Introduction

• Today: Chapters 17–18: Banking, Debt and (Sovereign) Default.
• Rest of term:
  • Week 11:
    • Thursday: Claire Macallan from the Bank of England.
    • Friday: Chapters 19–21: Exchange Rates (guaranteed question).
• Unable to cover chapters in full detail.
• Reading all the chapters will be beneficial.

Essay

• Due Friday March 27 4pm.
• Word limit: 2000, strict (no 10%).
  • Words after 2000th will not be counted (it’s electronic submission).
    • Ability to write succintly and clearly an acquired skill.
  • Footnotes do not count (but no obligation to read footnotes).
  • Tables and figures do not count (but do not abandon them).
  • Harvard style referencing (copy style in academic papers). Bibliography does not count, in-text references do.
• Question Choose one of the guest lectures by Joe Grice, John Redwood and Sam Juthani and answer the following questions:
  1. Summarise the lecture given by your chosen guest.
  2. Identify which economic theories covered in lectures that the lecturers referred to. Was the lecturer in agreement with the theory?
  3. Explain whether you agree with the lecturer.
• All parts equally weighted.
• Suggestion:
  • Question splits up into three parts. Answer those three parts explicitly.

Debates in Class

• Thanks for participating!
• Tutors gave me very positive feedback.
• Attendance low again, but suspect those who fail to attend classes fail to attend lectures.
• Next week:
  • Why is the way you vote economically coherent.
  • Visit: https://voteforpolicies.org.uk
    • Select policies on “Economy” and choose your preferred policies.
  • Be prepared to defend your voting intention on economic grounds.

Important Notice!

• General Election Debate for Reading East:
  • Thursday March 26, 7:30pm in 3sixty

Chapter 17: Banking

• Banks are financial intermediaries:
  • Channel funds from savers to borrowers.
• Commercial bank: Takes deposits and lends to individuals and firms.
• Investment bank: Act as intermediaries in financial markets.
• Functions:
  • Efficient payments system: Enable transactions.
  • Economies of scale: Matching borrowers/lenders of very different scales.
  • Effective monitoring: Ensuring loans are monitored for performance.
  • Maturity transformation: Matching borrowers/lenders with different maturity needs.

Scale of Intermediation

Banks Often Operate Internationally

Services Offered by Banks

SMEs Need Banks for Finance

Mismatching Maturity can be Problematic

Extreme Mismatches Cause Bank Runs

Incentives in a bank run: Contagion (theory)

Bank Failures, Historically, and Contagion

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Response to Bank Failures: Deposit Insurance

Leverage, Moral Hazard, Risky Borrowing

• Deposit insurance provides implicit guarantee of bank bailout.
• Shareholders also have limited liability for losses banks make.
• Banks may create more risky loans in response, to make returns.
  • If loan paid back, greater return.
• Furthermore, if interest paid on deposits lower than that on loans, incentive for leverage:
  • Leverage: Borrowing to create assets (loans).
• Deposit insurance creates moral hazard problem.
  • General solution is more regulation: Capital adequacy.

Banking Crises Happen Often (pre-2008)

Real Estate Often Associated with Crises

Housing has Long Booms and Sharp Busts

Real Estate Crashes Happen in Financial Crises

The 2008 Crisis: Interbank Market

Repercussions of Credit Crises: Broad Credit Channel

The Bank Lending Channel

Credit Crunch Recessions are Different

Financial Crisis: What Happened?

• Banks profit maximised, leading to high leverage levels.
  • Borrowing to lend.
  • When all added up, more than the GDP of many small countries.
• Real estate crisis began in the US:
  • Pushed many mortgages into default.
  • But value of house less than outstanding loan.
  • Led to banking panic according to spiral earlier.
  • International in nature, severe due to leverage.
• Impact on real economy via bank lending:
  • Banks, realising many assets worthless, sought to call in other assets to cover liabilities.
  • Led to firms going bankrupt (e.g. Woolworths), even banks being allowed to fail.
  • Impact of bank failures (Lehman Brothers and Northern Rock) dramatic:
    • Govts had been expected to bail out failing banks.
• Why banks so reckless?
  1. Allowed to be?
  2. Encouraged to be by likelihood of bailout (too big to fail)?
  3. Fooled into being by Credit Ratings Agencies?
• On 3, why did credit ratings agencies rate bundled sub-prime mortgages as “safe”?
• Conflict of interest?
• Absence of competition?

