Category: Essentials of Economics: Ch 12

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Will AI make the world less equal?

With businesses increasing their use of AI, this is likely to have significant effects on employment. But how will this affect the distribution of income, both within countries and between countries?

In some ways, AI is likely to increase inequality within countries as it displaces low-skilled workers and enhances the productivity of higher-skilled workers. In other ways, it could reduce inequality by allowing lower-skilled workers to increase their productivity, while displacing some higher-skilled workers and managers through the increased adoption of automated processes.

The effect of AI on the distribution of income between countries will depend crucially on its accessibility. If it is widely available to low-income countries, it could significantly enhance the productivity of small businesses and workers in such countries and help to reduce the income gap with the richer world. If the gains in such countries, however, are largely experienced by multinational companies, whether in mines and plantations, or in labour-intensive industries, such as garment production, few of the gains may accrue to workers and global inequality may increase.

Redistribution within a country

The deployment of AI may result in labour displacement. AI is likely to replace both manual and white-collar jobs that involve straightforward and repetitive tasks. These include: routine clerical work, such as data entry, filing and scheduling; paralegal work, contract drafting and legal research; consulting, business research and market analysis; accounting and bookkeeping; financial trading; proofreading, copy mark-up and translation; graphic design; machine operation; warehouse work, where AI-enabled warehouse robots do many receiving, sorting, stacking, retrieval, carrying and loading tasks (e.g. Amazon’s Sequoia robotic system); basic coding or document sifting; market research and advertising design; call-centre work, such as enquiry handling, sales, telemarketing and customer service; hospitality reception; sales cashiers in supermarkets and stores; analysis of health data and diagnosis. Such jobs can all be performed by AI assistants, AI assisted robots or chat bots.

Women are likely to be disproportionately affected because they perform a higher share of the administrative and service roles most exposed to AI.

Workers displaced by AI may find that they can find employment only in lower-paid jobs. Examples include direct customer-facing roles, such as bar staff, shop assistants, hairdressers and nail and beauty consultants.

Such job displacement by AI is likely to redistribute income from relatively low-skilled labour to capital: a redistribution from wages to profits. This will tend to lead to greater inequality.

AI is also likely to lead to a redistribution of income towards certain types of high-skilled labour that are difficult to replace with AI but which could be enhanced by it. Take the case of skilled traders, such as plumbers, electricians and carpenters. They might be able to use AI in their work to enhance their productivity, through diagnosis, planning, problem-solving, measurement, etc. but the AI would not displace them. Instead, it could increase their incomes by allowing them to do their work more efficiently or effectively and thus increase their output per hour and enhance their hourly reward. Another example is architecture, where AI can automate repetitive tasks and open up new design possibilities, allowing architects to focus on creativity, flexibility, aesthetics, empathy with clients and ethical decision-making.

An important distinction is between disembodied and embodied AI investment. Disembodied AI investment could include AI ‘assistants’, such as ChatGPT and other software that can be used in existing jobs to enhance productivity. Such investment can usually be rolled out relatively quickly. Although the extra productivity may allow some reduction in the number of workers, disembodied AI investment is likely to be less disruptive than embodied AI investment. The latter includes robotics and automation, where workers are replaced by machines. This would require more investment and may be slower to be adopted.

Then there are jobs that will be created by AI. These include prompt engineers, who develop questions and prompt techniques to optimise AI output; health tech experts, who help organisations implement new medical AI products; AI educators, who train people in the uses of AI in the workplace; ethics advisors, who help companies ensure that their uses of AI are aligned with their values, responsibilities and goals; and cybersecurity experts who put systems in place to prevent AI stealing sensitive information. Such jobs may be relatively highly paid.

In other cases, the gains from AI in employment are likely to accrue mainly to the consumer, with probably little change in the incomes of the workers themselves. This is particularly the case in parts of the public sector where wages/salaries are only very loosely related to productivity and where a large part of the work involves providing a personal service. For example, health professionals’ productivity could be enhanced by AI, which could allow faster and more accurate diagnosis, more efficient monitoring and greater accuracy in surgery. The main gainers would be the patients, with probably little change in the incomes of the health professionals themselves. Teachers’ productivity could be improved by allowing more rapid and efficient marking, preparation of materials and record keeping, allowing more time to be spent with students. Again, the main gainers would be the students, with little change in teachers’ incomes. Other jobs in this category include social workers, therapists, solicitors and barristers, HR specialists, senior managers and musicians.

