What causes the erosion of Sovereignty and Territorial Integrity?

Hello readers, welcome back.

In my last post I looked at one of the most heated conflicts the world has seen between two nations over territory, namely the region of Jammu and Kashmir. I hope that you found this interesting and a change from hearing about Brexit or Trump in the media or my usual posts about topical economics news stories. In this post I will also be looking at something more abstract, and will be exploring the factors that lead to the erosion of sovereignty and territorial integrity. Such factors are extremely relevant in the current economic climate and in fact they go as far as explaining some of the reasons why Britain voted to leave the EU-“To get our country back” and restore sovereignty or what it would mean if Scotland were to become an independent state. I would be interested to hear any thoughts you may have on this subject, so please leave your comments below.

Sovereignty refers to the absolute authority which independent states exercise in the government of the land and people in their territories. In other words, it refers to the power or independent control that states have. Territorial integrity is the principle that a state’s borders are sacrosanct; the idea that states should not attempt to promote secessionist movements or to promote border changes in other states. The two are interrelated as states exercise their sovereignty within a specific territory; the boundaries of which have been established by international law. Thus the preservation of territorial integrity and sovereignty is important in achieving and maintaining international security and stability in the world. Although it may appear at the outset that political factors/geopolitics such as the transnational movement of terrorist and extremist activity across the Turkey-Syria border or contested maritime boundaries such as in Atlantic Waters off Ivory Coast and Ghana are responsible for the erosion of sovereignty and loss of territorial integrity, they can be influenced by a number of economic, social and even environmental factors.

Let us first consider the political factors, which are often said to play the greatest role in eroding territorial integrity and sovereignty. Firstly, the current system of nation states is based on the Westphalian model and these principals of sovereignty and territorial integrity are reinforced in the UN charter today. The system has been challenged by many current threats and in the last two decades, both within and between sovereign states we have witnessed contested territory-the most obvious example being Russia’s annexation of Crimea and support for separatists in Ukraine. This conflict has led to the deaths of 7000 people, including 298 people shot down in a civilian aircraft. Although sanctions/embargos were imposed by the EU and USA on Russia, these caused impacts for other countries e.g. Germany’s oil supply and often had regressive effects, whereby the poorest and most vulnerable in society were most affected. Other examples include contested islands in South & East China seas, as well as the U.K. and Argentinian claims over the Falklands. In the Middle East/North Africa, factional or sectarian tensions have led to political and ethnic conflicts, which has reduced sovereignty. Furthermore, transnational movement of terrorist/extremist activity such as across the Turkey-Syria border, where smuggling of foreign fighters, oil and weapons, has threatened territorial integrity and sovereignty of the two countries. In addition, the legacy of colonialism such as the ‘Scramble for Africa’ has lead to ethnic partitioning which has promoted nationalist groups that weaken the states power.

As well as the role of individual governments, supranational institutions such as the EU, UN, and NATO are made up of member states that retain their sovereignty; however, they are bound to the requirements of this body, including any treaties they sign. For this reason they are sometime said to “surrender” sovereignty, as they must comply with these. The EU, made up of 28 sovereign member states, was first established as a trading bloc with a common tariff/access to the European single market, but is now an economic and political union with its own parliament. On one hand, the benefits of this integration protect states interest, for example, transnational issues such as air/water pollution and international crime. On the other, some states are required to implement EU laws and decisions even if they did not vote for them and 19 members of the Eurozone have financial restrictions preventing them from setting interest rates and forcing them to accept harsh austerity measures e.g. Greece. This was one of the driving forces behind Brexit-“To get our country back” and regain sovereignty. Similarly one of the policies of the UN is that the international community will intervene in a state without its consent when that state is allowing violation of human rights to occur. Although this may be deemed the right thing to do, there is still a loss of sovereignty to such countries and there is the argument that why should Western countries be enforcing their ideology on the rest of the world.

Although such factors are central, it may be argued that the role and influence of economic factors in disputes are just as important. For example TNC’s who exploit ‘soft power’, bi-lateral trade agreements or even currency strength can all come into play. A good example is Scotland who over the past few years has been seen to be ‘vacillating’ between remaining within the UK and becoming a separate state. If they were to leave, this is likely to cause economic complications and ultimately a loss of sovereignty for Westminster. The most notable of all being the loss of oil, tourism, fishing stocks/controls and even the trident nuclear programme. Furthermore, there is likely to be a loss in territorial integrity as a large piece of land is at stake here. In terms of currency, with the UK’s vote to leave the EU, the pound took a major hit and since then imports have become more expensive. This has already led to issues over trade agreements with EU countries.

TNC’s such as Nike who has 692 factories in 42 countries and employs over a million people, have become a driving force of global economic integration and some LIDC’s such as Kenya or Nigeria are reliant on TNC’s to integrate their economy into the global market and promote development or create multiplier effects, thus lifting the population above the poverty level. However, such corporations present major challenges to government control and state sovereignty. Firstly in the last two decades, TNC’s have expanded operations regardless of state boundaries-some states have lost control of territory, work force, environment and even political decision making. Moreover TNC’s have been criticised for pursuing their own profit-making interest at a cost to countries in which they have invested. Business decisions to invest which affect many local people are made outside the host country, which has little involvement, and often there is disrespect for human rights by some TNC’s such as exploitation, low wages, poor conditions and child labour in pursuit for higher profits. That being said, companies such as Nike now aim to shed this reputation with other TNC’s such as Nestlé, Toyota, and Shell following suite, implementing policies to achieve corporate social responsibility and conform to the UN Global Compact.

Social or cultural factors in disputes, which include the challenges by strong nations/people such as the Kurds, the Basques or more topically the Catalonians, are causing a loss to sovereignty and territorial integrity and are often significant as they interlink or affect economic and political factors. Ethnic groups with strong identities often demand full independence to create a new state e.g. Tuareg in Mali or ISIS in Iraq and Syria. Internal conflict between ethnic groups results in governments unable to protect all its citizens often leading to civil wars. We should also note that the geographical distribution of ethnic groups does not always coincide with current political borders. Sovereign states may include more than one ethnic group within its territory such as South Sudan (60 ethnic groups/indigenous tribes) or a single ethnic group may be partitioned by modern state borders e.g. Kurdistan extends across 5 states.

The Basque nation is a prime example of how cultural factors were responsible for the loss of sovereignty and how nationalism (people with a shared identity) can exist without a formal state. It spans across 7 provinces and has a population around 3.1 million. They have a distinct culture, language and a strong tradition of independence/political autonomy with their own Basque parliament. In the past the separatist movement-ETA has carried out violent acts, responsible for over 800 deaths and the French and Spanish governments have always seen them as a threat to sovereign power and territorial integrity. It is often referred to as the IRA of France/Spain. With unique sports (pelota), set traditions such as the Pamplona bull running, and their own food, language, and culture which dates back to the late 1800s which saw rapid industrialisation in Bilbao, the people of Basque have been struggling for either further political autonomy or, chiefly, full independence for years. Despite the violence and turbulence within the political sphere, the key leader of this ‘terrorist’/’ ‘freedom fighters’ group was arrested and this marked the end of the armed activity with a formal ceasefire in 2011. However challenges to sovereignty will exist so long as there are active members of ETA not just in the Basque land but dispersed across the world.

