The Fisher effect
Named after US economist Irving Fisher, the Fisher effect refers to the impact of inflation on nominal interest rates, and the difference between nominal and real rates. Suppose you earn 10 per cent interest on a bond each year – how much this return is worth (in terms of what you can actually buy with it) depends crucially on the rate of inflation. If inflation had been 4 per cent then your real return would be only 6 per cent.
From this, one can see that the 10 per cent nominal interest rate can be divided into a real interest rate and the rate of inflation: the nominal rate is equal to the real interest rate plus inflation. If inflation rises by 1 per cent – perhaps because of an increase in the supply of money – then nominal interest rates should also rise by 1 per cent. Studies of trends in interest rates and inflation over time appear to confirm the Fisher effect: high inflation rates and high interest rates seem to go together.
Trends in US inflation and interest rates appear to confim the Fisher effect.
Banks and financial intermediation
National income can be consumed today or invested in projects that promise future returns. Investments in infrastructure, factories, technology and skills all drive growth and so investment is the lifeblood of economies. So banks – in the role of financial intermediaries connecting savers with investors – are an important artery for investment. People who don’t consume all of their income today save it, depositing it in banks from where it is channelled to those who wish to use money to carry out investment projects.
Banks are able to pool savings from many people and then transform them into loans. By dealing with many savers and borrowers, they are able to manage risks. An important part of this involves balancing the interests of borrowers and savers: savers might want immediate access to their funds, while borrowers carrying out large investment projects require long-term loans. Poor management of the various risks can disrupt the mechanism of financial intermediation.
Bank runs
Typically, banks keep only a small percentage of deposits as cash, which they can use to pay immediately to depositors making withdrawals. Banks need to judge the prudent level of deposits to keep as ready cash, balancing this with the need to earn profits by lending the money to borrowers. A bank run happens when depositors believe that the bank is no longer able to pay them back their money.
Bank runs create their own momentum and can even be self-fulfilling: this is due to the fact that banks operate on the assumption that only some borrowers will want to withdraw their money in a given period. If borrowers come to doubt the bank’s ability to pay them back, they will all rush to withdraw simultaneously and then the bank really won’t be able to pay them. This is why many governments insure bank deposits in the hope that this will short-circuit the cycles of panic that have the potential to sink otherwise healthy banks.
Bonds
US railroad bond, c.1900
Borrowers can get loans from savers through financial intermediaries such as banks. But they can also gain direct access to savers through financial markets such as the bond market. Suppose that Mega Foods Inc. wants to build a new plant. It can raise funds by selling bonds that are, in essence, IOUs. John’s purchase of a bond from Mega Foods Inc. is a loan to the company – the bond states a date of maturity at which John’s loan will be repaid, along with a rate of interest that will be paid until then. John can hold onto the bond until it matures or sell it on earlier. Governments also issue bonds to finance expenditure.
Bonds vary in how long they take to mature – short-term bonds may mature in a matter of months, while long-term bonds may run for decades. Some bonds are more risky – those for which there is a higher probability that the firm or government might not make its repayments. Risky borrowers need to offer higher interest rates on their bonds in order to raise finance.
Risk and return
Risk and return for different forms of investment
Risk and return go together: risky financial assets or investment projects tend to offer higher potential returns in the future, and when risk is low, potential returns are also likely to be low. Because people tend to avoid risk but like high returns, risk and return form a trade-off: to get higher potential returns, one has to take on more risks.
Imagine that a firm starts producing a novel product: it is hard to predict whether the product will catch on and the firm will survive, and for this reason, an investor lending to the firm would demand a high rate of interest. If the product did well and the firm made huge profits, its shareholders would make a lot of money and the people who’d lent it money would receive their hefty interest payments. But conversely, the firm might also end up going bust, in which case investors would lose out. At the other extreme, one could invest in safe government bonds: these have a very low risk of default but pay low rates of interest.
The stock market
One way for firms to raise finance directly from investors is by selling shares (stock). When an investor purchases a share in a company, she owns a share of the firm. This form of finance contrasts with debt financing from the issuing of bonds: bondholders have lent money to a firm, while shareholders actually own the firm. As a result, investing in shares is relatively risky but offers a high potential return – if the firm does well it may pay out some or all of its profits in the form of a dividend on each share, and its share price will also rise – in both ways, its shareholders become richer. But if it goes bust, shareholders lose their investment completely. In contrast, bondholders receive the same interest payments even if the firm’s share price hits the roof. The trading of shares takes place on central stock markets like the London Stock Exchange. Once a firm has issued shares they can be sold on by investors. Companies’ share prices rise and fall depending on firm performance. Stock prices are also affected by the overall state of the economy.
