For the Fed, where’s the worry?

Featured Image Credits: Dan Smith and “Dontworry” on Wikimedia Commons.

The past month or so, US equities have been zealously barreling towards past highs, buoyed by the most exceptional and exquisite of all financial drugs: forward guidance.

Mostly, however, the markets’ high originated far abroad in Europe; Portugal, to be precise. Mario Draghi’s dovish tone convinced investors of the ECB’s ability to use both the rates and quantitative easing mechanism to bolster growth. Given in the past decade or so that global developed-market rates tend to move synchronously with each other, the march upward of US equities wasn’t exactly surprising either.

Nothing in this saga after Draghi’s recent speech has come as all too unexpected, including Jerome Powell’s warnings on the global economic outlook. The proverbial sea of central bank governors is teeming with doves, eager to cut interest rates as soon as the slightest threat of a slowdown or (God forbid!) a recession rears its ugly head. It seems to make sense; who wants the music to stop?

Until you realise what the current US federal funds rate is.

2.5%.

One question springs up instantly from this: where’s the wiggle room? If things do go topsy turvy and then some, what can Powell do? You could say he could use quantitative easing. When you’re one of the biggest global players, though, and your best maneuver is a policy that’s efficacy is doubtful at best, you might indeed find yourself asking how you put yourself in that position.

Is it really worth exhausting your best shot on somewhat reduced growth from a large boom in the economic cycle? Yes, there are the fears of a trade war with China. Yes, concerns regarding Iran persist. And yes, we have no idea what Trump’s fellifluous self could conjure up at any moment. There are a lot of tailwind risks to the US and global economy right now, but my take is they don’t necessitate cutting interest rates by the expected 0.5%. Especially not when in the first quarter of 2019, the US grew at a more than healthy clip of 3.1% annualised.

We’re about a decade on from the Great Recession, a time where an investment banking behemoth collapsed, credit froze over and consumer confidence sunk faster than Rory Stewart’s hope of being Prime Minister. That (or at least something close to that) is when you suck the last drops of juice from the interest rate mechanism. In my opinion, a time where economic stimulus in the form of, for example, cuts in corporation tax have (perhaps unsustainably) bolstered growth is not a good time.

Recent dovishness has led the US two-year yield to drop to as low as 1.82%, and cuts in interest rate could potentially inflate further already huge equity valuations. A dollar of an American company’s earnings has gone from setting you back around $15 to setting you back $22 or $31, depending on the data which you use. When Netflix shares dropped significantly on the back of decreased US subscribers, it may have indeed been a sign that valuations are becoming increasingly optimistic (and perhaps superfluous). Not to preempt any sort of bubbles which may be occurring in equity and broader asset markets, but signs such as this don’t really point towards much else. As any five-year-old child will tell you, inflate too much and the bubble goes “pop!”. And when the bubble affects millions of people’s livelihoods and could pose a huge threat to pensions everywhere, you really don’t want to inflate too much.

While Powell brings about legitimate concerns regarding slowing global trade and inflation, I question the need for any substantive change in policy at the present moment. Growth was frequently demeaned as laggard in the years following the 2008 recession, and it seems when economic growth finally picked up meaningfully, he thought it would continue for far longer than it did. Moreso, forward guidance can backfire, in signalling to investors that there’s some sort of grave boogeyman ready to jolt the US economy any time soon. In fact, this is simply not the case. Powell should save his best for when we’re far nearer to the trough of an economic cycle, when growth is closer to 0% than 3%, and the US labour market isn’t adding nearly as many as 224,000 jobs in June. Otherwise, he might find himself out of ammo, just when he needs it the most.

 

So Trump is a hypocrite: what’s new?

Featured Image credits: The White House

Not to say that we in the UK don’t have our own share of clownish politicians, but the phrase “hypocritical Donald” isn’t exactly an oxymoron. How about the fact that he’s pro-life and yet not disclosing how many abortions he’s paid for (hint: he should be saying zero). Or what about when he criticised Obama for playing golf while in office before playing even more golf himself in the same time period while in office? Regardless of all these, though, I’m here to talk about quite a recent example of hypocrisy from the 73-year-old’s Twitter. The tweet, from yesterday, read:

“German DAX way up due to stimulus remarks from Mario Draghi. Very unfair to the United States!”

Where to begin with this? Trump’s rationale (presumably, at least; do we ever really know?) is that Draghi’s statements that the European Central Bank (ECB) could enact stimulus measures (including cutting policy rates further) in the future adds further negative pressure on the euro. This in turn makes US manufacturing uncompetitive with respect to that of Europe, and thus has the potential to depress the US economy through reducing exports and increasing imports. This is because the dollar appreciating vis-a-vis the euro makes exports from the US more expensive for foreign buyers, and makes imports into the US less expensive for US buyers.

While this train of thought is logical, it ignores the myriad of other reasons why the ECB would try and cut rates. Growth in the Eurozone has been flagging, due to, among other factors, the risk of a disruptive Brexit and a global trade war; OECD projections state growth as most likely around 1% for the year. While I’m not denying that a part of Mr Draghi’s army of reasons to act this way would be to add downwards pressure to the euro, Occam’s razor suggests that the currency argument isn’t the primary reason why Draghi is considering such action. Moreso, it’s not as if what the ECB is doing is unconventional; monetary authorities have been using interest rates as a tool to manage the economic cycle for decades.