Thus there is likely to be a distribution away from lower-skilled workers to both capital and higher-skilled workers who can use AI, to people who work in new jobs created by AI and to the consumers of certain services.

AI will accelerate productivity growth and, with it, GDP growth, but will probably displace workers faster than new roles emerge. This is likely to increase inequality and be a major challenge for society. Can the labour market adapt? Could the effects be modified if people moved to a four- or three-day week? Will governments introduce statutory limits to weekly working hours? Will training and education adapt to the new demands of employers?

Redistribution between countries

AI threatens to widen the global rich–poor divide. It will give wealthier nations a productivity and innovation edge, which could displace low-skilled jobs in low-income nations. Labour-intensive production could be replaced by automated production, with the capital owned by the multinational companies of just a few countries, such as the USA and China, which between them account for 40% of global corporate AI R&D spending. For some companies, it would make sense to relocate production to rich countries, or certain wealthier developing countries, with better digital infrastructure, advanced data systems and more reliable power supply.

For other companies, however, production might still be based in low-income countries to take advantage of low-cost local materials. But there would still be a redistribution from wages in such countries to the profits of multinationals.

But it is not just in manufacturing where low-income countries are vulnerable to the integration of AI. Several countries, such as India, the Philippines, Mexico and Egypt have seen considerable investment in call centres and IT services for business process outsourcing and customer services. AI now poses a threat to employment in this industry as it has the potential to replace large numbers of workers.

AI-related job losses could exacerbate unemployment and deepen poverty in poorer countries, which, with limited resources, limited training and underdeveloped social protection systems, are less equipped to absorb economic and social shocks. This will further widen the global divide. In the case of embodied AI investment, it may only be possible in low-income countries through multinational investment and could displace many traditional jobs, with much of the benefit going in additional multinational profit.

But it is not all bad news for low-income countries. AI-driven innovations in healthcare, education, and agriculture, if adopted in poor countries, can make a significant contribution to raising living standards and can slow, or even reverse, the widening gap between rich and poor nations. Some of the greatest potential is in small-scale agriculture. Smallholders can boost crop yields though precision farming powered by AI; AI tools can help farmers buy seeds, fertilisers and animals and sell their produce at optimum times and prices; AI-enabled education tools can help farmers learn new techniques.

Articles

Questions

  1. What types of job are most vulnerable to AI?
  2. How will AI change the comparative advantage of low-income countries and what effect will it be likely to have on the pattern of global trade?
  3. Assess alternative policies that governments in high-income countries can adopt to offset the growth in inequality caused by the increasing use of AI.
  4. What policies can governments in low-income countries or aid agencies adopt to offset the growth in inequality within low-income countries and between high- and low-income countries?
  5. How might the growth of AI affect your own approach to career development?
  6. Is AI likely to increase or decrease economic power? Explain.
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How to increase productivity – the key to economic growth

The productivity gap between the UK and its main competitors is significant. In 2024, compared to the UK, output per hour worked was 10.0% higher in France, 19.8% higher in Germany and 41.1% higher in the USA. These percentages are in purchasing-power parity terms: in other words, they reflect the purchasing power of the respective currencies – the pound, the euro and the US dollar.

GDP per hour worked (in PPP terms) is normally regarded as the best measure of labour productivity. An alternative measure is GDP per worker, but this does not take into account the length of the working year. Using this measure, the gap with the USA is even higher as workers in the USA work longer hours and have fewer days holiday per year than in the UK.

The productivity gap is not a new phenomenon. It has been substantial and growing over the past 20 years. (The exception was in 2020 during lockdowns when many of the least productive sectors, such as hospitality, were forced to close temporarily.)

The productivity gap is shown in the two figures. Both figures show labour productivity for the UK, France, Germany and the USA from 1995 to 2024.

Figure 1 shows output (GDP) per hour, measured in US dollars in PPP terms.

Figure 2 shows output (GDP) per hour relative to the UK, with the UK set at 100. The gap narrowed somewhat up to the early 2000s, but since then has widened.

Low UK productivity has been a source of concern for UK governments and business for many years. Not only does it constrain the growth in living standards, it also make the UK less attractive as a source of inward investment and less competitive internationally.

Part of the reason for low UK productivity compared to that in other countries is a low level of investment. As a proportion of GDP, the UK has persistently had the lowest, or almost the lowest, level of investment of its major competitors. This is illustrated in Table 1.

