Macroeconomics Blog

Conducting theoretical and empirical work across macroeconomics and finance

A tale of steel and deficit

📥  Uncategorized

Economics is once more dominating the news, which oft times means that the news is not good. Today there are four stories which caught the attention. These are the problems of the steel industry, the tax havens story, the UK's record current account deficit and the onset of a new minimum wage. The tax havens story is a sad reflection of the age we live in, of how those with already very substantial wealth are reluctant to pay for the public services economies around the world depend upon. It has reflections in the tax avoidance schemes often followed by many multinationals. But in this blog, we focus  not on that, nor the minimum wage but the steel industry and the current account deficit.

I heard on the radio the beginnings of a discussion along the lines - what is so special about steel jobs, if jobs in the service sector can replace them. The answer is simple, many, but not all, service jobs do not help with the trade balance. If we stop producing steel in this country, then we will import more steel and export none. This will not help the current account deficit, indeed it will make it worse. A country, like an individual, has to pay its way in the world. If not then the country moves into economic decline.

Now I am not saying here that we should save the steel industry, although to my mind it would be regrettable if the country which gave birth to the industrial revolution were no longer to make steel. But I am saying that we need a vibrant manufacturing industry as one of the pillars on which a thriving export sector can flourish. We also, of course, need firms in the service sector which do the same. But it would be, I think a mistake to rely on services alone. Hence the need as a country to reverse the long steady decline in manufacturing.  Key to this is not just investment in infrastructure and people, but innovation. Developing new products and services the world wants to buy.

 

 

A Tale of Two Taxes

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Mike Peacey, Department of Economics, University of Bath.

It was the best of times. The UK economy was booming and mortgages could be taken out with a LTV of 125%. It was the worst of times. The house price bubble had burst and inaugurated the worst financial crisis since 1929.

Fast forward five years and astonishingly the best of times seem to be coming back. Asset price inflation in the housing market is once again hitting the headlines. It’s no surprise that people want to get on the housing ladder after seeing how well their parents have done. The expectation that house prices will rise faster than other assets has been vindicated by decades of experience.

Many people hoped that the experience of the financial crisis might change these expectations, but recent events suggest this is wrong. Asset price bubbles present policy makers with politically difficult choices - particularly in the conduct of monetary policy.

Notoriously, the advantageous tax treatment of housing contributes to these problems. Today the most important advantage homeowners enjoy is private residence relief (PRR). In contrast to other assets, where capital gains are taxed, PPR exempts the payment of capital gains tax (CGT) on our homes.

This gives homeowners an unfair advantage over those with most other assets, and encourages asset price inflation – as one is willing to spend more on assets with such tax relief. Written by a youngster this blog post might just seem like a selfish way to buy a cheap house. The experienced forty-something shakes her head explaining “although I made £50k when I sold my flat, I needed this money to move up the ladder.” Removing the PRR exemption would mean less money to put towards her next property - but her next property would most likely be cheaper!

The losers from the elimination of CGT exemption will be “Last-time sellers” (LTS) - In practice the baby boomers. For future generations, the tax payments they make when they sell will be offset by lower house prices when they buy. The result is the necessary wealth transfer from the current baby boomers to the increasingly indebted youth. Moreover, the introduction of what would amount to a kind of Tobin tax should ensure the problem is never repeated.

The conventional wisdom is that the exemption of homes from the current system of CGT is politically impossible to reverse. However, the elimination of MIRAS (Mortgage Interest Reduction at Source), and the recent tightening of the rules in the coalition’s autumn statement (i.e. on 2nd homes and foreign owners), demonstrate that tax reform in the field of housing is possible.

Housing is not entirely exempt from taxation. Stamp Duty Land Tax (SDLT) is the transaction tax which is payable on the purchase of property. The infamous feature of SDLT is that the marginal tax rate will exceed 100% every time the price crosses one of the thresholds, because a single tax rate applies to the whole transaction. If CGT on housing is unacceptable to public opinion, SDLT is equally unpopular with economists (e.g. here, here, here, here, etc!). If it is accepted that an explicit extension of CGT to housing is politically impossible, perhaps SDLT could be reformed to incorporate an element of capital gains taxation whilst removing the distortions so disliked by economists.

