s remit and refocus on the core question of price stability, it does not follow that nothing should change.

First, there is no convincing basis for raising the inflation target, as some have argued, as this is not consistent with price stability. Such a move would prolong the pain of rising prices for households on low incomes and may make our public debt burden unmanageable, as interest rates would rise accordingly.

Some have argued that an increase in the inflation target would help to prevent policy being constrained by the ZLB: it would raise the long-run level of the policy rate and then there would have to be an even larger economic shock for the ZLB to be hit and so constrain policy.

But inflation would be more difficult to control if it chugged away at 4-5% a year. What’s more, as our research has demonstrated, with the use of QE, guidance and some use of negative interest rates (abroad), there are sufficient levers available even when the policy rate hovers around zero.

Second, there does not seem to be a strong case for broadening the remit of the MPC to consider questions of aggregate or distributional wellbeing or climate change, as the Bank does not have the tools to affect real standards of living across the income distribution or across generations.

But worse still, any multiplication in the Bank’s objectives, whether real or apparent, will undermine the ability of the MPC to hit the target for which it has both credibility and the necessary instruments.

Let us be clear that questions about the income distribution, intergenerational justice and the challenge of climate change are for the Treasury not the Bank of England. In fact, the biggest danger facing the Bank is that it is being asked to make up for the deficiencies or failures in Treasury policy-making.

But where the MPC can do better is to recognise more clearly that we are now in uncharted territory for this regime. It is more of a risk than before that such high levels of inflation will turn out to be stubborn and feed through into a persistent overshoot with wages and prices feeding off each other rather than low and stable inflation expectations.

This is even more likely because we are starting from a level of real interest rates (nominal rates adjusted for inflation) that are at historically low levels and not in themselves consistent with price stability.

There is also a significant risk that the temporary inflation resulting from a large one-off change in food and energy prices may rebound and even turn into deflation (a general fall in the prices of goods and services) if rates were to overshoot and policy became too tight.

In this highly uncertain world, there is a need to be clearer not only about what might happen at the next MPC meeting but how Bank rate and the stock of QE might evolve over time under worst- and best-case scenarios for inflation.

In this, many would favour a move away from seeking consensus at MPC meetings to encouraging much more dissent: unusually for economists, perhaps there is simply too much agreement!

None of us know the future, so let each member be allowed to project their opinions, including on the path of Bank rate based on their own view of the economy, and be prepared to provide and be subject to much more expert scrutiny. We need to examine the different paths for policy interventions and assess alternatives.

Then we may have to choose or focus on the least-worst option. It is a much-abused phrase, but it is also very instructive: let’s get back to the basics – which for the Bank of England means producing and explaining policy alternatives to markets, the media and the public.

Where can I find out more?

• The Money Minders: The parables, trade-offs and lags of central banking – recently published Cambridge University Press book by Jagjit Chadha.
• Surging inflation shows no signs of slowing: Publication from the National Institute of Economic and Social Research (NIESR).
• Global inflationary pressures and the UK economy: NIESR publication focusing on the economic impact of the war in Ukraine, the UK labour market, and UK inflation.
• No respite for UK consumers and the Bank of England as inflation hits 7 per cent.

Who are experts on this question?

• Kate Barker
• Willem Buiter
• David Cobham
• Petra Geraats
• Charles Goodhart
• DeAnne Julius
• David Miles
• Stephen Millard
• Charles Nolan
• Andrew Scott
• Paul Tucker
• John Turner

Author: Jagjit S. Chadha

Photo by skywaytoheaven on iStock

The post The Bank of England’s Monetary Policy Committee at 25: where next? appeared first on Economics Observatory.

This article sets out some principles, relevant for all countries but particularly for a newly independent country, to consider when designing future fiscal policy strategies. 

What is fiscal policy?

Fiscal policy represents a government’s choices related to public expenditure and the revenue raised from taxes or debt issuance. Its fundamental objective is to manage society’s risks by securing the provision of public goods that would otherwise not be supplied to a sufficient degree by the market. It also ensures that risk is shared across different sections of society and/or with future generations. 