It is generally recognised by government, business and economists that if the economy is to be successful, the productivity gap must be closed. But there is no ‘quick fix’. The policies necessary to achieve increased productivity are long term. There is also a recognition that the productivity problem is a multi-faceted one and that to deal with it requires policy initiatives on a broad front: initiatives that encompass institutional changes as well as adjustments in policy.

So what can be done to improve productivity and how can this be achieved at the micro as well as the macro level?

Improving productivity: things that government can do

Encouraging investment. Over the years, UK governments have increased investment allowances, enabling firms to offset the cost of investment against pre-tax profit, thereby reducing their tax liability. For example, in the UK, companies can offset a multiple of research and development costs against corporation tax. The rate of relief for small and medium-sized enterprises (SMEs) allows companies that work in science and technology to deduct an extra 86% of their qualifying expenditure from their trading profit in addition to the normal 100% deduction: i.e. a total of 186% deduction. Meanwhile, since April 2016, larger companies have been able to claim a R&D expenditure credit, initially worth 11 per cent of R&D expenditures, then 12 per cent from 2018 and 13 per cent from 2020. This was then raised to 20 per cent from 2023.

Strengthening competition. A number of studies have revealed that, with increasing market share, business productivity growth slows. As a result, government policy sought to strengthen competition policy. The Competition Act 1998, which came into force in March 2000, and the Enterprise Act of 2002, enhanced the powers of the Office of Fair Trading (OFT) (a predecessor to the Competition and Markets Authority) in respect to dealing with anti-competitive practices. It was given the ability to impose large fines on firms which had been found guilty of exploiting a dominant market position. Today, one of the strategic goals of the Competition and Markets Authority (CMA) is the aim of ‘extending competition frontiers’ in order to improve the way competition works.

Encouraging an enterprise culture. The creation of an enterprise culture is seen as a crucial factor not only to encourage innovation but also to stimulate technological progress. Innovation and technological progress are crucial to sustaining growth and raising living standards. The UK government launched the Small Business Service in April 2000, later renamed Business and Industry. Its role is to co-ordinate small-business policy within government and liaise with business, providing advice and information. However, according to the OECD, there remains considerable scope for increasing the level of government support for entrepreneurship in the UK.

Improving productivity: things that organisations can do

In the podcast from the BBC’s The Bottom Line series, titled ‘Productivity: How Can British Business Work Smarter’ (see link below), Evan Davis and guests discuss what productivity really looks like in practice – from offices and factories, to call centres and operating theatres.’ The episode identifies a number of ways in which labour productivity can be improved. These include:

  • People could work harder;
  • Workers could be better trained and more skilled and thus able to produce more per hour;
  • Capital could be increased so that workers have more equipment or tools to enable them to produce more, or there could be greater automation, releasing labour to work on other tasks;
  • Workplaces could be arranged more efficiently so that less time is spent moving from task to task;
  • Systems could put in place to ensure that tasks are done correctly the first time and that time is not wasted having to repeat them or put them right;
  • Workers could be better incentivised to work efficiently, whether through direct pay or promotion prospects, or by increasing job satisfaction or by management being better attuned to what motivates workers and makes them feel valued;
  • Firms could move to higher-value products, so that workers produce a greater value of output per hour.

The three contributors to the programme discuss various initiatives in their organisations (an electronics manufacturer, NHS foundation trusts and a provider of office services to other organisations).

They also discuss the role that AI plays, or could play, in doing otherwise time-consuming tasks, such as recording and paying invoices and record keeping in offices; writing grants or producing policy documents; analysing X-ray results in hospitals and performing preliminary diagnoses when patients present with various symptoms; recording conversations/consultations and then sorting, summarising and transcribing them; building AI capabilities into machines or robots to enable them to respond to different specifications or circumstances; software development where AI writes the code. Often, there is a shortage of time for workers to do more creative things. AI can help release more time by doing a lot of the mundane tasks or allowing people to do them much quicker.

There are huge possibilities for increasing labour productivity at an organisational level. The successful organisations will be those that can grasp these possibilities – and in many cases they will be incentivised to so so as it will improve their profitability or other outcomes.

Podcast

Articles

Data

Questions

  1. In what different ways can productivity be measured? What is the most appropriate measure for assessing the effect of productivity on (a) GDP and (b) human welfare generally?
  2. Why has the UK had a lower level of labour productivity than France, Germany and the USA for many years? What can UK governments do to help close this gap?
  3. Find out how Japanese labour productivity has compared with that in the UK over the past 30 years and explain your findings.
  4. Research an organisation of your choice to find out ways in which labour productivity could be increased.
  5. Identify various ways in which AI can improve productivity. Will organisations be incentivised to adopt them?
  6. Has Brexit affected UK labour productivity and, if so, how and why?
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A four-day week – a solution to sluggish productivity growth? (Updated)

In a blog from March 2023 (reproduced below), we saw how there has been growing pressure around the world for employers to move to a four-day week. Increasing numbers of companies have adopted the model of 80% of the hours for 100% of the pay.

