A Level Economics 92: UK's Financial Sector

Changes in the Structure of the UK Economy:

In recent years, the UK economy has undergone significant changes in its structure. One notable trend is the growing size and influence of the financial sector. The financial sector includes banks, insurance companies, investment firms, and other financial institutions. Some key factors contributing to the growth of the financial sector in the UK include:

1. Global Financial Hub: London, the UK's capital, has established itself as a global financial hub, attracting financial institutions and professionals from around the world. The presence of a well-developed financial infrastructure, including stock exchanges, financial services firms, and regulatory institutions, has further strengthened the UK's financial sector.

2. Financial Services Exports: The UK's financial sector is a significant contributor to the country's export revenue. Financial services, such as banking, insurance, and asset management, are exported to other countries, generating substantial income for the UK economy.

3. Technological Advancements: Technological advancements have facilitated the growth of financial services, such as online banking, digital payments, and fintech innovations, contributing to the expansion of the financial sector.

4. Deregulation and Globalization: Deregulation and increased globalization have allowed financial institutions to operate more freely across borders, expanding their reach and influence.

Asset Bubbles and Economic Consequences: Asset bubbles occur when the prices of certain assets, such as real estate, stocks, or commodities, rise to unsustainable levels, driven by excessive speculation and investor optimism. When the bubble eventually bursts, asset prices collapse, leading to severe economic consequences. Examples of asset bubbles include the dot-com bubble in the late 1990s and the housing bubble that preceded the 2007-2008 financial crisis.

Causes of Asset Bubbles:

1. Easy Credit: Loose monetary policies and low-interest rates can encourage borrowing and speculative investments, driving up asset prices.

2. Speculative Behavior: Investors' expectations of ever-increasing prices can lead to speculative buying, further inflating asset values.

3. Herd Mentality: As more investors rush to buy a particular asset, it can create a herd mentality, pushing prices higher.

Economic Consequences of Asset Bubbles:

1. Wealth Erosion: When asset prices collapse, individuals and institutions holding these assets can experience significant wealth losses.

2. Financial Instability: Bursting asset bubbles can lead to financial instability, impacting banks and financial institutions with exposure to the affected assets.

3. Investment Downturn: Asset bubble bursts may discourage investment and lead to a slowdown in economic activity.

4. Consumer and Business Confidence: Sharp declines in asset prices can erode consumer and business confidence, leading to reduced spending and investment.

The Role and Purpose of Regulation: Financial regulation is crucial for creating financial stability and protecting consumers and investors. Regulation aims to:

1. Ensure Soundness: Regulators set standards to ensure that financial institutions maintain adequate capital, manage risks prudently, and comply with rules to avoid excessive leverage and instability.

2. Prevent Systemic Risks: Regulation addresses systemic risks that could threaten the stability of the entire financial system.

3. Consumer Protection: Regulation safeguards the interests of consumers and investors, ensuring fair treatment and transparency.

4. Maintain Market Integrity: Regulations promote fair competition, prevent market manipulation, and ensure the integrity of financial markets.

Evaluation of the UK's Large Financial Sector: The UK's large financial sector has both benefits and challenges for the real economy:

Benefits:

1. Contribution to GDP: The financial sector contributes significantly to the UK's Gross Domestic Product (GDP) and employment, supporting economic growth.

2. Global Competitiveness: The financial sector's global competitiveness enhances the UK's position as a financial hub, attracting foreign investment and skilled professionals.

Challenges:

1. Vulnerability to Financial Crises: A large financial sector can make the economy more susceptible to financial crises and their repercussions.

2. Income Inequality: The concentration of wealth in the financial sector can exacerbate income inequality in the economy.

3. Overreliance on Finance: An overreliance on the financial sector may divert resources from other sectors of the economy.

In conclusion, the growth of the UK's financial sector has been significant, making London a global financial center. However, the size and influence of the financial sector bring both benefits and challenges, requiring careful regulation to ensure financial stability and balanced economic growth.

Britain is the Dorian Gray economy, hiding its ugly truths from the world. Now they are exposed

From Tony Blair to George Osborne, our rulers painted false pictures of success while real wealth and wages withered away writes Aditya Chakrabortty in The Guardian 

You know the central conceit of Oscar Wilde’s The Picture of Dorian Gray, of course you do. A lad of sun-kissed beauty is presented with a stunning likeness of himself. Disturbed at the notion that he will grow old while the painting doesn’t, he locks it away – where it is the portrait that ages and uglifies while Dorian stays boyish and beautiful. But perhaps you’ve forgotten what happens next.