Arguably less important, we should also consider some of the environmental factors that may affect sovereignty. Firstly, TNC’s exploit natural resources; particularly in LIDC’s who are desperate for foreign investment and allow oil rigs/mines to be constructed in exchange for new roads/infrastructure. Secondly, fishing quotas in the Common Fisheries Policy & the Countryside Stewardship under Common Agricultural Policy under EU law has also been criticised for causing environmental degradation/wasting resources.

Overall it is clear that although political factors are important, the issues of sovereignty and territorial integrity are also influenced by a combination of economic e.g. TNC’s, environmental e.g. EU agricultural policy, and social factors e.g. Basque people. Moreover, the issue is actually more complex than this and we should consider the fact that every dispute is unique, meaning some factors will be more dominant than others; it all depends on the situation and each one evolves over time. However we can conclude that stating just political factors in most cases would only examine a part of the issue, in reality a combination of factors work together and there is no “one size fits all” explanation.

 

 

The ongoing dispute between Jammu and Kashmir.

Hello readers,

Welcome back to my blog. You may have seen that in this week’s economist, the main story was on “The war the world ignores”-Yemen. Having read this article, I thought I would base this week’s post on the issue of conflict and explore some of the other wars that are not widely understood or discussed especially in the media today. Currently the news seems to be flooded with stories about Trump or his North Korean counterpart or the issues with the Brexit bill and the negotiations. Although we have seen the ‘ethnic cleansing’ of the Rohingya muslims in Burma in the media recently, we seem to have stopped following one of the biggest, oldest and on going territorial disputes the world has ever seen-Jammu and Kashmir between India and Pakistan. This post will give an overview of the history between the two countries, and consider some of the possible solutions. You might be wondering how at the outset this relates to economics. The answer is that this is directly related to economics. For example such conflicts determine trade, migration, confidence in the economy, sovereignty, foreign investment and social welfare. Furthermore, funding such conflicts has an opportunity cost involved; that is, the money spent on financing this cannot be spent in areas such as education or health which are under severe pressure especialy by India’s 1.3 bn plus population. It is important to remember that Economics does not just look at topical issues in the news or outline how the economy is performing by using mathematical models. Instead the subject is all encompassing and for that reason many economists have different views about its definition. The most interesting definition that I have come across about economics is that “economics is what economists do”-Jacob Viner.  It is not possible to give any fixed definition about this social science and even if it is defined, it is only temporary.

Area of dispute:

  • Some of the biggest geopolitical events in the world are centred on disputed territories-land whose sovereignty is claimed by more than one nation. The list of territorial disputes is long and ever changing/dynamic. There are now more than 150 disputes under way that involve territory, mostly in Africa, Asia, and the Pacific region, but also in Europe and the Americas. Some disputes are on the distant horizon (Antarctica) some are long simmering (Jammu and Kashmir), and others like Syria are at their boiling point.
  • Kashmir, officially referred to as Jammu and Kashmir, is an 86,000-square-mile region (about the size of Idaho) in Northwest India and Northeast Pakistan. The region has been violently disputed by India and Pakistan since their 1947 partition, which created Pakistan as the Muslim counterpart to Hindu-majority India.

Screen Shot 2017-12-03 at 16.25.54.png

Reasons for the dispute to the territorial integrity:

  • When India and Pakistan became separate and independent nations in August of 1947, theoretically they were divided along religious lines. In the Partition of India, Hindus were supposed to live in India, while Muslims lived in Pakistan. However, the horrific ethnic cleansing that followed proved that it was impossible to simply draw a line on the map between followers of the two faiths – they had been living in mixed communities for centuries.

 

  • For the past 60 years, this mountainous region, often described as a legacy of British colonialism has provided the stage for some extremely tense moments between India and Pakistan, with some claiming that it’s “one of the most dangerous and prolonged disputes in the world, which in the worst-case scenario could trigger a nuclear conflict.” Currently Kashmir is administered by India and claimed by Pakistan and a heavily militarized, 450-mile-long Line of Control has long turned Indian and Pakistani forces against each other in this contested Himalayan region.

 

  • After the partition of India in 1947, because of its location and under the partition plan provided by the Indian Independence Act, Kashmir was free to accede to India or Pakistan. Maharaja Hari Singh, the ruler of Kashmir at the time, was Hindu while most of his subjects were Muslim, thus he was unable to decide which nation Kashmir should join. In the end he chose to remain neutral and declared Jammu and Kashmir’s independence as a separate nation in 1947; however, Pakistan immediately launched a guerrilla war to free the majority-Muslim region from Hindu rule. The Maharaja then appealed to India for aid, signing an agreement to accede to India in October of 1947, and Indian troops cleared the Pakistani guerrillas from much of the area. The newly formed United Nations intervened in the conflict in 1948, organizing a cease-fire and calling for a referendum of Kashmir’s people in order to determine whether the majority wished to join with Pakistan or India. Although, that vote to date has never actually been taken and the Kashmir dispute still remains on the United Nations Security Council’s agenda.

 

  • Since 1948, Pakistan and India have fought two additional wars over Jammu and Kashmir, in 1965 and in 1999. The region remains divided and claimed by both nations; Pakistan controls the northern and western one-third of the territory, while India has control of the southern area.

 

  • Islamabad (capital of Pakistan) has always maintained that majority-Muslim Kashmir should have been a part of Pakistan. India claims that Pakistan lends support to separatist groups fighting against government control and argues that a 1972 agreement, signed after the Bangladesh war, mandates a resolution to the Kashmir dispute through bilateral talks.

 

  • India and Pakistan did indeed agree a ceasefire in 2003 after years of bloodshed along the existing border (formally known as the Line of Control). Pakistan later promised to stop funding insurgents in the territory while India offered them an amnesty if they renounced militancy. Then, in 2014, a new Indian government came to power promising a tougher line on Pakistan.

 

  • Many people in the territory do not want it to be governed by India, preferring instead either independence or union with Pakistan. The population of the Indian-administered state of Jammu and Kashmir is more than 60% Muslim, making it the only state within India where Muslims are in the majority. High unemployment and complaints of heavy-handed tactics by security forces battling street protesters and fighting insurgents have aggravated the problem.

Possible Solutions:

  • Relocation and support for the poorest and most vulnerable from both sides. In November, 2016 – Raja Farooq Haider, the prime minister of Azad Jammu and Kashmir, the Pakistani-controlled part of the disputed region, said the government has so far moved 8,000 people to “safer places” in the wake of on-going “Indian shelling,” and plans are being made to move even more people.In October 2016 India relocated more than 10,000 people from around the disputed border area of Kashmir as tensions continued to escalate with Pakistan.

 

  • China and India both also claim a Tibetan enclave in the east of Jammu and Kashmir called Aksai Chin; they fought a war in 1962 over the area, but have since signed agreements to enforce the current “Line of Actual Control.”

 

  • Further ceasefires/treaties. However the UN has already tried this and has been unsuccessful.

 

  • Carry out the referendum that was suggested by the UN to see what the people want. Although India is reluctant to do this.

 

  • Make a formal boundary-the half that is already occupied by India could be assigned to them and the rest of the area could go to Pakistan. However this is unlikely to hold and each country will almost inevitably encroach further. It is also easier said than done and may even lead to further ethic tensions and just like the partition in 1947-similar consequences may arise e.g. difficult to draw a boundary between villages/towns.