As we see below, the model adopted has varied across companies, depending on what was seen as most suitable for them. Some give everyone Friday off; others let staff choose which day to have off; others let staff work 80% of the hours on a flexible basis. Firms adopting the model have generally found that productivity and revenue have increased, as has employee well-being. To date, over 200 employers in the UK, employing more than 5000 people, have adopted a permanent four-day week.

This concept of 100-80-100, namely 100% of pay for 80% of hours, but 100% of output, has been trialled in several countries. In Germany, after trials over 2024, 73% of the companies involved plan to continue with the new model, with the remaining 27% either making minor tweaks or yet to decide. Generally hourly productivity rose, and in many cases total output also rose. As the fourth article below states:

The primary causal factor for this intriguing revelation was simple – efficiency became the priority. Reports from the trial showed that the frequency and duration of meetings was reduced by 60%, which makes sense to anyone who works in an office – many meetings could have been a simple email. 25% of companies tested introduced new digitised ways of managing their workflow to optimise efficiency.

Original post

In two previous posts, one at the end of 2019 and one in July 2021, we looked at moves around the world to introduce a four-day working week, with no increase in hours on the days worked and no reduction in weekly pay. Firms would gain if increased worker energy and motivation resulted in a gain in output. They would also gain if fewer hours resulted in lower costs.

Workers would be likely to gain from less stress and burnout and a better work–life balance. What is more, firms’ and workers’ carbon footprint could be reduced as less time was spent at work and in commuting.

If the same output could be produced with fewer hours worked, this would represent an increase in labour productivity measured in output per hour.

The UK’s poor productivity record since 2008

Since the financial crisis of 2007–8, the growth in UK productivity has been sluggish. This is illustrated in the chart, which looks at the production industries: i.e. it excludes services, where average productivity growth tends to be slower. The chart has been updated to 2024 Q2 – the latest data available. (Click here for a PowerPoint of the chart.)

Prior to the crisis, from 1998 to 2006, UK productivity in the production industries grew at an annual rate of 6.9%. From 2007 to the start of the pandemic in 2020, the average annual productivity growth rate in these industries was a mere 0.2%.

It grew rapidly for a short time at the start of the pandemic, but this was because many businesses temporarily shut down or went to part-time working, and many of these temporary job cuts were low-wage/low productivity jobs. If you take services, the effect was even stronger as sectors such as hospitality, leisure and retail were particularly affected and labour productivity in these sectors tends to be low. As industries opened up and took on more workers, so average productivity rapidly fell back. Since then productivity has flatlined.

If you project the average productivity growth rate from 1998 to 2007 of 6.9% forwards (see grey dashed line), then by 2024 Q3, output per hour in the production industries would have been 3.26 times higher than it actually was: a gap of 226%. This is a huge productivity gap.

Productivity in the UK is lower than in many other competitor countries. According to the ONS, output per hour in the UK in 2021 was $59.14 in the UK. This compares with an average of $64.93 for the G7 countries, $66.75 in France, £68.30 in Germany, $74.84 in the USA, $84.46 in Norway and $128.21 in Ireland. It is lower, however, in Italy ($54.59), Canada ($53.97) and Japan ($47.28).

As we saw in the blog, The UK’s poor productivity record, low UK productivity is caused by a number of factors, not least the lack of investment in physical capital, both by private companies and in public infrastructure, and the lack of investment in training. Other factors include short-termist attitudes of both politicians and management and generally poor management practices. But one cause is the poor motivation of many workers and the feeling of being overworked. One solution to this is the four-day week.

Latest evidence on the four-day week

Results have just been released of a pilot programme involving 61 companies and non-profit organisations in the UK and nearly 3000 workers. They took part in a six-month trial of a four-day week, with no increase in hours on the days worked and no loss in pay for employees – in other words, 100% of the pay for 80% of the time. The trial was a success, with 91% of organisations planning to continue with the four-day week and a further 4% leaning towards doing so.

The model adopted varied across companies, depending on what was seen as most suitable for them. Some gave everyone Friday off; others let staff choose which day to have off; others let staff work 80% of the hours on a flexible basis.