The story has come to my mind many times, as the foulness of British politics becomes ever harder to ignore. Genteel liberals wonder how their land of cricket whites and orderly queues could be ruled by a grasping liar such as Boris Johnson and I hear a whisper on the wind: Dorian Gray. The New York Times and Der Spiegel report in bewilderment on a country with pockets of deep poverty and unslaked anger, and again rasps that hoarse voice: the horror was hidden here all along.

Now it’s all out in the open. In one of the richest societies in human history, inhabitants are starting to twig that by 2030 or thereabouts they will earn less per head than the Poles they so recently patronised. Whatever the politicians and pundits may argue, this debacle owes nothing to Jeremy Corbyn or Brexit or any supposedly un-British “populism”. It is homegrown and has deep roots.

Like Dorian Gray, Britain has for too long presented one face to the world while concealing the awful truth. The author of that novel, Oscar Wilde, was the son of an Irish nationalist and a graduate of Oxford, where he became a fine student of the British upper classes and their mellifluous hypocrisy. He would have recognised much of the mess we’re in, because it grew among shadows and cover-ups. From Tony Blair’s Cool Britannia through to George Osborne’s “march of the makers”, our rulers have trumpeted every false success, while ugly facts have been waved away as anomalies: from the former manufacturing suburbs and towns turned into giant warehouses of surplus people, to the fact that 15% of adults in England are on antidepressants. We’re winning the global race, claimed David Cameron, even as the population’s life expectancy fell far behind other rich countries. We shan’t stunt future generations with debt, he boasted, as our five-year-olds became the shortest in Europe.

Or take the housing bubble that politicians pretended was true prosperity – until this week, as the Bank of England hiked rates for the 13th time in a row and the prospect of it bursting began to terrify them. Yet the Westminster classes blew their hardest into that bubble. As soon as estate agents were out of lockdown, Rishi Sunak gave up £6bn of taxpayers’ money for a stamp duty holiday – an act as prudent as pouring petrol on a fire. Many of those he lured up the property ladder will be hardest hit by rising mortgage rates. Analysis done for me by UK Finance suggests that 465,000 house purchases during that tax break were financed with two- or three-year fixed rate mortgages – the very ones running out right now. In other words, nearly half a million households took the chancellor’s inducement; many will plunge into dangerous financial straits; some face losing their homes. They were mis-sold a dream by Sunak. Still, at least the Tories enjoyed a bounce in the polls.

Helmut Berger stars in the 1970 film adaptation of The Picture of Dorian Gray. Photograph: Sargon/Kobal/Rex/Shutterstock


“Sin is a thing that writes itself across a man’s face,” Dorian is told by his portraitist Basil Hallward. “If a wretched man has a vice, it shows itself in the lines of his mouth, the droop of his eyelids, the moulding of his hands even … But you, Dorian, with your pure, bright, innocent face and your marvellous untroubled youth – I can’t believe anything against you.” The picture of Dorian, which would have revealed the grotesque truth, is hidden away. So, too, has the UK avoided admitting its ills. Even now, in a country where patently so little works for people who rely on work for their income, commentators and frontbenchers still blame supposedly all-powerful interlopers: Boris, Nigel, Jeremy. And from Sunak to Starmer, all push growth and jobs as the remedy for what ails us.

Yet growth in this country is falling and not because of Ukraine or Covid or Brexit. Since the 1950s, the growth rate adjusted for inflation has been on a gentle but insistent downward slide. Our economy has become ever more stagnant and dependent on debt. It is fatuous to pretend this is going to turn around through magicking Britain into an AI free-for-all or a jolly green industrial giant. Employment? One in four employees are on low weekly wages – either because the pay is too low or the hours aren’t enough – while the average real wage has flatlined for many years.

Much of this analysis comes from a new book, When Nothing Works, written by a team of scholars. Although specialising in economics and accountancy, what they have produced is an essential text for understanding British government: the polarised politics of a highly unequal and increasingly stagnant society.

Take the issue at the top of today’s agenda: wages. Why can’t you and I take home more money? Because of a lack of productivity, politicians will say. Yet the researchers point to how labour has got a smaller and smaller share of economic output since the 1970s.

If the same share of GDP was paid out in wages today as in 1976, the average working-age household would have an extra £9,744 a year. We haven’t lost that 10 grand a year through laziness at work but because politicians from Thatcher onwards smashed up trade unions, undermined labour rights, and crowed over the result as a “flexible labour market”. What they really created was a low-wage workforce, in a low-growth country ruled by politicians with low ambitions for everyone bar themselves.