However, it is also true that Trump never explicitly said that the intention was to depreciate the euro; he merely said it was unfair to the United States. Does this absolve him of any blame for the statement?

I don’t think so, for the following reason: Trump has repeatedly maintained his opposition to the mildly hawkish tone of the Chairman of the Federal Reserve, Jerome Powell, with respect to interest rates. If it’s so unfair that the ECB may cut rates in case of future economic stagnation, then why is it not also unfair for the Federal Reserve to cut their interest rates instead of raising them? The world Trump lives in, where interest rates are a primary tool of exchange rate warfare, is a world where there is every action is an act of hostility. If Trump really believes his own tweet, he should expect a barrage of European criticism once he inevitably again tries to persuade Powell to halt his hawkish tone on rates.

It’s not as if Draghi is actually cutting rates right now either; his point is that they remain a tool in case Eurozone growth slows even further, a perfectly rational position to take. Draghi’s speech was somewhat reminiscent of his “whatever it takes” speech in 2012, which is widely credited for saving the euro. If Trump means that even suggesting that interest rates should be used to curb a potential recession (or decrease in growth) is unfair, he means that a central banker looking out for the interests of those he or she governs (as Draghi did in 2012) is unfair as well. In this case, one has to ask: isn’t all this “America First” nonsense that Trump keeps spouting wildly unfair as well?

The fact I’ve read so deeply into what is probably an off-the-cuff tweet from one of the most volatile Presidents in US history is a carry-forward from previous administrations. A tweet (or any sort of official statement from the President) used to be taken seriously by all, and was almost always well crafted and thought out. It speaks volumes about Trump that more and more, his tweets are beginning to look like jokes, and the markets his personal see-saws to tip up and down as he wishes. I suppose Trump being a hypocrite isn’t exactly a groundbreaking observation, but the blatant ignorance that comes with a tweet such as this is something that I felt I had to comment on.

Santander delivers a shock

The additional tier 1 (AT1) market for bonds is a relatively new addition into the world of finance. They are a mix between debt and equity, essentially meaning that when a bank’s capital ratio falls below a certain level, the AT1 bonds are converted to equity, or shares in the bank. They were introduced by regulators during the 2008 financial crisis, where worries about both banks’ solvency and liquidity brought the global financial system to its knees [1]. So far, coverage on them has been limited, given that fortunately we have yet to see another major event of the same proportions as the financial crisis. However, last week we saw a relatively unusual event, that had not been seen since more than a decade ago.

The first thing to note is that these AT1 bonds have perpetual maturity; in essence, there is no “maturity date” for these bonds so a sum needs to be paid each year, in theory, in perpetuity, unless the bank pays the whole amount in advance. However, a convention is in place whereby investors in these bonds acknowledge that they will be repaid at the earliest possible date, usually around 5 years after the bond has been sold [2]. However, last week Santander opted to roll over an AT1 bond, which is highly unusual given what has been happening for the past 10 years [3]. The news spooked investors in Santander as they sent Santander’s share price falling lower on Wednesday morning. While the decision makes sense for Santander for purely economical reasons, it jeopardises the global AT1 market as investors no longer can claim almost absolute certainty that these bonds will be called on their redemption date. The bond in question’s value fell two percent rapidly following the news, falling to 96.75 cents on the euro.

Moreso, the news sparks fear in some investors that banks are hoarding capital for longer durations due to falling liquidity. In addition, given that the assets and liabilities of investment banks, being so complex and interconnected, are very difficult to value (let alone quickly in a financial crisis), it is very difficult to determine if a bank is solvent in the event of a financial crisis. Given that Santander is such a large and systemically important bank in the financial system, concerns surrounding it inevitably turn to concerns regarding the financial system as a whole. Since the market for complex financial instruments may only have a few financial institutions in it to begin with, many of the assets and liabilities of major banks are interconnected. Hence concerns understandably amplify, explaining the decline in Santander’s share price but also explaining broader investor uncertainty, especially since we are a decade off the financial crisis and a recession is expected in major economies in the next few years, with Italy already having fallen into one [4].

Overall, then, this case represents an example of why always going for the most purely economical option may not always be the best thing to do for a firm. In their actions Santander upset global investors and, significantly, the AT1 bond market, as yields rose on AT1 debt with falling investor confidence in banks’ ability to repay. While the financial system in at least developed countries is in theory much safer (with more stringent capital requirements), the ability of financial institutions to create complex and murky assets knows no bounds. Given this, valuation of these is inevitably going to prove difficult and so caution still needs to be taken with regards to how banks finance themselves. The AT1 debt instruments were a noticeable step forward in handling this but it also goes to show how quickly the market for these sorts of instruments can change, even in seemingly calm conditions.

In future, given that it seems Santander has no actual issue with paying off their debt the impact of this news will be muted. However, whatever reaction there has been will prove an additional disincentive for other banks to undergo similar kinds of action, for fear of not only unsettling their own investor base but also unsettling the market for AT1 (or CoCo) debt instruments. The news enhances Santander’s own reputation for ruthless frugality but they may indeed regret the move in future.