 

  • Others suggest that there is no viable solution and that this battle based purely on religious differences. It is clear that neither country wants Kashmir to become an independent nation, and the future of this long-disputed region is still blurred. Since India, Pakistan, and China all possess nuclear weapons; any hot war over Jammu and Kashmir could have devastating results.

 

Fiscal Facts & Fables

Hello readers,

Welcome back to my blog. I recently discussed monetary policy and the role of interest rates in the economy. In this post I thought I would do some research into fiscal policy and assess some of the different proposals that have been introduced over the years by Osborn and Hammond. For those of you who don’t know, fiscal policy refers to government spending and taxation and such changes are announced in the annual budget. In the 2017 budget which took place last month the main policy we saw being implemented by the chancellor was abolishing stamp duty for first time buyers purchasing homes under £300,000. Although the aim of this was to enable such buyers to gain a foothold in the property market, it is likely that house prices may just increase by the amount that is being saved or by more as a larger number of people will be able to afford a house which they were previously unable to afford, thus increasing demand and pushing up prices. Furthermore, most homes in London are well above this price and there will be no impact to these buyers. Aside from that there were few major changes other than the usual increase to alcohol duties and the implementation of a tax on new diesel cars. More money was inevitably promised to fund the NHS and Hammond has announced that he will be increasing the budget for teaching mathematics across the country as this is vital for long term productivity gains. If you have any questions about the budget or after reading this post, please comment below.

Screen Shot 2017-11-05 at 23.37.17

  1. Phillip Hammond’s Current Fiscal Objectives:

Taxation

  • Chancellor says that £140bn has been raised since 2010 by tackling tax avoidance evasion.
  • Top 1% now pay 29% of all income tax.
  • People’s choices for employment should not be driven by tax implications.
  • Sugar tax set at 18p and 24p.
  • Corporation tax set to fall to 17% by 2020.

Infrastructure

  • £300m of previously announced fund to support “brightest and best research talent”; £200m for local projects to leverage private sector investment in fibre broadband networks; £16m for a 5G hub; £270m for robots.
  • £90m for the north and £23m for the Midlands for “pinchpoints” on the national road network.

Education and skills

  • “While investing in education and skills helps to tackle our productivity gap… it does something else as well: it delivers greater fairness,” Mr Hammond says.
  • Funding for a further 110 new free schools on top of the existing 500, including new specialist maths schools.
  • £216m more investment in the schools estate over the next three years, taking total investment in schools of over £10bn in this Parliament.
  • Loans for part-time undergraduates and doctoral students.
  • Increase by more than 50pc the number of hours of training for technical students aged 16-19 so when they qualify they will be “genuinely work ready”.

Healthcare

  • £2bn of additional grant funding for social care over the next three years, with £1bn available in 2017-18, allowing local authorities to “act now” to commission care packages.
  • £425 million more for NHS development and A&E departments.

2. Current Level of National Debt:

The UK national debt is the total amount of money the British government owes to the private sector and other purchasers of UK gilts. According to the ONS General government gross debt was £1,731.4 billion at the end of December 2016, equivalent to 89.3% of gross domestic product (GDP); an increase of £65.4 billion on December 2015. The UK national debt grows at a rate of £5,170 per second. The truth however is much worse, factoring in all liabilities including state and public sector pensions, the real national debt is closer to £4.8 trillion, some £78,000 for every person in the UK. Although 89% of GDP is high by recent UK standards, it is worth bearing in mind that other countries have a much bigger problem. Japan, for example, has a National debt of 225%, Italy is over 120%. Also, the UK has had much higher national debt in the past, e.g. in the late 1940s, UK debt was over 200% of GDP. Prior to the crash the debt to GDP in 2007 in the UK was 42% and after the recession in 2010 it was 76% of GDP.

3. Current budget deficit (annual borrowing):

The budget deficit is the annual amount the government has to borrow to meet the shortfall between current receipts (tax) and government spending. Net borrowing for the UK 2016/17 is £45bn or 2.3% of GDP. The forecast for 2017-18 is net borrowing of £58bn or 2.9% of GDP.

In 2009/10 at the height of the great recession net borrowing was £152bn or 10% of GDP. This was due to:

  • The financial crisis which led to falling tax revenues, e.g. lower incomes led to less income tax revenue; fewer house sales-led to lower stamp duty.
  • Expansionary fiscal policy including ‘VAT holiday’.
  • Higher spending on unemployment benefits during the recession.
  • Long term spending commitments, e.g. government spending increases in the early 2000s.

4. Role of the OBR:

The Office for Budget Responsibility was created in 2010 to provide independent and authoritative analysis of the UK’s public finances. It is one of a growing number of official independent fiscal watchdogs around the world. They have 5 main roles: Economic and Fiscal forecasting, evaluating performance, sustainability and balance sheet analysis, evaluation of fiscal risks, and scrutinising tax and welfare policy costing.

5. The last time the UK government ran a budget surplus:

In 2000/01, the UK ran a budget surplus of £17bn or 1.7% of GDP.

6. Osborn’s budget in “normal times”:

  • “With our national debt unsustainably high, and with the uncertainty about what the world economy will throw at us in the coming years, we must now fix the roof while the sun is shining,”
  • He was in favour of enforcing austerity in order to ‘balance the books’ and run a budget surplus in “normal times”.
  • However the target was criticised and referred to as ambitious. The savings were to come from a £12bn cut to the welfare bill mainly from cuts to tax credits, housing benefits and a lower welfare cap.
  • The BBC was required to make cuts to its own budget as well as take on the annual £650m bill for providing the over 75s with free TV licenses.
  • He said that this is “A Budget that sets out a plan for Britain for the next five years to keep moving us from a low-wage, high-tax, high-welfare economy; to the higher wage, lower tax, lower welfare country we intend to create”.
  • He pledged to make Britain the richest economy in the world by the 2030s under his plans, suggesting that he would bring in his budget surplus rule once he is nearly finished with his cuts.
  • His idea was: in the good times we stay in surplus – raising more money than we spend and using that to pay down our debts,” Osborne said. “And when the bad times come, the Government will have to set out a clear plan to get back to health.”

7. Taxes in the UK:

According to the Institute for Fiscal Studies (IFS), the proportion of national income that is taxes in the UK is approximately 33% and the total tax receipts in 2017–18 are forecast to be £690 billion. By 2019–20, tax receipts are forecast to be at their highest share of national income (34.4%) since 1981–82. Total government receipts, which include interest, dividends and gross operating surplus, are forecast in 2019–20 to be at their highest level (37.2%). A study by the think-tank the Centre for Cities found that London generated almost as much tax as the next 37 largest cities combined and increased its share of “economy taxes” underpinning the Treasury’s finances to 30%.

In Scandinavian countries Finland, Norway of the Netherlands, taxation make up a larger proportion of national income and these societies are often referred to as being more ‘equal. On the flipside countries such as the UAE or Saudi Arabia who are oil rich, depend less on tax income with many people exempt from paying any income tax at all, as majority of their national income is from oil.

8. Proportion of national income that is government spending:

Government spending as a proportion of national income in the UK is at a similar level to that in Germany but is considerably higher than in Switzerland, Australia and Ireland. Government spending is also somewhat higher in the UK than in Canada, the US and New Zealand. Before the First World War, government spending was about 10 per cent of national income. By 1920, the figure was 20 per cent; and by 1937, it was 30 per cent. Now it is around 46% of national income.