The difference between aggregate tax receipts and expenditure is the government deficit (or surplus). The extent to which this adds to (or takes away from) aggregate demand can mitigate the scale and impact of the business cycle. The outcome from fiscal policy over time is a sequence of fiscal deficits (rarely surpluses).

Other contributions to this series have extensively covered debates over Scotland’s potential fiscal position if it were to become independent and the institutions it might need to establish. 

In this article, we focus on the necessary technical frameworks to manage an independent fiscal position. 

Post-negotiation of whatever share of existing UK public debt an independent Scotland might take on, the Scottish national public debt at any point in time would then be the accumulation of deficits and interest rate payments due on outstanding debt. 

Managing that debt is a critical question for any national government acting on behalf of its current and future citizens, and of particular importance to a newly independent country. 

Should the fiscal framework of an independent Scotland focus on minimising public debt?

A fiscal framework policy must be designed to ensure that the government is able to deal with risks as they emerge and has sufficient access to the tools at its disposal (Dornbusch and Draghi, 1990). 

In practice, this means the ability to borrow against future tax receipts, where access to the pool of savings is guarded by international capital markets. The mindset in this case, as for any loan market, is whether the borrower can pay back the loan in the manner expected. 

But when we are in the realm of sovereign debt, the question is as much about the capacity of the state to manage its overall affairs as the simple accounting of revenues and expenditure that face any firm. 

Fundamentally therefore, fiscal policy involves the management of social risk and it must confront the question of uncertainty over future states of nature. Specifically, this includes the level of GDP, the level of required expenditure and the impact and timing of (distortionary) taxes. 

Fiscal policy involves expenditure decisions made today in response to unfolding events, as well as strategies for the repayment of debt over the long run. As a result, the framework and institutions matter greatly for belief, or credibility, in those strategies, which ultimate feeds into the costs of debt service.

The response to the question of fiscal credibility – to pay interest service and repay debt – by policy-makers in most countries has been to try and shore up the plans for debt repayment by setting up mechanisms for expenditure control. 

This was done first to conform to set plans for expenditure in line with a medium-term economic strategy. But latterly, it has become subsumed in a ritual that assesses whether the government will meet a particular path for the deficit and a level of public debt relative to income. (In the March 2021 Budget, Chancellor Sunak effectively suspended the rules put in place by his predecessor but one, Chancellor Hammond, in 2016.)

The overall objective is to give the impression of rules-based policies that conform to the expectations of financial markets that public debt will be repaid on schedule. The plans and the act of planning has some considerable merit as they can force government departments to confront their individual inefficiencies and jointly meet a given expenditure target. 

The actual practice of expenditure control and planning turns out to be quite different. In the UK, we find that expenditure plans and expected revenue receipts are significantly affected by revisions to our expectations of the level of economic activity (Chadha et al, 2021). 

This is because of both surprises in the evolution of demand in the short run and as a result of the difficulty of understanding long-run trends in productivity capacity. 

It is also clear that certain elements of planned expenditure, such as public investment, have been hard to implement over time. This is a result of the difficulty of identifying appropriate projects, garnering local political and business support, and identifying sufficient social returns. 

It is also the case that there are revisions from changes in political preferences, for example, when a different party is voted into government. 

All of this means that when the government alters its fiscal expenditure plans, it is signalling something about its revised view of the state of the economy and/or its preferences on how it wishes to meet risk in the economy.

What is the role of public debt management?

It is helpful to go back to basics briefly. Let us start from the proposition that taxes are distortionary, in other words their incidence influences our decision to work, spend, produce and invest. 

What matters here are not only the tax rates themselves but also their timing. The government will seek to raise a present value of taxes that retains the ability to respond to future shocks - what is frequently called fiscal space. It will aim to do so in a manner that minimises the distortionary effects of those taxes – what economists call deadweight losses. This observation has direct implications for debt strategy.

First, changes in tax rates should be smoothed over time to limit the distortionary implications in any one period. This means that a sequence of budget deficits rather than increases in taxes should accompany temporarily high episodes of public expenditure. 

Moving forward beyond the current Covid-19 crisis, governments are likely to seek to run budget surpluses when public expenditure returns to normal. With no future movements in tax rates, the level of public debt is capped by the expected sequence of future surpluses levied on the future tax base. 