Bibliography

[1] Euromoney. (2018). AT1 capital/CoCo bonds: what you should know. [online] Available at: https://www.euromoney.com/article/b12kqjlwvsz26k/at1-capitalcoco-bonds-what-you-should-know [Accessed 15 Feb. 2019].

[2] Ft.com. (2019). Santander shocks market with bond decision | Financial Times. [online] Available at: https://www.ft.com/content/8539f7b4-2ad9-11e9-a5ab-ff8ef2b976c7 [Accessed 15 Feb. 2019].

[3] Bloomberg.com. (2019). Santander’s CoCo Bond Creates All Kinds of Trouble. [online] Available at: https://www.bloomberg.com/opinion/articles/2019-02-13/santander-s-coco-creates-all-kinds-of-trouble [Accessed 15 Feb. 2019].

[4] BBC News. (2019). Italy in recession amid sluggish eurozone. [online] Available at: https://www.bbc.co.uk/news/business-47068401 [Accessed 15 Feb. 2019].

This article, along with others from my peers, is on the LSE Business and Finance Guild website.

On Tesla and the efficient market hypothesis

Featured image is licensed under the Creative Commons Attribution-Share Alike 2.0 Generic license. Author: einstraus

Recently, one of the big stories in the world of finance has been Elon Musk and Tesla. Following a declaration from the Tesla CEO that he was willing to take Tesla private at $420 a share, Tesla’s share price soared and then fell almost as quickly following a lack of substantial evidence that he could, indeed, secure the funding to actually put this plan into action. However, this is not the main focus of the article; my main focus is instead the market reaction to Elon Musk appearing to smoke marijuana during a discussion with popular podcast host Joe Rogan on The Joe Rogan Experience. My argument, in a nutshell, is that such reaction to Musk’s activities in itself disproves the efficient market hypothesis, and moreover that other readily obtainable evidence cements this point of view as correct. Before I start, I’ll explain the efficient market hypothesis as an idea that states market prices readily reflect any publicly available information in the market, so any movement in the price of a security is the result of changing market information regarding a particular security, or securities.

According to this model of market behaviour, when Musk smoked marijuana there should have theoretically been no effect on Tesla’s share price, given that marijuana has been proven to actually be less harmful to the body than alcohol. This is because you would expect less of a negative movement in Tesla’s stock price due to Musk doing this than if he drank alcohol, which he has admitted to doing in the past with no noticeable impact on Tesla’s share price. However, on the day that Musk admitted smoking marijuana Tesla shares fell by as much as 9 percent, with the only other notable news on the day being the resignation of two C-level executives in the company. This very event shows that the effect of investor psychology (i.e. animal spirits) on security prices can indeed be substantial, and a company’s share price is not always solely a reflection of all available information about it. In addition to this, if the efficient markets hypothesis is so correct, how have numerous investors consistently made significant profits by “beating the market”?

For example, the well-known investor Warren Buffett has amassed a fortune of almost $90 billion dollars value investing (essentially believing that in the short term the market underprices certain stocks relative to their fair value, and that substantial profits can be realised by investing in these stocks and waiting for them to return to their fair value in the long run). Over a career spanning over half a century, the probability that all Buffett’s amassed fortune is down to luck or chance is infinitesimally small, meaning that even Warren Buffett’s huge wealth is a strong counterargument to the efficient markets hypothesis. Expounding on this further, according to the efficient markets hypothesis it is impossible for any investor to generate alpha (or market-beating returns) in the long run due to stocks never being underpriced relative to fair value. This is in direct contradiction to the reality of the fund management industry, where many fund managers (such as Kenneth Griffin) can generate consistent alpha through, for example, extensive prior due diligence or another type of edge. If securities were indeed priced so efficiently, the opportunity for these investors to make their millions and billions would not arise in the first place.

Moreso, there are more examples than just Tesla of how security prices rising or falling can be more a result of fear and greed than any sort of fundamental shift. The dotcom bubble is another example of how businesses like Pets.com had their market capitalisations rise (and then fall even quicker) despite any significant change in their balance sheet, suggesting the initial rise was due to irrational exuberance. Again, with efficient markets these same sorts of market bubbles would not exist and the only time stock prices would rise and fall with such ferocity is if something about a company actually changed that quickly (for example if their CEO or CFO left). To conclude then, over the course of this article we’ve taken a look at why, to me, the efficient market hypothesis is flawed using three key examples. The first is recent, explaining that under the efficient market hypothesis the response to the Tesla CEO smoking marijuana in their share price would not be so severe. The second explores the idea that with efficient markets investors such as the famous Buffett would not have been able to amass such large fortunes at all, and the third explains that financial market bubbles as we know them today would not exist in a world of efficient markets. These proofs by contradiction illustrate why, for me, why the efficient market hypothesis is heavily flawed and does not provide an accurate indicator of financial market behaviour.

Why the Dow’s rise isn’t a sign of President Trump’s great policy for me

The featured photo is licensed under the Creative Commons Attribution-Share Alike 2.0 International license, and was taken by Gage Skidmore.