There was little difference in outcomes across different types of businesses. Compared with the same period last year, revenues rose by an average of 35%; sick days fell by two-thirds and 57% fewer staff left the firms. There were significant increases in well-being, with 39% saying they were less stressed, 40% that they were sleeping better; 75% that they had reduced levels of burnout and 54% that it was easier to achieve a good work–life balance. There were also positive environmental outcomes, with average commuting time falling by half an hour per week.

There is growing pressure around the world for employers to move to a four-day week and this pilot provides evidence that it significantly increases productivity and well-being.

Additional articles

Original set of articles

Questions

  1. What are the possible advantages of moving to a four-day week?
  2. What are the possible disadvantages of moving to a four-day week?
  3. What types of companies or organisations are (a) most likely, (b) least likely to gain from a four-day week?
  4. Why has the UK’s productivity growth been lower than that of many of its major competitors?
  5. Why, if you use a log scale on the vertical axis, is a constant rate of growth shown as a straight line? What would a constant rate of growth line look like if you used a normal arithmetical scale for the vertical axis?
  6. Find out what is meant by the ‘fourth industrial revolution’. Does this hold out the hope of significant productivity improvements in the near future? (See, for example, last link above.)
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UK banking regulation: ring-fencing revisited

The UK government announced on 14 October 2024 in a ministerial statement that it intended to raise the threshold for the ring-fencing (separation) of retail and investment banking activities of large UK-based banks. These banks are known as ‘systemically important financial institutions (SIFIs)’, which are currently defined as those with more than £25bn of core retail deposits. Under the new regulations, the threshold would rise from £25bn to £35bn.

Ring-fencing is the separation of one set of banking services from another. This separation can be geographical or functional. The UK adopted the latter approach, where ring-fencing is the separation of core retail banking services, such as taking deposits, making payments and granting loans to small and medium-sized enterprises (SMEs) from investment banking and international operations. The intention of ring-fencing was to prevent contagion – to protect essential retail banking services from the risks involved in investment banking activities.

Reducing regulation to increase competition

Raising the limit is intended to facilitate greater competition in the retail banking sector. In recent years, US banks, such as JP Morgan and Goldman Sachs, have been expanding their depositor base in the UK under their respective brands – Chase UK and Marcus.

These relatively small UK subsidiaries were not ring-fenced from their wider investment banking operations as their retail deposits were under (but not far under) the £25bn limit. However, this restricted their ability to increase market share further without bearing the additional regulatory burden associated with ring-fencing that much larger incumbents face. Raising the threshold would allow them to expand to the higher limit without the regulatory burden.

The proposals are part of a broader package of reforms aimed at reducing the regulatory burden on UK-based banks. The hope is that this will stimulate greater lending to SMEs to boost investment and productivity.

The proposals also include a new ‘secondary’ threshold. This will exempt banks providing primarily retail banking services from the rules governing the provision of investment banking accounts. This exemption will apply as long as their investment banking is less than 10% of their tier 1 capital. (Tier 1 capital is currently the buffer which banks are required to retain in case of a crisis.) The changes were the outcome of a review conducted in 2022 but had not been implemented by the previous government.

The announcement has sparked a debate about ring-fencing, with some commentators calling for it to be removed altogether. Therefore, it is timely to revisit the rationale for ring-fencing. This blog examines what ring-fencing is and why it was introduced, and explains the associated economic costs and benefits.

Why was ring-fencing introduced?

Ring-fencing was recommended by the Independent Commission on Banking (ICB) in 2011 (see link below) and implemented through the Financial Services (Banking Reform) Act of 2013. The proposed separation of core retail banking services from investment banking were intended to address issues in banks which arose during the global financial crisis and which required substantial taxpayer bailouts. (See the 2011 blog, Taking the gambling out of high street banking (update).)

Following deregulation and liberalisation of financial services in the 1980s, many UK banks had extended their operations so that they combined domestic retail operations with substantial investment and international operations. The intention was to open up all dimensions of financial services to greater competition and allow banks to exploit economies of scope between retail and investment banking.

However, the risks associated with these services are very different but, in the period before the financial crisis, were provided alongside one another within banking groups.

One significant risk which was not fully recognised at the time was contagion – problems in one dimension of a bank’s activity could severely compromise its ability to provide services in other areas. This is what happened during the financial crisis. Many of the UK banks’ investment operations had made significant investments in off-balance sheet securitised debt instruments – CDOs being the most famous example. (See the 2018 blog, Lehman Brothers: have we learned the lessons 10 years on?.)