“The prayer of your pride has been answered,” Basil counsels Dorian, when he finally sees the portrait and its horrific truth. “The prayer of your repentance will be answered also.” When Nothing Works will inevitably be termed pessimistic, but it is no such thing. Realism comes from facing who we are and dropping the pretence that a growth miracle is just around the corner. Instead of trying to boost “the economy”, it is high time to boost our people: to ensure they have the basics they need to live a life free from indignity and free to flourish. This will come from redistribution rather than growth, from replacing extractive businesses with fair ones. Such ideas will not go down well in SW1, where both Tory and Labour are increasingly hostile to pluralism and brittle in their dogmatism. Self-knowledge is the hardest knowledge, as one of the book’s authors, Karel Williams, says. And self-delusion leads eventually to disaster.

Unable to face his loathsome self-image, Dorian slashes that portrait. He is found by servants. “Lying on the floor was a dead man, in evening dress, with a knife in his heart. He was withered, wrinkled and loathsome of visage. It was not till they examined the rings that they recognised who it was.”

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The GameStop affair is like tulip mania on steroids

It’s eerily similar to the 17th-century Dutch bubble, but with the self-organising potential of the internet added to the mix writes Dan Davies in The Guardian

  

Towards the end of 1636, there was an outbreak of bubonic plague in the Netherlands. The concept of a lockdown was not really established at the time, but merchant trade slowed to a trickle. Idle young men in the town of Haarlem gathered in taverns, and looked for amusement in one of the few commodities still trading – contracts for the delivery of flower bulbs the following spring. What ensued is often regarded as the first financial bubble in recorded history – the “tulip mania”.

Nearly 400 years later, something similar has happened in the US stock market. This week, the share price of a company called GameStop – an unexceptional retailer that appears to have been surprised and confused by the whole episode – became the battleground between some of the biggest names in finance and a few hundred bored (mostly) bros exchanging messages on the WallStreetBets forum, part of the sprawling discussion site Reddit. 

The rubble is still bouncing in this particular episode, but the broad shape of what’s happened is not unfamiliar. Reasoning that a business model based on selling video game DVDs through shopping malls might not have very bright prospects, several of New York’s finest hedge funds bet against GameStop’s share price. The Reddit crowd appears to have decided that this was unfair and that they should fight back on behalf of gamers. They took the opposite side of the trade and pushed the price up, using derivatives and brokerage credit in surprisingly sophisticated ways to maximise their firepower.

To everyone’s surprise, the crowd won; the hedge funds’ risk management processes kicked in, and they were forced to buy back their negative positions, pushing the price even higher. But the stock exchanges have always frowned on this sort of concerted action, and on the use of leverage to manipulate the market. The sheer volume of orders had also grown well beyond the capacity of the small, fee-free brokerages favoured by the WallStreetBets crowd. Credit lines were pulled, accounts were frozen and the retail crowd were forced to sell; yesterday the price gave back a large proportion of its gains.

To people who know a lot about stock exchange regulation and securities settlement, this outcome was quite inevitable – it’s part of the reason why things like this don’t happen every day. To a lot of American Redditors, though, it was a surprising introduction to the complexity of financial markets, taking place in circumstances almost perfectly designed to convince them that the system is rigged for the benefit of big money.

Corners, bear raids and squeezes, in the industry jargon, have been around for as long as stock markets – in fact, as British hedge fund legend Paul Marshall points out in his book Ten and a Half Lessons From Experience something very similar happened last year at the start of the coronavirus lockdown, centred on a suddenly unemployed sports bookmaker called Dave Portnoy. But the GameStop affair exhibits some surprising new features.

Most importantly, it was a largely self-organising phenomenon. For most of stock market history, orchestrating a pool of people to manipulate markets has been something only the most skilful could achieve. Some of the finest buildings in New York were erected on the proceeds of this rare talent, before it was made illegal. The idea that such a pool could coalesce so quickly and without any obvious sign of a single controlling mind is brand new and ought to worry us a bit. 

And although some of the claims made by contributors to WallStreetBets that they represent the masses aren’t very convincing – although small by hedge fund standards, many of them appear to have five-figure sums to invest – it’s unfamiliar to say the least to see a pool motivated by rage or other emotions as opposed to the straightforward desire to make money. Just as air traffic regulation is based on the assumption that the planes are trying not to crash into one another, financial regulation is based on the assumption that people are trying to make money for themselves, not to destroy it for other people.

When I think about market regulation, I’m always reminded of a saying of Édouard Herriot, the former mayor of Lyon. He said that local government was like an andouillette sausage; it had to stink a little bit of shit, but not too much. Financial markets aren’t video games, they aren’t democratic and small investors aren’t the backbone of capitalism. They’re nasty places with extremely complicated rules, which only work to the extent that the people involved in them trust one another. Speculation is genuinely necessary on a stock market – without it, you could be waiting days for someone to take up your offer when you wanted to buy or sell shares. But it’s a necessary evil, and it needs to be limited. It’s a shame that the Redditors found this out the hard way.