Characteristically, President Trump has recently been all about showing off how well he’s performed in his first year as one of the most powerful people on Earth. While for myself and some others his first year has been unsuccessful (to put it mildly), Trump is dead set on proving us naysayers wrong largely by using the sustained rise in the Dow Jones Industrial Average (an index showing how shares in 30 of the US’ largest companies have traded over periods of time) during his presidency. While at first glance well-performing large companies may seem to indicate that the economy as a whole is performing well (which it is currently), in this article I will make and support two propositions: firstly that the current US economic boom is unsustainable (assuming the Dow is a good measure of current economic performance), and secondly that the Dow, either way, isn’t a very good reflection of how the economy is doing.

Looking more in depth at our first strand of argument, while business spending increases have allowed the US economy greater than 3% economic growth over the past two quarters, the Trumpian tax cuts for corporations and the wealthy run the risk of actually increasing the American budget deficit (exactly the opposite of what many Republican deficit hawks campaigned for). Politically, this becomes very difficult for the Republicans to justify, but more than that, the fact that that according to the Tax Policy Centre Trump’s plan actually would hurt the lower 50% of income earners represents a decrease in future consumption and thus a decrease in US short run (and long run if firms then stop investing) economic growth arising from this set of policies. Essentially, then, the point I’m trying to make here is that hurting the little guy may boost growth in the short term, but in the long term when real after-tax incomes and consumption fall, the economy might not be doing so great. This is because the rich consume less than the poor for an equal addition to income, so even though the rich get richer, it might not actually boost consumption and growth all that much. So Trump can be happy with the buoyant Dow and economy for now, but he should know it may not last long.

Taking the issue from another perspective weakens Trump’s Dow-focused point further. If we look at who the Dow Jones’ rise actually helps, we see that it serves to increase income inequality further. A NYU report in 2013 showed that the richest 20% of Americans owned 92% of stocks, indicating that the benefits from the Dow’s rise are not equally distributed. Even if we look at the Dow’s rise in isolation as a sign that the economy is doing well, we still see numerous faults with the theory. By seeing what the Dow actually is, and how it may have been affected by recent news, we can see that it may have been buoyed by Trump’s plans to cut business taxes and not actually an improving economy. Within this plan, Trump has also presented changes to the individual tax code that disproportionately benefit the wealthy, but although the American middle and lower economic classes may not actually benefit from his plans, the Dow is rising. This one example shows the divorce that may exist between the performance of large companies and the economy in general; income inequality worsens the economy through decreasing growth, but tax cuts boost large corporations’ after-tax profits. Hence, through this example we can see that the Dow Jones may not be able to accurately gauge US economic performance, putting another dent in the logic behind some of Trump’s recent tweets.

To summarise and conclude, I have established in this piece why I think that President Trump using the Dow Jones Industrial Average to cement his claim to doing well in his new job is flawed. This is both for reasons relating to economic unsustainability, and also because the Dow doesn’t actually tell us how the economy performs all that well. On another, slightly related note, this sort of issue is why I think that the backlash against experts these days is so unhelpful. The things I’m saying here would be much more credible if an actual expert was saying it, but without experts there are no credible voices to inform people that their President may not actually be doing the wonders for the economy that they think he is. I sincerely hope that in the future we can arrive in a world where experts are given the respect they deserve, and are able to call out any figure for saying something potentially wrong without being disregarded because they can’t predict a world that is fundamentally unpredictable. Without it, well, we’ll have lost one crucial, perhaps vital, check on people in positions of great power.

Why, for me, the euro has and will continue to fail

Photo Credits: Ottmar Hörl License: CC BY-SA 3.0

Whatever your views on the euro, it’s clear to see that it isn’t in the best of places right now.

Really, it’s a culmination of a number of things that have led to its current malaise, starting from when the concept was first introduced, all the way back in 1993. Six long years and stern British and Danish opposition followed, but on New Year’s Day in 1999, the single currency went from a theoretical concept to a practical reality. It was even used by every country in the then EU apart from the UK and Denmark, who still now have a fixed exchange rate with it. Under the control of the Frankfurt-based European Central Bank, the euro has grown to become the world’s second largest reserve currency, and ECB decisions affect directly 340 million people across the globe. Given all this, the fortunes of the euro take on that much greater global significance worldwide, which is why it’s crucial that it finds its way out of the doldrums or ceases to exist altogether. Draghi and his team have tried to find a way to accomplish the former, however their measures haven’t gone nearly far enough to soothe the economic pain of oh so many. For me, this is because the euro in its current state is fundamentally unworkable; it cannot exist without imposing massive economic damage to a large proportion of its users. Here’s why.