Chapter 18: Sovereign Debt and Default

Developed and Developing Countries and the Financial Crisis

The Experience Across Countries

Deficits and the Business Cycle

• Natural tendency for government borrowing to be cyclical:
  • More spending on benefits, fewer receipts from taxation.
  • Such spending referred to as automatic stabilisers.
• Tax smoothing suggests better for govt to borrow to fund deficit than tax.
• Can we determine underlying fiscal position? Structural or cyclically-adjusted deficit: \[ \begin{align} \text{Structural revenues} &= \text{Actual revenues}\times\left(\frac{\text{Potential output}}{\text{Actual output}}\right)^\alpha,\\ \text{Structural spending} &= \text{Actual spending}\times\left(\frac{\text{Potential output}}{\text{Actual output}}\right)^\beta,\\ \text{Structural balance} &= \text{Structural revenues} - \text{Structural spending}. \end{align} \]
• \(\alpha\) elasticity of govt revenue wrt output, \(\beta\) elasticity of govt spending wrt output.

Deficits and the Business Cycle

But What is Potential Output? Has it Fallen?

Output Gap and Structural Balance, Globally — the Disagreement

Long-Run Sustainability

• What level of structural deficit sustainable in the long run?
• If debt doesn’t rise relative to GDP, govt can keep paying interest.
  • If interest rates do not change, interest burden would remain constant.
• Stability of debt-to-GDP ratio best judge of sustainability of fiscal position.
• Since GDP rises over time, so then can debt, hence deficits can be run.
• When is debt-to-GDP ratio stable? \(D\) is debt stock, GDP is \(Y\).
• Split up deficit and primary deficit by interest payments

Long-Run Sustainability

Long-Run Sustainability

• Debt-to-GDP ratio \(D/Y\) can change by three means:
  • Interest on existing debt, adding \(r(D/Y)\).
  • GDP growth reduces by \(g(D/Y)\).
  • Larger/smaller primary deficit relative to GDP. \[ \text{Change in }\frac{D}{Y} = (r-g)\frac{D}{Y} + \frac{\text{Primary deficit}}{Y}. \]
• So debt sustainable if no change in \(D/Y\) hence when: \[ (r-g)\frac{D}{Y} = \frac{\text{Primary surplus}}{Y}. \]

Government Inter-Temporal Budget Constraint

• If \(r>g\) govt has to run surplus to keep debt-to-GDP stable — or bring it down.
• This is inter-temporal decision: Pay now or pay later?
• Assume only two periods; end of first period: \[ D(0) = G(0) - T(0). \]
• To pay off debt in second period, need: \[ T(1) - G(1) = D(0)(1+r) = \left(G(0) - T(0)\right)\times(1+r). \]

Government Inter-Temporal Budget Constraint

• Debt equals present discounted value of future surpluses: \[ D(0) = \frac{T(1)-G(1)}{1+r}. \]
• If strong growth expected, \(T(1)\) higher, more debt can be taken on.
• But if weak growth, then smaller debt feasible: Politically problematic.
• Post-WWII growth was strong enabling debt repayment; same true for 2014–2064?
• Nonetheless, deficits to fund investments may lead to higher \(T(1)\). Picture dynamic.

Future Spending Commitments

The Choice to Default

• One method to reduce debt is fiscal consolidation. Another is default:
  • Govt no longer services debt obligations.
• Distinction between corporate and sovereign default: Latter is a choice.
  • No laws to enforce debt repayment, countries can do as they wish.
  • Countries unlikely to face invasion for default (parallel to corporate bankrupcy procedures).
  • Countries may suffer lack of re-access to international capital markets, and higher rates.

Countries in Default

Repeat Offenders

Recent Episodes

Inflation as Default

• Printing money is alternative to taxation to finance government spending.
  • Consequence of printing money usually inflation.
• Inflation helps repayment of debt denominated in own currency:
  • Debt is nominal sum hence by reducing value of currency, reduce size of debt.
• But if debt issued in another currency inflation problematic:
  • Inflation reduces value of domestic currency.
  • Many creditors refuse to lend denominated in local currency for this reason.

Credit Risk (Risk of Default): Cost of Borrowing

The Most Unnecessary 3D Graph Ever Created?

Chicken or Egg?

Debt Intolerance

Debt Forgiveness: Good for all?

The Most Wrong (but is it?) Plot In the World?

• Controversy over Excel: See, for example, http://www.economist.com/blogs/freeexchange/2013/04/debt-and-growth if you’re interested.

Concluding

• Today:
  • Chapter 17: Banking.
  • Chapter 18: Sovereign Debt and Default.
• For classes in week 10:
  • Is the way you vote economically coherent? Why?
  • Visit: https://voteforpolicies.org.uk
    • Select policies on “Economy” and choose your preferred policies.
  • Be prepared to defend your voting intention on economic grounds.
• Next Thursday: Clare Macallan, Bank of England.
• Next Friday: Chapters 19–21: All about exchange rates.