9. Tax system in the UK:

The UK has a progressive tax system. This means that the rate of tax increases as income increases. The US also has a progressive tax system and essentially it reduces the burden on people who can least afford to pay them. These systems leave more money in the pockets of low-wage earners, who are likely to spend all of their money and stimulate the economy. Progressive tax systems also have the ability to collect more taxes than flat taxes or regressive taxes, as tax rates are indexed to increase as income climbs. Progressive taxes allow the people with the greatest amount of resources to fund a greater portion of the services all people and businesses rely on, such as roads, first responders etc. Critics of progressive taxes consider them to be discriminatory against wealthy people or high-income earners.

10. Examples of countries with a proportional or flat rate tax system:

Romania-16%    Russia-13%     Hungary-15      Jamaica-25%

11. Government’s objectives for direct taxation (income) and indirect taxation (VAT):

  • Finance government expenditure & infrastructure
  • Prevent Concentration Of Wealth In A Few Hands- Progressive systems-prevents wealth being concentrated in a few hands of the rich i.e. narrowing the gap between rich and poor.
  • Redistribute Wealth For Common Good- the wealth of the rich is redistributed to the whole community.
  • Promoting economic growth, stability and efficiency-The government controls or expands the economic activities of the country by providing various concessions, rebates and other facilities. The effective tax system can boost the economy. Similarly, taxes can correct for externalities and other forms of market failure (such as monopoly). Import taxes may control imports and therefore help the country’s international balance of payments and protect industries from overseas competition.
  • Reduce Structural Unemployment-The government can reduce the unemployment problem in the country by promoting various employment generating activities. Industries established in remote parts or industries providing more employment are given more facilities.
  • Remove Regional Disparities-Regional disparity has been a chronic problem to the developing countries. Tax is one of the ways through which regional disparities can be minimized. The government provides tax exemptions or concessions for industries established or activities carried out in backward areas. This will help increase economic activities in those areas and ultimately regional disparity reduces to minimum.

12. Reasons for public expenditure:

  • Improve Public Services-Higher government spending can lead to improved public services like health, education and transport. These are important for increasing the quality of life and economic well being.
  • Increase Productive Capacity of Economy-Some types of government spending, can help to overcome market failure. For example, education can help increase labour productivity and reduce structural unemployment; if the education spending is well targeted it can help to increase the long run trend rate of growth. However, not all government spending is guaranteed to actually increase government spending, it may be subject to government failure and inefficiency.
  • Expansionary Fiscal Policy-Increased government Spending without higher taxes is likely to increase AD. It will cause a budget deficit, however, the increased government spending is an injection of spending to the economy and could help to increase the rate of economic growth. Some monetarists argue increased government spending will just cause crowding out, and therefore it will not increase AD.
  • Reduce Inequality-A significant % of government spending is spent on social security. This includes benefits, such as; unemployment benefit, income support, child benefit and housing benefit. The majority of these benefits are means tested; this means they are targeted to those on low incomes. The aim is to reduce relative poverty and inequality.

13. Key Principals of Taxation:

Adam Smith developed his four famous ‘canons’ of taxation:

  • Equity: The amount payable by taxpayers should be equal, by which he meant proportional to income.
  • Ability: The taxpayer should know for certain how much he will have to pay.
  • Convenience: There should be convenience of payment.
  • Economy: Taxes should not be imposed if their cost of collection is excessive.

Other principals include:

  • Adequacy: taxes should be just enough to generate revenue required for provision of essential public services.
  • Broad Basing: taxes should be spread over as wide as possible section of the population, or sectors of economy, to minimize the individual tax burden.

14. UK Current level of:

  • Corporation Tax- 19%
  • VAT- 20%
  • Top Rate of Income Tax- 45% (over £150,000)
  • Tax Free Allowances- up to £11,850 (increase from £11,500-announced in this year’s budget-in line with inflation).

15. Examples of goods exempt from VAT:

Charity shops – selling donated goods, lottery ticket sales, education, water supplied to households, children’s clothes and books.

16. Difference between a cyclical and structural deficit:

Cyclical budget deficit-A cyclical budget deficit takes into account fluctuations in tax revenue and spending due to the economic cycle. For example, in a recession, tax revenues fall and spending on unemployment benefits increases.

Structural deficit-This the level of the deficit even when the economy is at full employment.

17. Examples of how government spending and taxation can influence the pattern of economic activity:

  • In a recession e.g. the 2008/09 crash, consumers may reduce spending leading to an increase in private sector saving. If government spending is increased it may create a multiplier effect e.g. the unemployed gain jobs, they will have more income to spend leading to a further increase in aggregate demand. (e.g. construction workers employed by government increase spending in pubs and transport, causing other sectors of the economy to benefit from the government spending). Some economists would argue increasing government spending through higher taxes would lead to a more inefficient allocation of resources, as governments tend to be less effective in spending money.
  • Increasing taxation perhaps to finance the growing budget deficit would leave consumers with less disposable income and is likely to reduce AD.

18. Factors which could put pressure on public finances over the next 10 years:

  • Healthcare-NHS
  • State Pensions (growing and ageing population)
  • Immigration-increased demand for education, welfare benefits, housing etc. However a ‘Hard Brexit’ i.e. with no free movement of people and a move to a ‘points based system’ may offset this.

Sources Used:

https://www.economicshelp.org/blog/2731/economics/impact-of-increasing-government-spending/

https://www.ifs.org.uk/publications/9178

http://uk.businessinsider.com/budget-2017-live-chancellor-philip-hammond-brexit-tax-borrowing-schools-tech-2017-3

https://www.gov.uk/guidance/rates-of-vat-on-different-goods-and-services

https://www.britannica.com/topic/taxation/Principles-of-taxation

http://www.economicsdiscussion.net/india/public-expenditure/public-expenditure-causes-principles-and-importance/17462

http://www.investopedia.com/terms/p/progressivetax.asp

http://www.telegraph.co.uk/finance/budget/11726259/Budget-2015-George-Osbornes-speech-in-full.html

Does Migration Benefit the Economy?

Hello readers,

Welcome back to my blog. In this post I thought I would discuss a topical yet controversial issue: migration.

With the recent vote to leave the EU in the UK to the refugee crisis across the world from war torn areas in the Middle East, I thought I would discuss some of the economics behind migration and dispel some of the myths that many people have about this topic. I will evaluate whether international migration creates more opportunities than threats, in the context of the UK and will also consider the social, political and moral issues. If you have any questions or would like to share your own views please comment below.

Screen Shot 2017-11-05 at 23.27.34

It is widely debated in today’s society as to whether the benefits of international migration actually outweigh the potential costs; and despite the fact that there have been many studies into this field, the nature of migration is extremely complex and thus the issue remains controversial. Many people across the world are attracted to this so-called “treasure island” due to a combination of factors ranging from higher salaries and existing migrant communities to increased quality of life and standard of living. This, coupled with an open visa policy and the recent rise of “Corbynism’ demonstrate how the UK is generally perceived as being more open/cosmopolitan compared to the USA, China or France. According to the ONS, the number of foreign-born people of working age in the UK increased from nearly 3 million in 1993 to 7 million in 2015. The recent outcome of the vote to leave the EU exemplified the growing tensions between different social groups and their negative views/perception on immigration with many stating that they wanted to get “our borders back” and “protect our jobs”. However one could argue that many people were myopic in the sense that they were not looking at the long-term viability of the UK economy or provision of services in light of the current crisis with the NHS and the growing problem of an ageing population/state pensions. Clearly these services are not sustainable and we need a stream of economic migrants to contribute to the tax base of the UK if we are to have a chance at tackling the increasing budget deficit. Many do not realise that migration may be the answer and with the possibility of a ‘Hard Brexit’ we may be headed in the wrong direction. That being said terrorism, which has been associated with increased migration, remains a topical and pressing issue.