Firstly, what the euro is trying to do is apply uniform monetary policy to a number of different states with different economies and different concerns that need to be assuaged. What this, of course, means, is that some policies will definitely not fit the needs of what some countries desire. As the former Bank of England governor Mervyn King claimed in his first book The End of Alchemy, the discontent caused by some nations having to bail out others (such as Greece recently) for what could be plain fiscal irresponsibility “may become too great to remain consistent with political stability”. I would argue strongly for this, extending on King’s point that this monetary union creates conflict between a “centralised elite” on one side and the “forces of democracy” on the other. Furthermore, I am of the belief that to stop King’s suggested wave of discontent, the only long-term sustainable option available to European policymakers is to bring together these countries in a fiscal union, and thus let the centralised elite coordinate the synergy of fiscal and monetary policy to what they believe to be the best interests of all parties involved. Obviously, there exists a problem with this: the backlash of the masses against what they perceive to be a moneyed elite. We’ve seen this with the famous Brexit and Trump’s election, so even this option presents substantial political risk that could, in my opinion, bring down this monetary union altogether. As we’ve seen here, there really isn’t a path which the EU can go down with this that doesn’t lead to some sort of political backlash or economic hardship: both of which could prove treacherous for the European establishment.

This point also becomes important when you have exogenous shocks affecting economies that cannot use their monetary policy tools to combat them. For example, the European Central Bank has set an interest rate of -0.40% on reserves, which in theory, should stimulate investment and economic growth within member economies. Setting aside the fact that the interest rate channel has proved relatively ineffectual in Europe till date, if it does indeed stimulate growth in a Eurozone economy, what happens if this economy overheats? The natural response would be to encourage saving by raising interest rates, however who now has the power to do this? That’s right: the European Central Bank. This also happens to be an institution who has to take into account the needs of the other tens of countries that happen to be at its monetary mercy, and when you have such an arrangement, be sure that the ECB’s decisions won’t always be what you need. This just makes a potentially negative situation that affects Europe worse, not just for the directly affected country, but for the Europe as a whole. This is because worsening economic conditions within a country could reduce consumer spending and aggregate demand for goods and services within that country and hence worsen export markets for other European countries. The excessive interconnectedness shown here acts as an amplifier that could shave down both European growth and that of the wider world.

However, it’s still possible that through some economic masterstroke, European policies largely benefit a majority of EU states. That’s one route of salvation for the EU, right? Unfortunately, as so occurs when one contrasts theory with reality, it doesn’t seem like this is anywhere close to a reality. Independent research has time and again proven that European austerity breaks the backs of Eurozone countries and further dampens private spending and investment. It seems that senior European policymakers do not see eye-to-eye with many academic experts (such as the famous Stiglitz) on the issue, and hence European growth continues to stagnate. While this is due in part to demographic decline, the lack of jobs in these advanced economies have led to youth unemployment being more than 50% in countries like Spain. When you combine European incompetence with the fundamental unworkability of uniform mass monetary policy, what you get is a concoction that proves so toxic for European economies.

That’s why, for me, the euro can’t work.

 

Price discrimination: the bane of consumers everywhere

Photo by James Petts. This file is licensed under the Creative Commons Attribution-Share Alike 2.0 Generic license.

If you’ve been to two different branches of the same retailer, one in the heart of London and one in a less central area, chances are you’ve been a victim of price discrimination. The “discrimination” part of this phrase is probably ringing a few alarm bells with you already, but in the end, price discrimination is just another (relatively harmless) way of firms’ seeking to maximise profits, as basic economic theory states that they do. But what is price discrimination? Essentially, what this is is when firms charge different prices to different buyers for the same good or service. This manifests itself in many forms in our daily lives, from our taking advantage of age discounts to the annoyance we feel when paying large amounts for coffee in Leicester Square. Whilst often denounced by many as simply a discrete form of consumer exploitation, I see it as an ingenious tactic employed by firms to yet again slip under the watchful eye of the average buyer; however, the reason you don’t see price discrimination employed in the real world as often as you thought it might have been is because there are a certain set of criteria that need to be fulfilled in order for price discrimination to take place, the first of which relates to price elasticity of demand.

Intuitively, one of the only reasons that price discrimination works in the first place is because different groups of people will think differently about changing their quantity demanded in response to the change in price of a good or service. Hence, a prerequisite for price discrimination to be viable is that the price elasticity of demand (the responsiveness of demand after a change in a product’s own price) by different consumer groups is different. If the price elasticity of demand for a product were to be similar for two different consumer groups, they would both, ceteris paribus, reduce their quantity demanded by around the same amount for an equivalent increase in price, therefore rendering this pricing strategy ineffective. The firm will also need substantial information about consumer preferences to be able to confidently change the prices for the same good for different consumers, which may prove difficult for a number of firms that are strapped for cash and cannot easily carry out the essential market research. The firm must also not be operating within a perfectly competitive market (otherwise any attempt at price discrimination would simply result in the firm’s getting priced out of the market), and with this, there cannot be a great deal of market seepage (whereby consumers buy the good/service where there is a high price elasticity of demand and sell where demand is comparatively inelastic).

As with many business strategies, price discrimination can take many different forms, with their severity denoted by the “degree” suffix, with first being most severe, and third being the least severe. First degree discrimination is when a particular firm produces products for the same marginal cost, but then sells each product at a different price, depending on the consumer. For example, if I were to want to buy a packet of crisps at a Tesco in Harrow, I’d find that the price of a packet would be quite comparatively cheap. Why? Because I’m surrounded by other retailers that could potentially take my money as opposed to Tesco, and more importantly, I, like many others buying a packet of crisps in Harrow, am likely not in any sort of hurry to buy one. If I’m in bustling central London, however, and am running late to meet my friends, then I’d want to buy a packet of crisps as quickly as I possibly can. Here’s where firms can exploit you. Because you’re less willing to look for alternatives in central London than Harrow, firms can charge you a higher price here, due to the price elasticity of demand for this consumer group being lower than it would be in Harrow. This reduces consumer surplus for the consumers in central London, while giving firms higher revenues. Clever, isn’t it?