But there is an important caveat to this point. If public expenditure is going to be permanently higher, then tax revenues must rise in accordance. If we think that the public sector is going to be larger - perhaps to meet the demands of an ageing population, the needs for human capital formation or to plug infrastructure gaps - then we have no alternative to raising tax rates. 

Either way, public debt will increase when there is economic distress, which raises the question of which debt instruments should be used. 

Can debt instruments help the management of economic uncertainty?

The choice of instruments matters when there is uncertainty about future states of nature. When setting fiscal policy today, we do not know the future path of public expenditure. Equally, we do not know the size of the economy, nor the rates of return demanded by financial markets. 

These combined uncertainties matter for the problem of minimising the distortionary effects of current and future taxes. By appropriate choice of instrument, these effects can be limited. 

Governments would ideally like to issue debt instruments that match payoffs to the risks that they face. For example, they would wish to limit payoffs from the bonds issued when government expenditure is high and output is low, as well as to limit the sensitivity of debt issuance to changes in the costs of funding. 

Ideally, government debt would be arrayed across possible instruments to limit the variance in the sequence of real payments on debt. It then becomes a question of how much nominal debt versus index-linked, short-run versus long-run debt, and foreign currency versus domestic debt. And then whether there is a case for other debt instruments, such as GDP-linked debt. 

Public debt and aggregate supply and demand

Across the world, most public debt is issued on a nominal basis. This means that the interest payments are known in actual cash terms, so the government does not face uncertainty about the amount of cash transfers (Barro, 1997). 

But there is considerable uncertainty about the real value of these cash transfers because we do not know the price level in the future. Nominal debt therefore implies considerable uncertainty in the sequence of real financing costs, and therefore on future taxes.

Debt interest that is index-linked to a measure of the price level offers a solution. It allows the issuer to know the real value of interest rate payments. But it leaves the government subject to nominal uncertainty as the actual cash amount of the payment cannot be known until the relevant price index has been published.

In terms of aggregate demand and supply shocks, the implications of issuance of these two types of debt are instructive (see Table 1). 

A government planner may like to hold nominal debt in the presence of dominant positive demand shocks but would be concerned about the possibility of a negative supply shock. 

That said, the holder of these bonds may be concerned about the payoffs in these states of nature, and may require compensation for the risks of variability in real returns or the possibility of default. 

Some holders of debt may have nominal liabilities and would value income streams that are fixed in nominal terms. Index-linked bonds offer certainty about real obligations but are still subject to risk on the variance in the tax base or GDP. 

Governments like to choose a mix of nominal and index-linked bonds depending on how well matched tax receipts are to nominal shocks and the extent to which holders of debt want nominal or real returns to be guaranteed. 

Table 1: Shocks and instruments

Governments can also secure some certainty from future variations in required rates of return by issuing long-term debt. At the same time, they would not want to have a large amount to re-finance in one future year. This is because it may leave them open to rollover risk should that year coincide with disruptions in capital markets or some political risk. 

The solution is to ensure that there is a similar quantity of debt at every issued maturity. Consequently, in any one year, the expected rollover is a constant and small fraction of the overall public debt stock. 

If there is an excessive need for debt to be issued in any one year – as was the case in 2020 because of Covid-19 - the central bank can allow a temporary overdraft (in the case of the Bank of England via the Ways and Means account) or re-ignite balance sheet policies and buy debt temporarily under the mantle of quantitative easing. This is possible provided that there is a credible framework for monetary policy (Chrystal, 1999).

Is there any value in GDP-linked bonds? 

Ideally, a government would like to issue instruments that have low payoffs when expenditure is high and also when output is low. 

An appropriate framework for debt would seek to limit these issues if they changed the incentive to deploy public debt. There is, for example, a danger that, if instruments reduced the real costs of debt issuance, government may over-issue debt. 

Indeed, the lowering and convergence of public debt costs for all member states in the euro area and the elevation of public debt levels prior to the global financial crisis of 2007-09 seems to have played a key role in the subsequent euro crisis (Dureé and Smets, 2014). 

That said, because there is in general a negative correlation between high government expenditure and output, issuing debt where payments are linked to GDP may offer an extra degree of freedom for debt issuers. 