Screen Shot 2017-11-05 at 23.27.07

Let us first consider the economic opportunities that are actually gained via pro-immigration strategies. Firstly it has been estimated that a 1% increase in immigration on average leads to a 1.25% increase in GDP (i.e. there is value added). This means that despite the fact that migration is often associated with creating unemployment for local people or putting pressure on “our” services, it actually has a net benefit. Furthermore, the claim that immigration takes jobs could be argued to be incorrect as often migrants are able to fill specific skill shortages or they take jobs which locals are unwilling to take e.g. Fenland-agriculture. It has also been shown that many of these migrants are extremely determined/motivated often with the goal of sending remittances abroad to support their families. As a result they have a higher productivity that employers favour. In fact a report by The International Longevity Centre think-tank suggests that EU immigrants can actually help increase employment opportunities instead of taking people’s jobs. On average, areas with higher employment rates for immigrants also tended to have more of the white UK-born population in work. Furthermore they suggested that by 2064-65, the UK’s GDP would be 11.4% (£625bn) larger with high migration than it would with low migration. They argued that because EU migrants have a higher employment rate than the UK average and because migrants from the European Economic Area made net tax payments totaling £22.1 between 2001 and 2011, they could be an asset in supporting the UK’s ageing population. The idea that immigrants crowd native Britons out of the jobs market “is built on the false premise that there are a fixed number of jobs in the economy.” Moreover, people often forget that Migrants also buy goods and services – providing a boost to the economy and creating new jobs. Migrants may also bring useful skills that complement those of the indigenous workforce. It also suggests migrants could boost the sustainability of government finances in the long run; under a high net migration scenario by 2064-65 net public debt would be expected to reach about 70 per cent of GDP – compared to 104 per cent of GDP in a low migration situation. Migration could therefore help support a population where the number of pensioners is expected to double between 2000 and 2050 and the number of over-85s is thought to be on course to more than quadruple in the same period. By contrast a reduction in the level of migration may require unpopular changes to government policy in other areas such as increased national insurance contributions or higher levels of tax.

Economists from the Centre for Economic Performance at the London School of Economics say that when they look at the areas with the largest increase in EU immigration, these have not seen the sharpest falls in employment or wages, and the OBR suggests that the UK’s fiscal position would be significantly worse in 50 years if migration was to be lower.

Aside from the economic benefits, there are a number of social and cultural opportunities created. Perhaps the best example of this is China Town. Not only does this allow people to experience and enjoy a different culture to escape their homogenized routines, but also it allows existing communities to feel at home-voluntary segregation as opposed to forced. Other benefits include new flows of ideas, work ethics, hobbies, sports, and beliefs. In terms of political benefits, it could be argued that migrants may have new ideas about certain policies, which may have previously worked, in their home countries.

Despite the opportunities created by international migration we must also consider some of the potential economic, social and political threats. Another issue felt keenly in the UK, is the concept that we are already ‘overcrowded’. In this case, a rapid increase in the population due to migration could lead to falling living standards. For example, the UK faces an acute housing shortage, but also an unwillingness to build on increasingly scarce ‘green belt’ land. In many cities, it is difficult to build more roads because of limited space. Increased population could increase congestion and urban pollution. Therefore, the increase in real GDP has to be measured against these issues, which affect the quality of life. From one perspective an increase in the labour supply may push down wages. This is especially true if migrants are keen to accept lower wages (e.g. willing to bypass traditional union bargaining/equilibrium level). However, again, net migration doesn’t have to push down wages. The massive immigration into the US, during the twentieth century, was consistent with rising real wages. That being said a Bank of England report found that a rise in immigration had a small impact on overall wages – with a 10% increase in immigration – wages fall by 0.31%.

The most common argument against increased migration as a solution to the problems associated with an ageing population is that ultimately the migrants themselves will get old thus contributing to the dependency ratio. However these arguments assume that migrants will remain in the UK for the entirety of their working lives and into retirement and there is evidence that migrants often choose to go home before they get old.

Although migration seems to have a broadly positive impact on public service delivery, there can be important problems at grass roots level. High net migration has resulted in rapid population growth. The Office of National Statistics ‘high’ migration scenario, which assumes net migration of 265,000, projects that the UK population will now increase by around 500,000 a year – the equivalent to a new city the size of Liverpool every year. This is unsustainable. It would result in the population growing by nearly eight million over the next fifteen years bringing it to 73 million. England is twice as crowded as Germany and nearly four times as crowded as France. To cope with this population increase huge amounts will have to be spent on the expansion of school places, roads, rail, health and other infrastructure. This is at a time when the government is running a budget deficit and aims to reduce public spending over the long term.

Public opinion however is clear. A large majority (76%) of the public want to see immigration reduced. The greater the number of new arrivals, the harder it is for everyone to become fully integrated in British society and undoubtedly the flow of new ideas leads to a loss of “Britishness” and cultural erosion.

In 2013, 62% of Britons worried that an increase in the Muslim population would weaken Britain’s national identity. This coupled with recent Islamist extremism attacks has led to a number of political issues and perhaps was one of the driving forces behind the vote to leave the EU. In addition, the rise of ‘white flight’ in Britain is ‘self-segregating’ as white families flee urban areas for the countryside and outer suburbs. The trend is causing an ‘ethnic cliff’, in which the proportion of households from minority backgrounds is vastly different in areas just a few miles apart.

In conclusion, I believe that migration is a process rather than a problem and given the rise of globalization, and the fact that humans will always strive to seek the best life possible it is almost inevitable. From considering the data, the consequences of international migration seem to be offset by the benefits such as increased contributions to taxation thus helping to reduce the deficit, promoting further investment and allowing for the expansion of the economy. Although statistically it may seem that by increasing migration the number of terrorist attacks have increased, it is important to note that correlation does not imply causation and it may be argued that the increase in such attacks reflect modern day conflict and political issues with previous government interventions in Middle Eastern countries. Even though there is evidence against immigration which suggest that it can have negative impacts, the majority of evidence states otherwise and generally the net benefit, taking into consideration all of the factors points towards a better future. Moreover, if we look back at history-immigration that supplied the labour that aided the post war economic recovery was vital. In more recent times, many doctors and healthcare workers in the NHS are migrants. Without them such services would not be able to function. Finally from a moral high ground, surely we have a responsibility to help fellow human beings where possible? Before employing anti-immigration policies or campaigns we should consider the stark juxtaposition between the lives of migrants and our current lifestyles and think about what we would do if we were in their shoes. Therefore since migration helps to support growth and the sustainability of public finances as our society ages we need not fear it. Migration is an expression of the human aspiration for dignity, safety and a better future. It is part of the social fabric, part of our very make-up as a human family.