Let’s now move on to second-degree price discrimination. Basically, this is when the average cost per item decreases when you buy the items in bulk. This can be used by companies who are not able to pick apart consumer groups as well as the ones carrying out first-degree price discrimination, for example. When companies want to shift excess supply due to changing consumer preferences, for example, they could potentially use this form of price discrimination as although profit margins will be hit, they get the double benefit of at least making some profit on the items and also shifting the excess stock that they needed to shift. This is quite frequently also employed in major retailers such as Tesco and Asda and also at restaurants such as McDonalds and Burger King in order to shift stock of items that just aren’t selling very well any more. Second-degree price discrimination is not exclusively limited to these scenarios, however, and could be used in a wide variety of other contexts, although it has to be said that this form of discrimination is probably quite ineffective in general when compared with the former.

Finally, we move on to third degree price discrimination, which is perhaps the most widely employed in everyday life. Unlike the previous version of price discrimination, this relies heavily on differentiation between different consumer groups. Normally, what happens is that a firm (for example a company offering trips to the cinema) splits ticket prices (broadly) into adults, seniors and children, due to the latter two having a higher price elasticity of demand than adults, for whom the cost of a cinema fare is a comparatively small proportion of their income. The firm attempt this only if if they feel that P1Q1 + P2Q2 + P3Q3 > P0Q0, where P1 and Q1 are the price and quantity demanded for adult tickets respectively, P2 and Q2 are the price and quantity demanded for senior tickets respectively, P3 and Q3 are the price and quantity demanded for child tickets respectively, and P0 and Q0 are the price and quantity demanded had there been a uniform ticket price for all ages of people. Given that first-degree price discrimination occurs quite rarely, and second degree price discrimination is comparatively ineffective, this form of price discrimination is the most lucrative for a potential firm to engage in.

So now we come to the question: is price discrimination ethical? Well, it depends. The profit motive is always going to encourage firms to try to maximise their revenues while minimising their potential costs, and this obviously means that some consumers will lose out; however, the fact remains that price discrimination strategies are employed by firms only because they work, plain and simple; they generate more profit than they would have done without these price discrimination strategies, meaning that the targeted consumers are, by and large, still willing to buy goods for which the strategies are employed, even if they don’t know exactly what firms are doing behind the scenes. Simply, this is just another development in the cat-and-mouse game that is firms’ trying to maximise profits and consumers trying to maximise potential utility, and the fact that firms are finding this worthwhile to do shows that we as a society don’t really have an objection to this happening, even when it’s happening right in front of our eyes (as shown in the third degree price discrimination example above). As firms continue to become more and more savvy to make profits, it’s down to consumers to ensure they’re not being continually one-upped by price discrimination.

So consumers, the ball is in your court.

Could globalisation bring developing countries and their financial systems to their knees?

PHOTO CREDITS: Dieu-Donné GameliPhoto licensed under the Creative Commons Attribution-Share Alike 3.0 Unported license.

If one was to rank recent economic issues by the division and depth of debate they cause, globalisation would surely be up there at the top. Whilst the Republican presidential nominee Donald Trump, amongst others, has spearheaded efforts to thwart the rise of globalisation, liberals around the world argue that the increasing interconnectedness and interdependence of our world today can only be a good thing. However, the actual answer to the question of the impacts of globalisation is not so clear-cut; if any answer exists at all, it would lie firmly in the grey area. But what is globalisation? In essence, globalisation is the process by which economies around the world become more closely and deeply integrated with one another. In a way, it can be thought of as a border-killer, bringing countries that are physically thousands of miles apart firmly together,. Is this desirable, though? A point frequently made is that the effects of the 2008 financial crisis in developing markets were magnified to a great degree by the increased integration between the financial systems of different countries, and without this, the effects would have been far more localised to developed markets. Is this true? Perhaps, although it has to be said that those who use this point as a catch-all of sorts are perhaps not thinking broadly enough. In this article, we can begin by analysing the effect globalisation has on the financial system of developing economies in the context of regulation.

One way in which globalisation has impacted the global economy is an increase in the velocity of international capital flows. While this can entail an increase in money put in to financial markets in developing countries, what it can also do is facilitate an increase in capital flows out of these developing markets, resulting in an increase in uncertainty and volatility in their financial markets. A direct impact of this is that a shock in one country that, at first glance, wouldn’t affect the developing market too much, could result in irrational behaviour and herd mentality driving money out of developing capital markets in bucketloads. The control that these countries so desperately need over their own destiny, is as a result forfeited to a degree due to globalised economic activity; a small shock in the United States could result in large percentage swings in some African markets, for example. This drives away the certainty needed for a long-term sustainable financial system to develop; in this way, it could be argued that the increase in the velocity of cross-country cash flows could actually serve to the detriment of developing economies.