In this case, for example, by linking real payments to GDP growth deviations around a trend, the government will gain extra fiscal space in a recession and pay it back in an upswing. 

The payments will move in line with the tax base and provide some hedge against uncertainty in the tax base. This will allow the government to offset the risks faced. 

There is a practical problem of ensuring that an appropriate measure of GDP, which is not revised, provides the appropriate payoff index. Furthermore, there is the possibility that holders of debt might value payments in a recession and would therefore require a premium for reductions in payment when they would value them most. 

It is also the case that a country with a credible monetary framework has a close substitute by being able to change the costs of funding in line with economic prospects. In the case of a negative shock, it can reduce its policy rate and thereby hold down issuance costs further along the yield curve. But with large enough shocks, the policy rate may not be able to fall enough, whereas linking payments to GDP itself may provide a cleaner hedge. Recent research has shown that this creation of fiscal space may be particularly helpful to countries that are bumping up against an informal debt limit. This is because the savings on debt interest allows transfers to poorer households to continue (Chadha, Kwon and Shibayama, forthcoming). This allows poorer households to maintain their living standards despite a temporary fall in income. It also helps to prevent an amplification of the original income shock, which would occur if their expenditures fell in line with their income, as it would also reduce income for better-off households. 

Conclusion

Debt management is a rarely discussed aspect of fiscal policy, including in debates about the fiscal sustainability of an independent Scotland. 

But it is the choice that must be made whenever any government sets an expenditure plan. If Scotland were to become independent, future Scottish governments would face a choice of how much to tax now and accordingly what kind of debt at what maturity to issue as a message about future taxes. 

The fiscal policy debate in Scotland has concentrated unduly on issues such as Scotland’s estimated net deficit position or how much public debt it might inherit. 

But the reality is that public debt is issued to support economic adjustment. Its evolution and costs are the result of the continuous revelation of states of nature that might mean that higher interest rates are perfectly affordable as the economy is booming, or that even low levels of debt pose problems as they are may be rolled over into markets that do not wish to hold them. 

An independent Scotland would, in time, need to set out a clear strategy on debt and the issuance of instruments alongside statements about planned levels of expenditure. 

Where can I find out more?

• Designing a New Fiscal Framework: Understanding and Confronting Uncertainty: National Institute of Economic and Social Research occasional paper by Jagjit Chadha, Hande Kuçuk and Adrian Pabst. 

Who are experts on this question?

• William Allen, NIESR
• Francis Breedon, QMUL
• Jagjit S. Chadha, NIESR
• Martin Ellison, Oxford
• Andrew Scott, LBS

Author: Jagjit S. Chadha

Editors' note: This article is part of our series on Scottish independence - read more about the economic issues and the aims of this series here.

Photo by AmandaLewis from iStock

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web3 promoters

For its advocates, web3 marks an important shift towards the next iteration of the internet. Its predecessor, Web 2.0 – the era of large, powerful social media platforms (such as Facebook) – is said to be characterised by asymmetries and injustices.

Dominated by a small number of Big Tech companies whose founders and investors have amassed unprecedented amounts of wealth and power, Web 2.0 has had consequences that are widely seen as damaging to society and democratic institutions. 

This financial success seems to have been built off the backs of Web 2.0’s users. Professional creators of music, imagery and video receive only a small fraction of the revenues that their content generates for platforms like Spotify and YouTube.

Developers of apps have no option but to pay 15-30% of their revenue to the App Store (Apple) and Play Store (Google/Android) in return for distribution. At the same time, ordinary users supply the posts, engagement and behavioural data that are integral to the advertising-based business models of Instagram, Twitter and TikTok. Despite their role as ‘prosumers’ (producing as well as consuming), they receive no financial compensation. 

By contrast, web3 is said to offer a more egalitarian, peer-to-peer vision of the web, giving all users 'skin in the game'. By using blockchain technology to decentralise the web’s technical, legal and payments infrastructure, web3 supposedly promises to sweep away today’s Big Tech companies, which are seen as abusing their market position as gatekeepers to extract economic rents. 

In their place will be new protocols and platforms, constituted as distributed autonomous organisations (DAOs). According to web3 advocates, DAOs will be governed by their communities, transparent in their operations and immune from capture by narrow financial interests thanks to smart contracts (self-enforcing contracts programmed in computer code). 