The capital asset pricing model
The capital asset pricing model (CAPM) is a method of calculating the expected return on an investment based on risk. An asset has two kinds of risk – specific and systematic. Specific risk affects a particular investment – for example, the potential fall in the share price of a pharmaceutical company whose flagship drug has been found to be harmful. This kind of risk can be offset by diversifying investments across many companies. Systematic risk is that which affects the whole market (for example, when the economy enters a recession and all stock prices fall) and cannot be offset by diversification.
Broadly speaking, the CAPM says that the expected return on an asset is related to the expected return on the stock market as a whole. Some assets move closely with the overall market: they have a high degree of systematic risk that can’t be diversified away and therefore a high expected return. Other assets have lower systematic risk and so usually offer lower returns.
The yield curve
When the rates of returns on debt of varying periods are compared, the resulting graph gives the relationship between short- and long-term interest rates, known as a yield curve. Normally, the curve slopes upwards: returns rise with the borrowing period; in other words, long-term interest rates are higher than short-term ones. Suppose an investor lends the government £100 by buying a bond. The government pays him interest and returns the money in six months. If the repayment period was three years, one might expect a higher interest rate. By lending for longer, the investor takes on more risk: in three years many unforeseen events could occur.
Sometimes, the yield curve slopes downwards: short-term rates exceed long-term ones. This indicates that investors expect short-term interest rates to fall (otherwise one could borrow at the long-term rate to re-lend at the short-term one). Expectations of falling short-term rates can be a sign that an economy is about to enter a downturn.
Financial engineering and derivatives
Financial derivatives have been around for centuries, but have grown in importance and sophistication in recent decades. Derivatives are contracts that involve an underlying commodi
ty such as wheat or dollars – for example, a contract could specify a price and future date of delivery for 100 tonnes of barley. These kinds of contracts are particularly useful for managing risk: they can reduce uncertainty about future prices. But this feature of derivatives also allows speculators to make money. Suppose I buy a derivatives contract for the delivery of 100 tonnes of barley in six months for £100 per tonne. If the actual price of barley in six months is £120 tonnes per tonne I can make a profit of £20 per tonne by immediately selling on the barley. In recent decades, highly complex derivatives have been devised using mathematical models to price the risk inherent in different kinds of contracts. Some have blamed the recent economic crisis on this kind of ‘financial engineering’, which introduced financial products so complex that few understood them.
Tobin’s Q
In 1968, economists James Tobin and William Brainard put forward an argument for a link between investment and the stock market. Tobin devised a measure showing this connection, which came to be known as Tobin’s Q.
Suppose that a firm is considering making an outlay on some new capital stock. It could do this by issuing new shares on the stock market (see The stock market). If the price of its shares is greater than the cost of the extra capital stock then the firm should make the investment. One can think of a share price as reflecting the market’s valuation of the firm’s capital, so if it is high relative to the cost of installing extra capital then the firm should make the outlay. Tobin’s Q is the total market value of a company divided by the cost of replacing its capital stock. When Q is high, investment should be high – in particular, when Q is greater than one the firm is ‘overvalued’: its market value is higher than the replacement cost of its assets, which should encourage it to invest in more capital.
The efficient markets hypothesis
According to the idea of market efficiency, the price of a stock, or any other good, should reflect all the information relevant to valuing it (see The capital asset pricing model). The efficient markets hypothesis suggests that it is therefore impossible for an investor to consistently ‘beat’ the market. In fact, if financial markets are really efficient, one might as well invest in a random selection of stocks. Investors constantly monitor the fortunes of companies and watch out for new information that may affect their values. They make money by buying the shares of undervalued firms and selling those of overvalued firms. In efficient markets, price brings supply into line with demand: those who want to buy a stock at a certain price should exactly balance those who want to sell it, and therefore stock prices are always a good indication of the value of a firm. The hypothesis is called into doubt by the fact that markets often seem irrational, with herd behaviour leading to bubbles and crashes. Recent crises have shown that markets don’t always take all information into account in an efficient manner.
Efficient and inefficient market responses
Financial crises
There are many kinds of financial crisis. The recent global crisis has led to the revival of an an idea put forward in the 1960s by Hyman Minsky, who argued that economic stability inevitably gives rise to instability and crisis. With sustained economic growth comes confidence in the future: people borrow money to invest in assets such as houses, and as confidence grows they may take on greater risk – they might take out larger loans and only pay back the interest, anticipating that the value of their assets will rise.