Screen Shot 2017-11-05 at 23.27.49.png

 

Sources Used:

http://www.migrationobservatory.ox.ac.uk/resources/briefings/migrants-in-the-uk-labour-market-an-overview/

http://www.independent.co.uk/news/uk/politics/eu-referendum-immigration-immigrants-jobs-brexit-remain-what-happens-unemployment-a7091566.html

https://www.economicshelp.org/blog/6399/economics/impact-of-immigration-on-uk-economy/

https://www.ft.com/content/0deacb52-178b-11e6-9d98-00386a18e39d

http://www.telegraph.co.uk/news/uknews/immigration/11409181/British-Muslims-integration-and-segregation-are-about-economics-not-values.html

https://www.theguardian.com/uk-news/2013/dec/01/white-flight-diversity-cities

Interest Rates in the UK rise for the first time in 10 years!

Hello readers, welcome back to my blog.

I hope you enjoyed reading my post last time about the financial crisis and now have a clearer understanding of why it actually happened. This week I thought I would take a look at the recent rise in the base rate of interest, by the Bank of England on the 2nd of November from 0.25% to 0.50%. As I discussed in my last post, interest rates have been at ‘ultra low’ levels since the financial crisis and only now are they starting to rise. The Bank of England is expecting two further rises by the turn of the decade which would leave them at 1%-still considerably lower than pre-crisis rates, thus indicating that Brexit related uncertainty and low overall ‘animal spirits’ in the economy are limiting the UK’s growth potential. However, Mark Carney has said that “any further increases in interest rates would be at a gradual pace and to a limited extent”. Despite the fact that high street sales are falling at their fastest level since the height of the recession in 2009 as consumers “tighten their belts”, and even though the UK is facing high levels of consumer debt, coupled with mounting uncertainty and sluggish growth, Threaneedle Street has indeed taken the decision to reverse the emergency action taken immediately after the Brexit vote, voting 7 to 2 for a raise. Within this post I will explain why we have  seen a rise, the impacts of this rise as well as evaluate whether monetary policy has been effective over the last few years.

Why have they risen?

For over 30 years control of inflation has been the main objective of U.K. monetary policy; in order to create conditions in which the ultimate policy objective of improved economic welfare can be attained. Changes to the Bank rate is referred to as conventional monetary policy; however, in come cases central banks have to resort to unconventional monetary policy measures such as Quantitate Easing (QE) as interest rates are at the ‘zero lower bound’ i.e. the bank has ‘run out or road’ and cutting interest rates will no longer control the economy.

The Bank of England has a target of 2.0% for CPI inflation and currently the level is at 3.0%, expected to rise to 3.2% next month. The rise in inflation is linked to the weaker pound which has meant that UK exports become cheaper in foreign currency terms and imports to the UK become more expensive in domestic currency terms. Although cheaper imports are likely to lead to an increase in demand for them, this is not always the case. For example, the ‘Martial Learner Condition’ suggests that the effectiveness of a depreciation depends on price elasticities of demand for exports and imports. It states that “For a fall in the exchange rate to improve the trade position, the combined elasticities of demand for exports and imports must be greater than 1. If combined elasticities are less than one, a fall in the exchange rate will worsen the defect”.

We could also look at the ‘J curve’ effect which states that in the short run, quantity demanded of exports and imports may be inelastic due to short term contracts and the ‘wait and see policy’ where by firms/consumers hold back spending to see what is likely to happen next in the economy. Thus if we consider the flipside-for a depreciation to be successful, firms in the domestic economy must have spare capacity to meet the surge in demand for exports. Also, the effect of a depreciation may be short lived as competitiveness may be eroded by cost push inflation. Hence, trade balances may actually worsen in the short term following a depreciation of the exchange rate. Moreover, the UK has a marginal propensity to import; that is, we as a nation are likely to spend more on imports as our disposable income rises.

Last month’s inflation was also thought to have risen since the cost of fuel and raw materials for industry was up by 8.4% a year ago, although clothes had come down in price. Consequently prices in the UK are rising at a faster rate than anywhere in the G7 group of leading global economies, according to the Organisation for Economic Co-operation and Development (OECD). The UK is only behind Turkey, Mexico and the eastern European states of Latvia and Estonia in the club of 35 developed nations. The rise in prices was also above the averages for the euro area, the wider European Union and the G20 nations.

The graph below from the BBC illustrates how the base rate of interest has changed since the millennium.

Screen Shot 2017-11-03 at 15.34.33.png

What does the rate rise mean for you and has monetary policy been effective?

For those of you who don’t know, Monetary Policy is part of the economic policy that attempts to achieve the Government’s macroeconomic objectives such as low and stable inflation using monetary instruments, such as controls over bank lending and the rate of interest. Quantitative easing an unconventional measure essentially involves new money being created electronically to buy financial assets such as government bonds, on the country’s financial markets, which influences a commercial banks’ ability to lend money. This can stimulate consumer spending (approx. 65% of Aggregate Demand), as well as investment spending, thus boosting AD and economic growth. The effectiveness of monetary policy however is questionable and certain policies have been carried out with varying degrees of success. For example changes to the base rate feed through the ‘Monetary Policy Transmission Mechanism’ meaning that there is an 18-24 month time lag before we see the full effects of a change to interest rates. Similarly with QE, many economists argue that this £375bn asset purchasing scheme did not drastically raise demand after the great recession since banks were reluctant to lend. Some economists argue that it would have been better to give people the money to spend rather than to the banks and that the money should have gone into the real economy e.g. via tax cuts. That being said, we cannot test the counter-factual; what would have happened without QE and we do not know where the economy may have been without these emergency measures. In  addition monetary policy may have been unsuccessful in 2010 since it was not in line with other macro-economic policies such as fiscal policy. During this time the coalition party, enforced austerity (higher taxes and less government spending) thus contracting the economy and the aims of expansionary monetary policy. Therefore we can say that although the economic theory may suggest what is likely to happen, the actual success of certain policies depends on a range of factors that economists cannot predict.

In Economics, there is never a “one size fits all” policy and inevitably there will be winners and losers in these situations. The winners will include 45 million savers, who are likely to see higher returns from savings accounts. A number of providers have already announced they will be increasing savings rates in line with the rise. Mark Carney, the Bank’s governor, said he expected other providers to follow suit. Those planning on buying an annuity to finance their retirement will also benefit. But for at least four million households with variable rate mortgages, monthly payments are set to rise immediately. Across the UK, 9.2 million households have a mortgage. Of these, around half are on a standard variable rate or a tracker rate, amounting to between four and five million households. These are the people who will be most affected, as their monthly payments will increase.

The average easy-access savings account is currently paying 0.14% in annual interest, according to the Bank of England. So someone with £10,000 worth of savings is earning £14 a year. If the rate rise is fully passed on, they would earn an extra £25 a year, making £39 in total. A saver with £10,000 in a typical cash Individual Savings Account (ISA) would see their income rise from £30 a year to £55.

Screen Shot 2017-11-05 at 11.49.55.png

Households, in total, are expected to face about £1.8bn in additional interest payments on variable mortgages in the first year alone. It is also estimated that households will pay as much as £465m in additional costs on credit cards, overdrafts, personal loans and car repayments.

Many argue that this is the last thing that hard pressured families need. With UK living standards falling, the economy needs boosting not reining in. Furthermore, many poorer households are using credit cards to finance their day to day spending suggesting that they are already struggling. With real wage growth still being negative, and rising household debt which ultra low rates have encouraged over the years, such a rise is likely to be regressive i.e the poorest and most vulnerable in society will be hardest hit. The prevalence of low interest rates has promoted a culture whereby such low levels of interest are the norm. While consumers may have got used to these levels, it is estimated that 8 million Brits have not seen a rise in their adult life.