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The lesson for diagnosing a bubble

Tim Harford in The Financial Times

Here are three noteworthy pronouncements about bubbles. 

“Prices have reached what looks like a permanently high plateau.” That was Professor Irving Fisher in 1929, prominently reported barely a week before the most brutal stock market crash of the 20th century. He was a rich man, and the greatest economist of the age. The great crash destroyed both his finances and his reputation. 

“Those who sound the alarm of an approaching . . . crisis have somewhat exaggerated the danger.” That was a renowned commentator who shall remain nameless for now. 

“We are currently showing signs of entering the blow-off or melt-up phase of this very long bull market.” That was investor Jeremy Grantham on January 3 this year. The normally bearish Mr Grantham mused that while shares seem expensive, historical precedents make it plausible that the S&P 500 will soar from present levels of around 2,700 to more than 3,500 before the crash occurs. 

Mr Grantham’s speculation is striking because he has tended to be a savvy bubble watcher in the past. But as any toddler can attest, it is not an easy thing to catch one before it bursts. 

There are two obvious ways to diagnose a bubble. One is to look at the fundamentals: if the price of an asset is unmoored from the cash flow it is likely to generate, that is a warning sign. (It is anyone’s guess what this implies for bitcoin, an asset that has no cash flow at all.) 

The other approach is to look around: are people giddy with excitement? Can the media talk of little else? Are taxi drivers offering stock tips? 

At the moment, however, these two approaches tell a different story about US stocks. They are expensive by most reasonable measures. But there are few other signs of speculative mania. The price rise has been steady, broad-based and was hardly the leading news of 2017. Given how expensive bonds are, it is hardly a surprise that stocks also seem pricey. No wonder investors and commentators are unsure what to say or do. 

It seems all so much easier with hindsight: looking back, we can all enjoy a laugh at the Extraordinary Popular Delusions and the Madness of Crowds, to borrow the title of Charles Mackay’s famous 1841 book, which chuckles at the South Sea bubble and tulip mania. 

Yet even with hindsight things are not always clear. For example, I first became aware of the incipient dotcom bubble in the late 1990s, when a senior colleague told me that the upstart online bookseller Amazon.com was valued at more than every bookseller on the planet. A clearer instance of mania could scarcely be imagined. 

But Amazon is worth much more today than at the height of the bubble, and comparing it with any number of booksellers now seems quaint. The dotcom bubble was mad and my colleague correctly diagnosed the lunacy, but he should still have bought and held Amazon stock. 

Tales of the great tulip mania in 17th-century Holland seem clearer — most notoriously, the Semper Augustus bulb that sold for the price of an Amsterdam mansion. 

“The population, even to its lowest dregs, embarked in the tulip trade,” sneered Mackay more than 200 years later. 

But the tale grows murkier still. The economist Peter Garber, author of Famous First Bubbles, points out that a rare tulip bulb could serve as the breeding stock for generations of valuable flowers; as its descendants became numerous, one would expect the price of individual bulbs to fall. 

Some of the most spectacular prices seem to have been empty tavern wagers by almost-penniless braggarts, ignored by serious traders but much noticed by moralists. The idea that Holland was economically convulsed is hard to support: the historian Anne Goldgar, author of Tulipmania, has been unable to find anyone who actually went bankrupt as a result. 

It is easy to laugh at the follies of the past, especially if they have been exaggerated for the purposes of sermonising or for comic effect. Charles Mackay copied and exaggerated the juiciest reports he could find in order to get his point across. Then there is the matter of his own record as a financial guru. That comment, this time in full, “those who sound the alarm of an approaching railway crisis have somewhat exaggerated the danger”, was Mackay himself, writing in the Glasgow Argus in 1845, in full-throated support of the idea that the railway investment boom of the time would return a healthy profit to investors. It was, instead, a financial disaster. In the words of mathematician and bubble scholar Andrew Odlyzko, it was “by many measures the greatest technology mania in history, and its collapse was one of the greatest financial crashes”. 

Oddly, Mackay barely mentions the railway mania in subsequent editions of his book — nor his own role as cheerleader. This is a lesson to us all. It’s very easy to scoff at past bubbles; it is not so easy to know how to react when one may — or may not — be surrounded by one.