In the run-up to the crisis of 2008, generous lending was fuelled by a growing market for financial securities based on mortgage loans. As a result, loans were issued to many homebuyers who were at a high risk of defaulting on their payments. Eventually, the behaviour encouraged by widespread confidence leads to instability – a so-called ‘Minsky moment’. When the US housing market began to decline many borrowers couldn’t repay, leaving lenders with huge debts and triggering the crisis.
Circumstances leading to the financial crisis of 2008
Credit crunches
Credit fuels economic activity: firms have to borrow to invest in factories or research new products, individuals take out loans to buy houses or to finance education. So when credit dries up the economy gets smothered. During a credit crunch, the supply of loans contracts: there is both less credit available and a tightening of the conditions for accessing it.
Credit crunches often arise from certain kinds of market failure. For example, at the start of the recent economic crisis in 2008, financial institutions realized that loans had been given to homebuyers based on a limited analysis of their creditworthiness, and that many were in fact worthless. To reduce their risks, they immediately began to restrict credit to borrowers. Much of this behaviour is driven by so-called ‘informational failures’: when it becomes apparent that there is not enough information about the true risks attached to a bank’s stock of loans, the response can be to switch from liberal to highly conservative lending policies.
Financial bubbles
During the Dutch ‘tulip mania’ of the 17th century, the price of some flowers exceeded many workers’ annual incomes.
Like a bubble, prices of assets such as stocks or property can sometimes seem to rise ever upwards. Prices often rise for good reason, but during a bubble the price rises above the fundamental value of the asset. Bubbles are an example of economic irrationality – people stop making decisions based on the true value of an asset but instead follow the herd. They buy the good – technology stocks in the early 21st century, tulips in the 17th – merely because they see that other people are buying it and believe that they will be able to sell it for a higher price in the future.
At first the prophecy is self-fulfilling – enthusiasm for the good pushes up the price and soon more investors join in a collective frenzy of buying, leading to an increasingly inflated price. Eventually, however, the process stalls and the market crashes. People seem to think that prices will go on rising forever, or at least that they will eventually be able to sell on their asset to someone who isn’t able to foresee the bursting of the bubble.
Financing firms
Traditionally, a firm can raise money through borrowing or through selling shares (equity). The Modigliani-Miller theorem states that the way in which a firm finances itself has no bearing on its value. The idea is that when markets are efficient and investors rational, all that matters is the profit that a firm makes, and it is this alone that determines its value.
One of the authors of the theorem explained it using the analogy of a firm as a vat of whole milk. The farmer could sell the whole milk (corresponding to pure equity financing – the sale of shares). Alternatively, the farmer could separate out the cream and sell this at a higher price (analogous to the firm financing itself through borrowing). However, just as skimming cream off the whole milk leaves less valuable skimmed milk, so borrowing makes the firm’s shares less attractive, offsetting any gain. Like the farmer deciding the split between cream and skimmed milk, the firm does just as well whatever combination of debt and equity it decides on.
Forecasting
Economic forecasters build mathematical models of the economy. The models are made up of many equations, each describing a part of the economy: for instance, there might be an equation showing the link between movements in interest rates and investment by firms. Together, the equations can then be used to forecast future economic trends from the current state of the economy.
Forecasts are important to the financial markets, whose participants use them as a guide to investment strategy. An important element of forecasting is the use of leading indicators – variables that tend to herald broader changes in the economy. For example, movements in the stock market often anticipate the direction of the overall economy. However, forecasting is fraught with difficulty – the economy is so complex that it is hard to build a watertight and comprehensive model – simplifying assumptions need to be made, and forecasts frequently err.
The existence of firms
In recent years there has been a trend for
firms to contract out many of their functions. The testing of products might be contracted to an independent laboratory, where it used to be carried out within the firm. What if this continued until all functions were contracted out – why would the firm need to exist at all? Economists have tried to answer this question using the notion of ‘transaction costs’.
The purchase of an apple is simple: parties to the transaction don’t need to gather complex information or take account of many uncertainties, so transaction costs are low. But many other economic relationships continue over time, are far more complex and take place in environments of uncertainty – they may involve high transaction costs. Employees of firms carry out complex tasks that can change over time in unanticipated ways: it might be impossible to specify all of these explicitly in a contract to a third party, so it may be more efficient for certain parts of production to remain organized as firms.
Economics in Minutes Page 4