This reform I am proposing would incorporate two elements, which together imply that the notorious ‘cliff edge’ would be removed.

The first change is that the tax would be paid by sellers rather than buyers. As every first year student knows this change should make no difference - since who pays the tax will depend of the relative willingness of buyers and sellers. However, it is not widely understood that, when buyer and seller bargain over the house price, the presence of a cliff edge tax means that this result does not hold. These cliff edges have been shown to suppress prices, so badly chosen alterations could increase house prices.

The second change is that the tax paid would be paid at a constant rate, which would depend on the seller’s capital gain. The cliff edge property would be removed (since any increase in the sale price would have a constant effect) and the rate at which these capital gains would be taxed could be very different from other assets.

In contrast to the current system the tax is only paid by the lucky winners, with those experiencing the largest gains paying the most. The proposal that the new tax should be paid by the seller has one further advantage. It will be much harder for the seller to “pass on the tax” by charging a higher price, than with a more conventional sales tax. This is because similar houses must sell for the same price – but the capital gain will be unique to the seller.

Finally, the principal should be established from the beginning that the treasury can change the rate in response to house price inflation.

 

Can we Trust the Banks again?

📥  Uncategorized

Chris Martin, University of Bath

In his 2010 book “Whoops! Why Everyone Owes Everyone and No One Can Pay”, John Lanchester compares the balance sheets of Apple and the Royal Bank of Scotland (RBS) on the eve of the 2008 Financial Crisis. RBS had assets of £1.9 trillion. This was significantly more than UK GDP. But it had capital of only £91 billion. Bankruptcy occurs if the difference between liabilities and assets exceeds the value of capital. The value of RBS’ assets, including substantial amounts of derivatives and corporate loans, both heavily linked to housing markets, were risky. But its’ liabilities, mainly short-term borrowing and customer deposits, were not. A fall in the value of assets of only 5% would bankrupt the Bank. By contrast, Apple had $19bn of liabilities against $21bn capital: there was no risk of Apple failing. This comparison highlights the risks the banking sector was taking before the financial crisis. RBS was not unusual. It had a gearing ratio (liabilities as a proportion of capital) of around 20; many banks had ratios in the 40s and even 50s.

In retrospect, the Financial Crisis looks like a disaster waiting to happen. Six years on, the economy is finally beginning to recover; national income is getting back to its 2007 value, real wages may be about to start rising, increased interest rates are approaching and there seems to be a cautious increase in optimism. Sustained growth requires a robust and responsive financial system. After the trauma of the last few years, can the banks deliver this?

Some things have changed since 2008. The average gearing ratio of UK banks has halved, to 20 (but this was the pre-crisis ratio at RBS). Markets in the obscure financial assets that were at the heart pf the crisis (collateralised debt obligations, asset backed securities and other exotic financial instruments) are subdued, only about half their pre-crisis size. But some things have not changed. The financial crisis highlighted the dangers of systemic failure, where the failure of one part of the financial system risks bringing everything down. “Too big to fail” is still a problem; in fact the wave of bank failure in 2007-8 has made the banking sector less competitive. Regulators are certainly more vigilant, more intrusive and better armed than before. But the new system of regulation and control has yet to prove itself. And some suspect that the powerful banking lobby (the financial system accounts for over 10% of total UK tax revenue) may succeed in further reducing the impact of regulation.

Is there a danger of “banker bashing”? Inevitably, yes; populist attacks focussing on the stellar rewards earned by some in the financial system, strike a chord with many. Amid this heated debate, there is not much discussion of what might be the most important question: what type of banking system would be best for the UK? From that perspective, the fundamental role of the banking system is to channel savings into the most desirable uses. The banking system should be structured so this is done efficiently. There are two main issues. First, how much risk should banks take? Lending is risky (the demand on banks, post-2008, that they both reduce risk and increase lending is paradoxical). Banks are skilled in risk management, but do not consider the wider social consequences of failure. Given that the costs of the financial crisis are estimated to be in excess of £7 tr in the UK ($22 tr in the US), the socially optimal upper-bound to risk-taking may be much lower than anything the banking system would tolerate (and this only considers monetary costs; the social and psychological costs are hard to measure but may be enormous). Second, what type of risks should banks take? Economic prosperity requires a banking system that provides the credit on which modern economies depend. In the years before 2008, banks shifted away from this core purpose, focussing more of their activities within the financial sector itself, using increased borrowing from other banks in order to purchase massive portfolios of the exotic financial assets which were the immediate cause of the crisis. 