The rise in interest rates is also likely to improve the exchange rate and help the weak pound to recover amidst the Brexit related uncertainty. This is because raising interest rates makes Sterling more attractive to foreign investors leading to a flow of money into the UK referred to as ‘hot money’.

Carney’s main justification was that adding higher interest rates in small incremental steps, were part of ensuring that the real income squeeze ends and does not come back i.e. reducing inflation back to ‘sustainable’ levels and helping the economy to rebound from what some call “the permanent damage to the economy” after the financial crisis, deep recession and the credit crunch.

Others argue that interest rates need to rise because if the UK does face any more external shocks, as interest rates are at the zero lower bound, there is little room left for any adjustment to control the economy.

The graph below shows how interest rates have changed over the last few decades in the UK:

Screen Shot 2017-11-05 at 11.52.10.png

Sources Used:

http://www.bbc.co.uk/news/business-41846330

http://www.telegraph.co.uk/personal-banking/savings/bank-england-interest-rate-rise/

https://www.theguardian.com/business/2017/oct/03/uk-highest-inflation-rate-oecd-brexit-prices-g7

What were the causes of the financial crisis and could such a crisis happen again?

Hello readers, welcome back to my blog.

This week I thought I would share with you my research that I have done on the 2008/09 financial crisis.

The 2008/09 financial crash led to a prolonged period of low/negative growth, high levels of uncertainty and rising unemployment. It was the largest and most dramatic recent example of financial systems being threatened by systemic failure. In 2013 the effects of the crash were still rippling through the world economy, GDP was still below its pre-crisis peak in many rich countries, especially in Europe, where the financial crisis had evolved into the euro crisis and banks were still reluctant to lend as they had been scarred by previous events which has reduced the overall effectiveness of Quantitative Easing programmes. Today most countries are on the rebound; however, other political shocks such as Brexit in the UK stand in the way of increased economic prosperity.

Screen Shot 2017-10-11 at 20.35.08.png

It is important to note that there was not one sole cause of the financial crisis; rather there were a combination of factors, which led to this economic downturn. The primary cause of the financial crisis however, was the credit crunch (sudden shortage of funds for lending, leading to a decline in loans available). This was driven by a sharp rise in the defaults on ‘sub-prime’ mortgages, which were mainly in America but the shortage of funds spread across the world. Sub Prime mortgages were essentially mortgages sold to customers generally with low income, poor credit and very small, if any deposits. The housing market in the US at the time was booming and there was little regulation on the sale of these products. Mortgage brokers were given commissions for selling mortgages, even if they were too expensive and had a high chance of default.

Screen Shot 2017-10-11 at 20.28.01.png

The problem was further exacerbated when mortgage companies bundles the debt into consolidation packages and sold the debt onto other finance companies. The issue was that sub prime mortgages had a high risk, although when the mortgages got bundled and passed onto other lenders, rating agencies such as Moody’s and Standard & Poor’s gave these risky products a better rating and thus the true risk in the financial system was denied. These were known as Collateralized Debt Obligations (CDO’s) and it involved mortgage companies borrowing to be able to lend mortgages. Financial intermediaries and investment banks such as JP Morgan bought these debts and the idea was to spread the risk, although it actually spread the problem at hand. Lehman Brothers has become synonymous with the financial crash and the idea of ‘Bank Failure’. They acquired five mortgage lenders including sub prime lenders. Given the size of its company and its status as a major player in the U.S. and the international economy, Lehman’s collapse created a state of turbulence in global financial markets. Many questioned the governments decision to let Lehman fail as it led to more than $46 billion of its market value being wiped out and served as a catalyst for the purchase of Merrill Lynch by Bank of America in an emergency deal.

Screen Shot 2017-10-11 at 20.28.29.png

Not only were these mortgages sub prime but they also had an introductory period of 1-2 years and at the end of this period, the rates increased significantly, something which consumers had been myopic about. In 2007, inflation in the US was rising and so the Federal Reserve had to increase interest rates to curb inflation, which made homeowners who had taken out mortgages during the introductory period, ‘feel the pinch’ even more as they faced extortionate payments. This was coupled with rising health care costs, rising petrol prices and food prices, reduced disposable income to a point where people were struggling to make ends meet and made defaults almost inevitable. This signaled the end of the housing boom and US house prices started to fall, which caused even further issues e.g. people with 100% mortgages now faced negative equity (the value of the loan is greater than the value of the house). Not only did this create a negative wealth effect, lower animal spirits and reduce confidence and spending but people could no longer rely on re-mortgaging to gain equity withdrawal. It also meant that these loans were not secured meaning the bank could not recoup the initial loan. This meant banks had to write off massive losses and this made them reluctant to make further lending. The result was that all over the world it became difficult to raise funds and borrow money and so ‘markets dried up’, and halted investment into startups, tech companies and many other firms, increasing unemployment, reducing productivity and above all slowing economic growth.

In the UK mortgage lenders did not lend so many bad mortgages as there were more stringent controls in place than the US. However, the credit crunch did have serious problems for Northern Rock who could no longer raise enough funds in the usual capital markets. It was left with a shortfall and eventually had to make the humiliating step of asking the Bank of England for emergency funds. Since the Bank asked for emergency funds, this caused its customers to worry and start to withdraw savings (even though savings weren’t directly affected), thus reducing the bank’s liquidity. The recession led to a rapid rise in levels of government borrowing to finance the growing deficit. In response, the UK and many Eurozone economies pursued a degree of fiscal austerity – cutting spending on services/higher taxes to try and reduce levels of government borrowing; but austerity in a time of recession, led to a further decline in aggregate demand. Perhaps Keynes’ idea that ‘governments should spend their way out of a recession’, would have been a better approach.

Screen Shot 2017-10-11 at 20.35.16.pngThe global nature of the crisis meant that there was a drop in world trade. Countries saw a drop in exports as the global downturn led to lower demand. In 2008, there was also a peak in oil prices. This complicated matters because it caused cost-push inflation. This cost-push inflation made Central Banks more reluctant to cut interest rates. Also, higher oil prices reduced disposable income and led to lower spending. Usually, in a recession, oil prices fall. However, because of rising demand in China and India, we saw rising oil prices – even as Europe and the US went into recession.

Another potential cause of the financial crisis was the partial repeal of the Glass-Steagall Act. The Glass-Steagall Act’s primary objectives were twofold – to stop the unprecedented run on banks and restore public confidence in the U.S. banking system; and to sever the linkages between commercial and investment banking that were believed to have been responsible for the 1929 market crash. During the 2016 presidential campaign, Donald Trump inferred the reinstatement of the Glass-Steagall Act. After his election to the presidential seat in 2017, his head of the National Economic Council, Gary Cohn, revived talks of restoring the Act to break up the big banks. By creating a wall between commercial banking activities and riskier financial institutions, ‘too big to fail’, banks will be forced to shrink in size, making them smaller and more secure for depositors, the financial sector, and the economy. Breaking up the large banks, which have been found to be larger in 2017 than they were before the 2008 financial crisis will also mitigate the risks of a government bailout in the future.

In addition, banks panicked when they realized they would have to absorb the losses. Consequently, they stopped lending to each other. They didn’t want other banks giving them worthless mortgages as collateral and as a result, interbank borrowing costs (known as LIBOR) rose. This mistrust within the banking community was a major contributor to the severity of the financial crisis.