Transactions will take place in cryptocurrencies, with non-fungible tokens (NFTs) allowing intellectual property rights to be asserted over digital files, with benefits for creators and markets.

In time, these technologies will supposedly form the basis for a thriving economy in the metaverse – the putative 3D online world in which people will be able to work, socialise and play games in virtual reality. For now, the majority of web3 companies are focused on building the underlying ‘rails’, such as payments (for example, Ripple), technical infrastructure (for example, Aligned) and fraud detection (for example, Chainalysis). 

web3 detractors

Critics of web3 bring a very different perspective. Cryptocurrency sceptics – so-called ‘NoCoiners’ – see web3 as a cynical rebranding exercise. In their view, blockchain is a defunct technology and cryptocurrencies are scams that combine elements of Ponzi, pyramid and multi-level marketing schemes. 

In such schemes, a constant supply of new marks is required to provide earlier investors with liquidity – and the inevitable conclusion is collapse. These critics say that web3 should therefore be understood as a story invented to make cryptocurrency investment appear more attractive to digital creators and those who otherwise dislike Big Tech. 

Some within the crypto movement also have deep reservations about web3 – including former Twitter chief executive officer, Jack Dorsey. Here, the objection relates to the influence of venture capital investors. With more funds at their disposal than there are good investment opportunities, investors like Andreesen Horowitz – a venture capital firm based in Silicon Valley – have been highly active in developing the web3 market, through public relations and government outreach (as well as large investments in web3 companies like the NFT marketplace OpenSea). 

Outsized returns for the same group of investors who have profited from the dominance of today’s Big Tech companies are clearly at odds with the libertarian project of radical decentralisation, to which Jack Dorsey and many other crypto enthusiasts subscribe. 

What are some possible implications for the UK economy?

The criticisms levelled by web3’s detractors seem to be good reasons to reserve judgement on the overall vision for web3. It is also useful to break it down into its component parts, specifically cryptocurrency adoption, tokenisation and virtual economic growth.

Cryptocurrency adoption 

‘Cryptocurrency’ is something of a misnomer. There are very few things that Bitcoin, Ether or DogeCoin can actually be spent on – illegal drugs and NFTs notwithstanding. While cryptocurrency exchanges report billions of dollars’ worth of trading, this is overwhelmingly financial speculation and barely touches the real economy. In fact, it is possible that such speculation is channelling capital away from more productive forms of investment.

Cryptocurrency prices are also extremely volatile. According to the Financial Conduct Authority (FCA), 2.3 million UK consumershave already invested in crypto assets, meaning that a market crash might lead to large losses for retail investors. This would inevitably bring adverse consequences for consumer confidence and spending.

The same goes for fraud, which appears to be endemic to the crypto space. Meanwhile, the anonymity afforded by cryptocurrency significantly increases cybercriminals’ economic incentives to mount ransomware attacks. Affecting three-quarters of UK businesses in 2021, these involve hackers encrypting an organisation’s data and demanding a Bitcoin ransom to decrypt it. 

But UK regulators seem to be more concerned about the risk of financial instability. Most cryptocurrency is held by institutional investors, including hedge funds with leveraged positions. A collapse in crypto asset prices could force investors to sell off other assets to cover losses, reducing liquidity in the financial system and affecting investor sentiment. This could then have potential knock-on consequences for the real economy. 

As such, cryptocurrency markets can be compared to markets for derivatives such as futures and options: they represent a growth opportunity for the financial sector, but a systemic risk to the wider economy. 

But were the Bank of England to launch a central bank digital currency (CBDC), other opportunities might open up. For example, in a future downturn, the government might want to use monetary policy to stimulate economic activity. If it were to issue stimulus payments to individuals and businesses in a CBDC, it could programme in rapid devaluation, creating a strong incentive to spend rather than save, and hence increasing the effectiveness of the policy.

Tokenisation

Rather than issuing shares, web3 organisations issue tokens. These can offer rights of access to the organisation’s products, voting rights on aspects of the organisation’s decision-making, rights over digital property or a combination of all three. 