The banking system is a central part of our economic infrastructure. It should be organised and regulated to benefit the wider economy rather than the more narrow interests of the banks themselves. Continuing with the current structure, with a small number of mega banks, too big to fail and too large to control, may not be the best way forward.



In his 2010 book “Whoops! Why Everyone Owes Everyone and No One Can Pay”, John Lanchester compares the balance sheets of Apple and the Royal Bank of Scotland (RBS) on the eve of the 2008 Financial Crisis. RBS had assets of £1.9 trillion. This was significantly more than UK GDP. But it had capital of only £91 billion. Bankruptcy occurs if the difference between liabilities and assets exceeds the value of capital. The value of RBS’ assets, including substantial amounts of derivatives and corporate loans, both heavily linked to housing markets, were risky. But its’ liabilities, mainly short-term borrowing and customer deposits, were not. A fall in the value of assets of only 5% would bankrupt the Bank. By contrast, Apple had $19bn of liabilities against $21bn capital: there was no risk of Apple failing. This comparison highlights the risks the banking sector was taking before the financial crisis. RBS was not unusual. It had a gearing ratio (liabilities as a proportion of capital) of around 20; many banks had ratios in the 40s and even 50s.

In retrospect, the Financial Crisis looks like a disaster waiting to happen. Six years on, the economy is finally beginning to recover; national income is getting back to its 2007 value, real wages may be about to start rising, increased interest rates are approaching and there seems to be a cautious increase in optimism. Sustained growth requires a robust and responsive financial system. After the trauma of the last few years, can the banks deliver this?

Some things have changed since 2008. The average gearing ratio of UK banks has halved, to 20 (but this was the pre-crisis ratio at RBS). Markets in the obscure financial assets that were at the heart pf the crisis (collateralised debt obligations, asset backed securities and other exotic financial instruments) are subdued, only about half their pre-crisis size. But some things have not changed. The financial crisis highlighted the dangers of systemic failure, where the failure of one part of the financial system risks bringing everything down. “Too big to fail” is still a problem; in fact the wave of bank failure in 2007-8 has made the banking sector less competitive. Regulators are certainly more vigilant, more intrusive and better armed than before. But the new system of regulation and control has yet to prove itself. And some suspect that the powerful banking lobby (the financial system accounts for over 10% of total UK tax revenue) may succeed in further reducing the impact of regulation.

Is there a danger of “banker bashing”? Inevitably, yes; populist attacks focussing on the stellar rewards earned by some in the financial system, strike a chord with many. Amid this heated debate, there is not much discussion of what might be the most important question: what type of banking system would be best for the UK? From that perspective, the fundamental role of the banking system is to channel savings into the most desirable uses. The banking system should be structured so this is done efficiently. There are two main issues. First, how much risk should banks take? Lending is risky (the demand on banks, post-2008, that they both reduce risk and increase lending is paradoxical). Banks are skilled in risk management, but do not consider the wider social consequences of failure. Given that the costs of the financial crisis are estimated to be in excess of £7 tr in the UK ($22 tr in the US), the socially optimal upper-bound to risk-taking may be much lower than anything the banking system would tolerate (and this only considers monetary costs; the social and psychological costs are hard to measure but may be enormous). Second, what type of risks should banks take? Economic prosperity requires a banking system that provides the credit on which modern economies depend. In the years before 2008, banks shifted away from this core purpose, focussing more of their activities within the financial sector itself, using increased borrowing from other banks in order to purchase massive portfolios of the exotic financial assets which were the immediate cause of the crisis.

The banking system is a central part of our economic infrastructure. It should be organised and regulated to benefit the wider economy rather than the more narrow interests of the banks themselves. Continuing with the current structure, with a small number of mega banks, too big to fail and too large to control, may not be the best way forward.