Don’t blame China for these global economic jitters

In truth the west failed to learn from the 2008 crash. Any economic ‘recovery’ was built on asset bubbles

Ha Joon Chang in The Guardian


 

‘There has never been a real recovery in North America and western Europe since 2008.’ Photograph: Kai Pfaffenbach/Reuters


The US stock market has just had the worst start to a year in its history. At the same time, European and Japanese stock markets have lost around 10% and 15% of their values respectively; the Chinese stock market has resumed its headlong dash downward; and the oil price has fallen to the lowest level in 12 years, reflecting (and anticipating) worldwide economic slowdown.

According to the dominant economic narrative of recent times, 2016 was the year when the world economy would recover fully from the 2008 crash. The US would lead this recovery by generating growth and jobs via fiscal conservatism and pro-business policies. Reflecting the economy’s robust growth, the US stock market reached new heights in 2015, although disrupted by the mess in the Chinese stock market over the summer. By last October, US unemployment had fallen from the post-crisis peak of 10% to 5%, bringing it back close to the pre-crisis low. In a show of confidence, last month the US Federal Reserve finally raised its interest rate for the first time in nine years.

Not far behind the US, the story goes, have been Britain and Ireland. Hit harder than the US by the financial crisis, they have, however, recovered handsomely because they kept their nerve and stuck to the right, if unpopular, policies. Spending cuts, focused on wasteful welfare spending, accelerated job creation by making it more difficult for people to live off the taxpayer. They sensibly didn’t give in to the banker-bashers and chose not to over-regulate the financial sector.

Even the continental European economies have been finally picking up, it was said, having accepted the need for fiscal discipline, labour market reform and cutting business regulations. The world – at least the rich world – was finally set for a full recovery. So what has gone wrong?

Those who put forward the narrative are now trying to blame China in advance for the coming economic woes. George Osborne has been at the forefront, warning this month of a “dangerous cocktail of new threats” in which the devaluation of the Chinese currency and the fall in oil prices (both in large part due to China’s economic slowdown) figured most prominently. If our recovery was to be blown off course, he implied, it would be because China had mismanaged its economy.

China is, of course, an important factor in the global economy. Only 2.5% of the world economy in 1978, on the eve of its economic reform, it now accounts for around 13%. However, its importance should not be exaggerated. As of 2014, the US (22.5%) the eurozone (17%) and Japan (7%) together accounted for nearly half of the world economy. The rich world vastly overshadows China. Unless you are a developing economy whose export basket is mainly made up of primary commodities destined for China, you cannot blame your economic ills on its slowdown.

The truth is that there has never been a real recovery from the 2008 crisis in North America and western Europe. According to the IMF, at the end of 2015, inflation-adjusted income per head (in national currency) was lower than the pre-crisis peak in 11 out of 20 of those countries. In five (Austria, Iceland, Ireland, Switzerland and the UK), it was only just higher – by between 0.05% (Austria) and 0.3% (Ireland). Only in four countries – Germany, Canada, the US and Sweden – was per-capita income materially higher than the pre-crisis peak.

Even in Germany, the best performing of those four countries, per capita income growth rate was just 0.8% a year between its last peak (2008) and 2015. The US growth rate, at 0.4% per year, was half that. Compare that with the 1% annual growth rate that Japan notched up during its so-called “lost two decades” between 1990 and 2010.

To make things worse, much of the recovery has been driven by asset market bubbles, blown up by the injection of cash into the financial market through quantitative easing. These asset bubbles have been most dramatic in the US and UK. They were already at an unprecedented level in 2013 and 2014, but scaled new heights in 2015. The US stock market reached the highest ever level in May 2015 and, after the dip over the summer, more or less came back to that level in December. Having come down by nearly a quarter from its April 2015 peak, Britain’s stock market is currently not quite so inflated, but the UK has another bubble to reckon with, in the housing market, where prices are 7% higher than the pre-crisis peak of 2007.

Thus seen, the main causes of the current economic turmoil lie firmly in the rich nations – especially in the finance-driven US and UK. Having refused to fundamentally restructure their economies after 2008, the only way they could generate any sort of recovery was with another set of asset bubbles. Their governments and financial sectors talked up anaemic recovery as an impressive comeback, propagating the myth that huge bubbles are a measure of economic health.

Whether or not the recent market turmoil leads to a protracted slide or a violent crash, it is proof that we have wasted the past seven years propping up a bankrupt economic model. Before things get any worse, we need to replace it with one in which the financial sector is made less complex and more patient, investment in the real economy is encouraged by fiscal and technological incentives, and measures are brought in to reduce inequality so that demand can be maintained without creating more debts.

None of these will be easy to implement, but we know what the alternative is – a permanent state of low growth, instability, and depressed living standards for the vast majority.