As tokens are financial assets, they can be traded speculatively in secondary markets. Much commentary has focused on cases where tokens have been instrumentalised in ‘pump-and-dump’ schemes – a form of scam where token-holders hype an asset to drive its price up sharply (pumping), before selling off their holdings (dumping) and precipitating a crash. 

Concerns have also been raised about the tokenisation of loyalty programmes and merchandise by UK football clubs, since it exposes fans to volatile crypto asset markets without obvious benefits over more conventional structures.

But from a purely economic perspective, tokenisation may prove to be an important innovation, in that it provides a new way for organisations to raise capital. The existence of the secondary market means that seed investors in web3 start-ups benefit from much greater liquidity than would be available if they bought equity. 

This can reasonably be expected to increase the pool of capital accessible to early stage tech businesses, with favourable consequences for the development of the tech sector. Given the UK’s strength in financial technology (fintech), decentralised finance (or DeFi) seems like a particular opportunity. 

Similarly, tokenisation could provide small and medium-sized businesses, which are ordinarily subject to banks’ fluctuating appetite for risk, with an alternative source of growth capital. Meanwhile, other types of organisation that typically have limited access to capital markets – including social ventures and community projects – may see issuing tokens as a scalable alternative to grant applications or crowdfunding.

Tokenisation is perhaps most advanced in the creative sector. Before the advent of NFTs, there were few incentives for producing monetisable digital artwork, as files could easily be pirated. By providing more or less immutable records of ownership for digital files, NFTs provide incentives and make it technically possible for artists to receive automatic royalties on re-sales of their work. 

Combined with the ability to sell directly to the public without intermediation by commercial galleries, NFTs seem to be making it easier for creators to develop real businesses (although it is not yet clear whether current levels of demand are sustainable).

In general, if one subscribes to the view that greater supply of capital leads to productive investment, job creation and growth, the potential of tokenisation should be taken seriously. 

Figure 1: UK consumer interest in cryptocurrencies and NFTs during the pandemic period, as measured by internet searches

Source: Google Trends

Virtual economic growth

The idea of a metaverse economy might seem particularly far-fetched, but a substantial virtual economy already exists. Sales of virtual goods inside ‘massively multiplayer online games’ (or MMOs) are estimated – admittedly by gaming industry market intelligence firms – to have amounted to $40-93 billion globally in 2019, and to be growing at a rate of around 15%. 

Many games have native currencies that can be exchanged for skins (virtual goods such as clothes or armour, which alter a player’s in-game appearance). In the video game Elite Dangerous, for example, a currency called ARX can be bought or earned through game-playing and then used to purchase livery for the player’s spacecraft.

Advocates of web3 argue that the development of the wider virtual economy is held back by the absence of property rights. Currently, a dashboard ornament purchased in Elite Dangerous cannot be taken into World of Warcraft: it remains the property of the game’s developer, Frontier Developments, which could, if they wished, confiscate it from a player who had paid for it. 

Replacing native currencies with cryptocurrency and minting skins as NFTs, on the other hand, would provide stronger incentives for third-party developers to create new ranges of virtual goods, and for players to increase their spending on them. This seems at least plausible and much more like real economic activity than cryptocurrency speculation (though it should be noted that many in the gaming community are unconvinced that it would be technically feasible or additive to the game-playing experience). 

What is more certain is the contribution of the UK video gaming industry to the economy: around £1.8 billion towards GDP and around 40,000 jobs in 2018. Larger than any of its European counterparts, it is well-placed to benefit if web3 technologies do indeed drive gaming innovations.

Conclusion

Predicting the economic impact of emerging technologies is notoriously difficult. The biggest benefits from technological change often come from positive spillovers and the biggest risks from unforeseen externalities. Which of the stories about web3 sketched out in this piece will come true is anybody’s guess. 

But increasing amounts of Silicon Valley’s abundance of capital and software engineering talent are being poured into web3 projects. And as the Web 2.0 era has shown, these decisions about where to focus energy will have repercussions for the economy and beyond. 

Where can I find out more?