However, a positive impact of the aforementioned variability in foreign direct investment (FDI) is also that the pressure of foreign buyers acts as an economic incentive for the governments of developing countries to solidify their financial system in order to attract and keep foreign capital. The threat of financial contagion should a global shock take place would, in theory, incentivise key individuals within developing countries to make sure that their underlying fundamentals are solid enough to withstand a global depression without too much long-term damage. If key markets are solidified soon enough, a virtuous cycle of investment and further growth could potentially be triggered, blurring the lines between these developing countries and their developed counterparts. Whilst the element of uncertainty and doubt will still be present, if the country is foresighted enough to secure their future prospects, the risk from this should be offset by the potential influx of foreign direct investment that could occur. Even if it does not work out, the meritocratic aspect of this scenario is still something to be commended and looked upon as a positive; countries will gain foreign direct investment if they see it as a rational economic decision to strengthen their financial system.

With the increase in available capital for corporations operating within developing countries to use, it is also important for regulation to be put in place such that the prevalence of moral hazard with regards to the risk/reward ratios of banks reduces. In a developing country, with arguably less financial infrastructure present than a developed one, it is somewhat easier to sign legislation that ensures that banks cannot operate in an unreasonably risky manner. As shown by the political lobbying of banks in the UK, USA and elsewhere, once a massive financial system has been built up, it is extremely hard to get major financial institutions to change their ways. Hence, if government puts its foot down quickly enough, it is possible that the developing countries of today could potentially have less of a glasshouse of a financial system than even the developed countries of today possess. The question of this article initially was “Could globalisation bring developing countries to their knees?”, and the answer to that is a resounding yes. Replace the “could” with a “will”, and you have an answer which depends on a multitude of factors, including primarily the quality of the country’s governance. If government manages itself correctly, globalisation could bring about rapid economic development and the bolstering of financial systems across the developing world. If not? Well then, we’ve all got ample reason to worry.

 

Shinzo Abe’s “Abenomics” has failed. But why?

Who would have thought that it would be in the Land of the Rising Sun that three arrows could miss their target so wildly?

Of course, I’m talking about the Prime Minister of Japan, Shinzo Abe’s, three arrows of fiscal stimulus, monetary easing and structural reform that were intended to claw Japan out of a dangerous cycle of recession and deflation. At the time, it seemed like the perfect policy, with fiscal stimulus intended to increase demand for goods and services and monetary easing by the Bank of Japan intended to generate the 2% inflation that Japan has so longed for, increasing aggregate demand and therefore triggering a virtuous cycle of economic growth. In addition to this, the structural reform intended to increase the competitiveness of Japanese industry with regards to the world as a whole should have ideally bolstered and healed Japanese companies’ future prospects, after years of sluggishness. Yet as so often turns out, while Abe’s plans seemed to be worth their weight in gold on paper, they have failed to revitalise Japan and return it to the supreme economic status which it once had. Amongst a whole host of other indicators, Japan’s inflation rate fell to -0.4% in July 2016, lowering the proverbial coffin into the ground of another seemingly great set of economic policies. But why has it failed when it looked so good on paper? How has Abe fallen flat yet again? Could external factors be preventing the three arrows from working their magic?

Well, when you take into account Japan’s rapidly changing demographic, the answer to the latter question would be resoundingly in the affirmative. Since 2010, Japan’s population growth has been negative and birth rates have steadily declined while life expectancy continues to rise. On the health side of things, this is a massive breakthrough for the country, but economically, what it means is that Japan now is faced with the problem of a gradually dwindling labour force. Hence, although Abe is injecting billions upon billions of fiscal stimulus into the economy, the decline in labour force has resulted in a decrease in consumer demand in spite of his policies, due to less people having the money in their pockets to actually spend in the first place. In this regard, what Abe could further focus on is spearhead a further push for immigration to bolster aggregate demand and consumer spending, in turn boosting growth before the arduous and potentially unfruitful wait for Japanese societal norms regarding children to change (he has made great strides towards this with his Abenomics 2.0 programme). Perhaps in the case of Japan, this policy would be far more beneficial to her than any fiscal package that Abe could come up with; it would certainly at least be worth a try.

One side effect of recent Japanese economic policy (in particular the monetary policy of setting negative interest rates) has also been a devaluation of the Japanese yen, allowing Japanese firms to become complacent in the face of high profits. Due to the weak yen increasing Japanese firms’ revenues from abroad, the result is a lack of incentives for these firms to innovate and increase productivity. Due to this, the economy’s productive capacity has stagnated, hindering its potential for long run economic growth. Recent reports indicate that distinguished figures such as former chairman of the Federal Reserve, Ben Bernanke, declaring that “monetary policy is reaching its limits” in many developed countries. Due to this, it is feasible that the cut in interest rates to negative levels, while effective on paper, has not worked so well in reality because it disincentives innovation within Japan, and without innovation, it is extremely difficult for a capitalist framework to thrive and prosper. Therefore, perhaps an appreciation of the yen against the dollar would not be as disastrous as many pundits claim, and instead, may indeed provide a route by which Japanese firms can finally move forward.