In terms of whether such a crisis could occur again, there have been numerous changes across the world from the potential revised glass stegeall act to the increased role of the Financial Policy Committee (part of the Bank of England) and the Financial Conduct Authority (not part of the Bank). Further, investment banks are now separate from retail banks so that they do not use people’s deposits for riskier investments. Following the publication of the final version of the Vickers Report in September 2011, the retail banking activities of banks operating in the UK must be ring fenced from their investment banking activities by 2019. This is likely to reduce systemic risk i.e. the breakdown of the entire financial system caused by inter-linkages within the system. Central banks have also imposed larger minimum required capital ratios on the banks. If banks hold more capital, they are less likely to become insolvent if there is a fall in the value of their assets-for examples, as a result of customers being unable to repay the money they have borrowed. At the same time, the UK has seen a change in the mortgage market: Mortgages have become more expensive and risky mortgage products like 125% mortgages have been removed from the market. Due to a shortage of supply, UK house prices have recovered much more quickly than abroad. Therefore it is unlikely that history could repeat itself in terms of sub prime mortgages, a run on the banks, and a housing bubble explosion. That being said in London, foreign investors who have purchased property, which is mostly unoccupied, have pushed houses prices up making them unaffordable for many. An interest rate rise by the Bank of England in the near future, coupled with the uncertainty from Brexit could lead to a fall in the value of prices and perhaps causes prices to crash.

What is more likely however is a potential crisis with PCP car loans. PCP car finance relies on the lenders’ ability to realise guaranteed future values, which can only happen in a strong used car market; but if hundreds of thousands of diesel drivers were to use consumer law to return their PCP-financed cars early – passing the early-termination losses back to the lenders – the cost would be so great that many finance companies wouldn’t be able to cope. It’s no exaggeration to speculate whether this could become the next financial crisis.

Screen Shot 2017-10-11 at 20.38.09It is clear that this ‘four-wheeled binge’, which reached a record £31.6bn in car loans last year, could have consequences if it ‘veers off the road’. What makes matters worse is that it takes just 20 minutes to fill in the forms for a new kind of loan that cuts the cost of financing to levels that allow people on modest incomes to afford the latest cars. This is compared with the three-hour affordability interview that mortgage applicants are now subjected to. The car financing industry is confident that this new breed of ultra-low-cost loans, which account for 82% of all new car registrations are a safe and secure way of financing new cars. It says sub-prime lenders, who offer loans to people with erratic incomes and damaged credit ratings, account for only 3% of the market and the industry can cope with any destabilising events coming down the track.

In conclusion the financial crash was caused by the credit crunch, which led to a fall in bank lending, due to a shortage of liquidity and a run on the banks. This triggered a chain of events: a fall in consumer and business confidence resulting from the financial instability, a fall in exports from the global recession and a fall in house prices leading to negative wealth effects. In Europe, the single currency created additional problems because of over-valued exchange rates. As the crisis highlighted, banks are sometimes tempted to take too many risks in pursuing the huge profit that lending long allows. It can be argued that they do this because they believe that the Bank of England in its role as lender of last resort, and the government through its bailouts, will not allow banks to fail. This illustrates the problem of a moral hazard whereby if something goes wrong firms know that someone else will bear a significant portion of the cost. It was clear that in the period leading up to the 2007-08 financial crisis insufficient attention was paid to tackling risks and vulnerabilities across the financial system as a whole. In light of what happened, new financial regulators and more rigid controls have been implemented to prevent another crisis. The FPC now fills that gap by identifying, monitoring and taking action to remove or to reduce systemic risks to the resilience of the financial system. Although we must be careful not to overlook the fact that PCP’s could become the new CDO’s.

OPEC’s Game Theory Dilemma

Hello readers, welcome back to my blog. Last time I discussed a concept proposed by Adam Smith: the diamond and water paradox. I hope that you found this interesting and can now start to see how economics permeates all aspects of our lives.

Having recently researched and read into game theory as well as having discussed one of the most famous examples of game theory in action, the prisoners dilemma, in an earlier post, I thought it would be useful to examine how it can be used to describe collusion within OPEC and the global economic effects of low oil prices.

Although I looked into OPEC and oil prices last year, I had not come across game theory at that stage and so in this post I aim to focus on the game theory aspect of OPEC. If you can’t remember much about the organisation or oil prices in general or need a reminder on game theory, then you might want to relate back to my previous posts to refresh your memory.

From reading Dixit and Nalebuff’s, ‘The Art of Strategy’, it becomes clear that most ‘games’ in life are cooperative, many are competitive and others are perverse. You will come to realise by the end of this post that the market for crude oil could be described as perverse.

OPEC is an oil cartel made up of 14 countries who collectively control about one-third of global oil production. They determine oil prices by agreeing to limit their oil production and therefore reducing oil supply in the global market. Both a freeze and a cut in production have the same goal – lower supply in order to raise prices-simple demand & supply laws of economics. In both cases, a situation very similar to the Prisoner’s Dilemma is created – if one country violates the agreement while the other abides, prices stay low and the country that violated the agreement benefits by selling more oil while the other has to sell the agreed amount of oil at a lower price. If both violate, output remains high and prices remain low. If both abide, prices climb and both players profit. The following chart portrays the possible outcomes. (You will notice it is very similar to the options that the prisoners were faced with in the prisoners dilemma game):

blog-post-1

According to Game Theory, each country will make the choice that is most beneficial for themselves independent of the other country’s strategy. In this case, both countries have a dominant strategy – violate the agreement – in which their own outcome is greater regardless of the strategy of the other country. Therefore, Game Theory implies that the countries in OPEC will make the choice that results in the lower outcome for both countries. Meanwhile, the most optimal outcome would occur if all of the countries abided by the agreement and limited production. Similarly in the prisoner’s dilemma, two parties that would benefit from cooperating together tend not to do so because of other incentives that if both follow, they will both end up in a worse place.

Two of the main problems that OPEC are currently facing:

  1. Saudia Arabians and Iranians do not want to take any action that would benefit the other, even if it would help themselves.
  2. It is almost impossible to keep member nations in OPEC, from cheating and producing more than their quota.

Game theory is based on having ‘rational-decision makers’. We have to remember that in reality people do not always make rational decisions and that the neoclassical model of man as a maximizer of utility or profits does not always follow.  People and nations are envious, and will make do with less if it means those that they dislike are worse off.  The Saudis may be burning through their financial reserves quickly, but virtually everyone else in OPEC is worse off.  The Saudis may think that they can drive a better deal inside OPEC when almost everyone else is desperate.

We must also consider a number of external factors that could come into play:

  • Weaker growth
  • Higher energy taxes
  • Further technological refinements that lower crude oil production costs further
  • Continued improvements in solar, wind, and energy storage (primarily battery) technology.

 

These factors would reduce the global demand for oil as suitable substitutes are developed and may result in countries oversupplying in an attempt to sell as much oil as they can before its too late-see my post, “What happens when we no longer need oil from the Middle East”.

Sources used:

https://www.bloomberg.com/view/articles/2017-08-02/opec-s-game-theory-dilemma

http://www.economist.com/node/17031126

https://blogs.cornell.edu/info2040/2016/09/18/game-theory-in-the-failure-of-opec/

http://alephblog.com/2016/04/19/opec-and-game-theory/

http://oilprice.com/Energy/Energy-General/Four-Possible-Outcomes-Of-The-OPEC-Meeting.html