• Policy Brief: Crypto, web3, and the metaverse: A simple explanation of cryptocurrencies, blockchain, NFTs and the metaverse, together with discussion of web3’s policy implications, by the Bennett Institute for Public Policy.
• web3 policy handbook: US venture capital investors Andreesen Horowitz make a bullish case for web3 and suggest actions that governments should take to encourage its development.
• Line Goes Up – The Problem With NFTs: an entertaining if somewhat polemical video essay that aims to debunk claims that web3 technologies can form the basis of a more equitable internet.
• The Crypto Syllabus: comprehensive reading lists for studying web3 from social, economic and technological perspectives, with short introductory overviews. 

Who are experts on this question?

• Molly White
• Vitalik Buterin
• Edward Ongweso Jr
• Balaji Srinivasan
• Evgeny Morozov

Author: Sam Gilbert

Picture by Antonio Solano

The post What is web3 and what might it mean for the UK economy? appeared first on Economics Observatory.

Before then, there were occasional long periods of mild inflation. Examples include the last years of the Roman Empire, Tudor times in England, and even during the Napoleonic Wars in England – each of these were in the region of a few percentage points increase each year.

There are other occasions when there were some bursts of rapid inflation such as in the American War of Independence in the 1780s, the French Revolution in the 1790s and the American Civil War in the 1860s. In these examples, the rise was more than 100% per year. But widespread and high inflation belongs almost entirely to the last 100 years or so (Capie, 1986).

Figure 1: Long run inflation rate

Source: Bank of England

There is an obvious reason for that. Only when paper money became easy to produce – with some basic security measures – was a rapidly growing money supply possible. The fundamental explanation for inflation is an excess of growth in money over growth in output.

When and why did inflation appear in the past?

Some hints have already been given as to why inflation appeared when it did in the past. Rapid inflation was not, contrary to the assertions in many textbooks, a consequence of war. Indeed, in the 18^th century, Britain was at war most of the time without any inflation.

Rather, extreme examples of inflation have almost invariably been found in countries during civil war or something close to that. In these cases, the established government is trying to preserve the peace but may end up fighting the rebels.

Either way, it is spending to placate the opposition or spending on fighting. But with the country divided, the opposition is not paying tax and a gulf opens between spending and revenues. There is a resort to borrowing, and when the possibilities for that are exhausted, money is printed.

Money growth quickly expands at a rate that precludes any possibility of output growth matching it and inflation follows. And a key lies therein: weak governments give in to spending in excess of their income.

There were several examples of hyperinflation in the early 1920s – in Russia, Poland, Hungary, Austria and Germany. Then in the 1940s, Hungary, Greece and China all experienced hyperinflation, which reached staggering rates frequently in the thousands of percentage points per year. After 1950, examples can also be found – in countries such as Indonesia in the 1960s, Serbia in the 1990s and in much of Latin America and elsewhere in between these dates. All of these were cases of civil war or something very close to that.

But this also spread to most other countries. What had become a common occurrence as the 20^th century progressed was either an inability or an unwillingness on the part of governments to keep their spending in line with their ability to raise tax revenues.

In the case of civil war or serious social unrest, governments are largely unable to do so. But unwillingness to keep spending and income in line over time has become more common, even when governments are not facing such pressures.

So how was inflation tackled?

When countries adhered to a metallic standard – when money was determined in metal, usually gold or silver – it was difficult or even impossible for inflation to develop. The supply of money could not grow fast enough. But when such a standard was abandoned, as it was, for example, in Britain during the Napoleonic Wars, inflation appeared.

The cause was clear to contemporaries – the loss of the discipline of the standard. The solution was therefore a return to that standard. After that was achieved in England at the start of the 1820s, prices were stable for almost 100 years. But where that option proved, or seemed, too difficult to achieve, inflation continued.

In some cases when inflation had been ruinous, the solution was to start again with a new currency and some old principles. This was often the case in Europe after the First World War – the German Reichmark and the Russian rouble being two examples.

What was the approach after the Second World War?

After the Second World War, the new international monetary arrangements held to an attachment to the US dollar, with the ultimate anchor to gold. Currencies linked to the US dollar through their foreign exchange rate, and the dollar was based on gold.

But this system broke down under pressures at the end of the 1960s and the connection with gold was severed. The US government would not contain its spending. The world thereafter, and for the first time ever, was on a fiat standard, backed only by the word of government.