Social attitudes in Japan currently are also not exactly conducive to economic progress. Due to many of the current Japanese young generation having known nothing but economic stagnation, deflation (or very low inflation), and failed government policy, these young people, traditionally some of the big spenders in a modern economy, have failed to provide the Japanese machine with a much needed boost. It has gotten so bad that one individual said to the Financial Times that she feels as if she is “more conservative than [her] grandmother.”, such is the backwards direction which Japan has gone in with regards to spending. The solution to this is much less science than it is alchemy, and the only way which Japan can really try and fix this problem is a bottom-up approach to incentivise spending amongst young people. In my opinion, this could be achieved by portraying spending on goods and services as some sort of natural duty, invoking patriotic sentiment and therefore triggering spending to lurch from its slumber. However, Japan’s problems are both deep and wide ranging, and will take years, or perhaps even decades of consistently successful government policy to solve. While Abenomics is well-intentioned, it simply has and will not work in practice, and perhaps what Abe and his fellow policymakers need to do is to think a little bit outside of the box.

How will Obama be remembered?

This image is licensed under the Creative Commons Attribution 2.0 Generic license – The photographer is Will White.

On January 20, 2009, the United States of America finally turned its back on George Bush and appointed Barack Hussein Obama as their 44th President. At the time, it was looked at as a landmark occasion; the first African-American President in the history of the most powerful country in the world. Many now say that this victory for equality has been overshadowed by backwards, regressive policy that has gone against the very agenda of progressivism that Obama stood for election for. However, others instead espouse the idea that Obama has laid the proverbial stepping stones for future progressives to unite America through economic policy. Regardless of whichever side you take, it’s undoubtable that the Obama administration has divided opinion like almost no other in contemporary politics and economics. Obama’s tax cuts for the wealthiest in society are something which have been campaigned for by many in the past, but some on the left side of the spectrum still regard him as far too business-friendly to be in any way compatible with the vision of equality for all Americans. In this regard, many of his policies have not necessarily been the most popular, yet it is still important to take into account the economic climate which the 55-year-old inherited from his Republican predecessor; the images of widespread depression and angst certainly add context to the debate, context that is needed when analysing any presidency from an economic perspective.

Today, in a global economic environment of stagnation and extraordinarily low interest rates, many are justified in claiming that we have never really escaped the proverbial wreckage of the Great Depression. Yet more economists than not claim that Obama’s Keynesian fiscal stimulus package to the tune of $787 billion, largely in the form of tax cuts to families, was instrumental in making sure that America did not stuck in a period of prolonged economic stagnation, amidst an environment of lesser trust in the prospects of the economy, and therefore less investment. According to James Feyrer and Bruce Sacerdote of Dartmouth College, the multiplier effect (the increase in final income arising from any new injection of spending) was between 1.96 to 2.31 for low-income spending, 1.85 for infrastructure spending, and finally in the range of 0.47 to 1.06 for stimulus as a whole. While this was not the only study carried out on Obama’s fiscal stimulus package, the methodology of the survey the two economists used is significant because they not only compared employment growth at state and county level, but they also compared month-by-month data to see how employment figures were changed at the point when the stimulus was injected into the economy. The significant upward trend generated by the stimulus here is thereby significant as it supports heavily the claim that the package was needed in order to usher America out of the stagnation that it previously endured; so Obama doesn’t seem to have done too badly so far.

The Dodd-Frank Financial Reform Bill also was a significant piece of legislation that Obama signed during his presidency. Described by the Washington Post as “the most ambitious overhaul of financial regulation in generations”, there’s no denying that the Bill has had and will continue to have significant effects on the way financial firms think about their operations going forward. However, it does not ameliorate the problem of the massive moral hazard which banks are allowed to possess when analysing whether to cut down on their portfolio risk or not. In the former Governor of the Bank of England, Mervyn King’s book “The End of Alchemy: Banking, the Global Economy and the Future of Money”, King argues that this is precisely what could lead to another catastrophic recession, and argues instead for a “pawnbroker for all situations” solution, one in which banks have to take significant measures before having any chance of being bailed out. Whilst I would suggest that one reads King’s book for more insight into this claim, the fundamental underlying principle is that banks will take risks if you allow them to, putting taxpayers at risk of having to bail them out once again, and for this reason, I argue that the legislation Obama approved has not gone anywhere near far enough.

And now we come to perhaps the most contentious issue of all: Obamacare. Although the program still has its glaring faults and areas where it should really be improved in order to improve the accessibility of healthcare for every American, it has to be said that the healthcare program has had overwhelmingly positive effect. For example, businesses with over 50 employees are required to have a health insurance program, with tax credits for these businesses also being put in place to help them finance this program. In my opinion, this strikes a near-perfect balance between stamping the need for increased healthcare coverage for the most vulnerable members of society and easing financial constraints on business, allowing these firms to flourish and expand their operations. If I had to summarise Obama’s economic policy in a few words, I’d use the phrase “getting there”. Whilst the African-American has made key policy moves that have steered America in the right direction, there are still large gaps that need to be filled and policy moves that need to be implemented to progress America’s economy further. He hasn’t done it all, but he’s definitely laid the foundations.

Shrey Srivastava, 16