Strangely, in this period of the late 1960s and into the 1970s when widespread inflation had begun to develop, its cause had been forgotten. A sociological theory was being advanced. Inflation was said to be the result of large powerful labour unions that were able to demand ever-increasing wage settlements; or of large powerful monopolists – such as oil producers – which were able to put up prices. And, it as argued, these actions were responsible for inflation (Kaldor, 1985).

The solution that followed was for governments to impose wage and price controls. Such controls have been employed for many hundreds and possibly thousands of years and yet seem never to have worked. They certainly did not work in the 1970s when inflation reached its highest ever level in the UK – an annualised rate of 30% – and in many other countries.

When did an alternative solution appear?

A gradual acceptance took hold among policy-makers that excess money was indeed the root cause of inflation and, in the 1980s, attempts were made to bring it under control. This could be done by operating either on price (interest rates) or on quantity.

One approach was to control the quantity of money directly. This might be done by controlling narrow money (the monetary base) – that part of money under the central bank’s control.

Others argued that a broader definition of money was the measure that mattered and the relationship between narrow and broad money was not constant. Broad money had to be controlled via reserve requirements imposed on the banks (Griffiths and Wood, 1981).

A certain amount of success followed, insofar as inflation rates fell wherever these methods were used. But the pattern was mixed and there was dissatisfaction.

What came next?

During this period, it also became clear that political pressure on central banks had to be removed. The old story of governments wanting to spend led to pressure on central banks to provide the cash. Take away that possibility and central banks should be able to control inflation.

The government would decide on the rate of inflation that was acceptable and mandate the country’s central bank to achieve that rate. As a result, inflation targeting was introduced in the 1990s (although there were one or two examples in the late 1980s).

The argument was that with the inflation target announced, the central bank’s credibility would persuade people that the inflation rate would be achieved. Indeed, inflation generally fell around the world in the 1990s and the first decade of the 21^st century.

An element of good fortune emerged at this point as global economic output and global trade produced pressures of a beneficial kind. Central banks’ task became easier. But, unfortunately, the idea developed that announcing the inflation target itself was all that was required. Now governments could spend what they liked without worrying because inflation expectations had been firmly anchored.

Furthermore, the targeting of consumer prices took attention away from asset prices. While the consumer price index (CPI) or the retail price index (RPI) may remain steady, excess money can be flowing into asset prices – for example, housing or the stock market.

This can result in potential danger in the future. For example, it was the rise and collapse in asset prices– particularly housing – that led to the global financial crisis of 2007-09.

What happened in and after the global financial crisis?

The response to the global financial crisis was generally the correct one. There had been a scramble for liquidity and the need for central banks to inject money into the economy. They did this on a grand scale through measures called quantitative easing.

Many warned of the inflation that would inevitably follow. But even though the injection was incorrectly left in the system, and often increased, that did not happen. This was because broad money growth did not rise greatly.

It did not rise because the authorities had decided that the banks needed to be better capitalised and insisted that they raise their capital/asset ratios. That cannot be achieved without constraining bank lending and the outcome was that money growth did not take place on a scale that led to inflation.

What has been happening during the pandemic?

The notion that governments could spend freely and not worry about inflation has been coming under increased scrutiny with the most recent surge in government spending following measures taken to deal with Covid-19. Money growth has surged and inflation has risen sharply.

Much has been written about whether this is a consequence of supply shortages arising as a result of the pandemic, which in turn has led to individual prices rising. This is a reversion to an old fallacy and indeed the tautology that it was rising prices that caused inflation.

The facts are that in 2020 and 2021, money growth has been extraordinary and greatly in excess of output growth – and this has produced inflation. Money growth has slowed in 2021-22, but there will still be inflation to come. There is no escaping the fundamental role that money plays in the process (King, 2022).

Where can I find out more?

• Institute of International Monetary Research
• Bank of England: Introduction to inflation
• Inflation reports: National Institute of Economic and Social Research

Who are experts on this question?

• Forrest Capie
• Jagjit Chadha
• Mervyn King
• Michael McMahon
• Patrick Minford

Author: Forrest Capie

Photo from Berlin Bank from Wikimedia Commons

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