When that market crashed in 2007, several UK-based banks incurred significant losses, as did other banks around the world. Given their thin equity buffers and the inability to borrow due to a credit crunch, such banks found it impossible to bear these losses.

The UK government had to step in to save these institutions from failing. If it had not, there would have been significant economic and social costs associated with their inability to provide core retail banking functions. (See the 2017 blog, Ten years on.)

The Independent Commission proposed that ‘the risks inevitably associated with banking have to sit somewhere, and it should not be with taxpayers. Nor do ordinary depositors have the incentive (given deposit insurance to guard against runs) or the practical ability to monitor or bear those risks’ (p.9). Unstructured banks, with no separation of retail from investment activities, increase the potential for both of these stakeholder groups to bear the risks of investment banking.

Structural separation of retail and investment banking addresses this problem. First, separation should make it easier and less costly to resolve problems for banks that get into trouble, avoiding the need for taxpayer bailouts. Second, structural separation should help to insulate retail banking from external financial shocks, ensuring that customer deposits and essential banking services are protected.

Problems of ring-fencing

Ring-fencing has been subject to criticism, however, which has led to calls for it to be scrapped.

It must be noted that most of the criticism comes from banks themselves. They state that it required significant operational restructuring by UK banks subject to the regulatory framework which was complex and costly.

In addition, segregating activities can lead to inefficiencies, as banks may not be able to take full advantage of economies of scope between investment and retail banking. Furthermore, ring-fencing could lead to a misallocation of capital, where resources are trapped in one part of the bank and cannot be used to invest in other areas, potentially increasing the risks of the specific areas.

Assessing the new proposals

It is argued that the increased threshold proposed by the authorities may put UK institutions at a competitive disadvantage to outside entrants that are building market share from a low base. Smaller entrants do not have to engage in the costly restructuring that the larger UK incumbents have. They can exploit scope economies and capital mobility within their international businesses to cross-subsidise their retail services in the UK which incumbents with larger deposit-bases are not able to.

However, the UK market for retail banking has significant barriers to entry. Following the acquisition of Virgin Money by Nationwide, only six banking groups in the UK meet the current threshold (Barclays, HSBC, Lloyds Banking Group, NatWest Group, Santander UK and TSB). Indeed, all of those have deposits well above the proposed £35bn threshold. Consequently, raising the threshold should not add significant compliance and efficiency costs, while the potential benefits of greater competition for depositors and SMEs could be a substantial boost to investment and productivity. Furthermore, if the new US entrants do suffer problems, it will not be UK taxpayers who will be liable.

Have we been here before?

In many ways, ring-fencing is a throwback to a previous age of regulation.

One of the most famous Acts of Congress relating to finance and financial markets in the USA is the Glass-Steagall Act of 1933. The Act was passed in the aftermath of the 1929 Wall Street crash and the onset of the Great Depression in the USA. That witnessed significant bank failures across the country and problems were traced back to significant losses made by banks in their lending to investors during the speculative frenzy that preceded the stock market crash of 1929.

To prevent a repeat of the contagion and ensure financial stability, Glass-Steagall legislated to separate retail banks and investment banks.

In the UK, such separation had long existed due to the historical restrictions placed on investment banks operating in the City of London. In the late 20th century, the arguments for separation became outweighed by arguments for the liberalisation of markets to improve efficiency and competition in financial services. Banking was increasingly deregulated and separation disappeared as retail banks increasingly engaged in investment activities.

That cycle of deregulation reached its nadir in 2007 with the international financial crisis. The need to bail out banks made it clear that the supposed synergies between investment and retail banking were no compensation for the high costs of contagion in the financial system.

Regulators must be wary of calls for the removal of ring-fencing. Sir John Vickers (chairman of the independent commission on banking) highlighted the need to protect depositors, and more importantly taxpayers, from risks in banking. It is the banks that should bear the risks and manage them accordingly. Ultimately, it is up to the banks to do that better.

Articles

Bank annual reports

Access these annual reports to check the deposit base of these UK banks:

Information

Report

  • Final Report: Recommendations

    • The Independent Commission on Banking, Sir John Vickers (Chair), Clare Spottiswoode, Martin Taylor, Bill Winters and Martin Wolf (September 2011)

Questions

  1. How did the structure of UK banks cause contagion risk in the period before the global financial crisis?
  2. How does ring-fencing aim to address this and protect depositors and taxpayers?
  3. Use the links to the annual reports of the covered banks to assess the extent of deposits held by the institutions in 2023. How far above the proposed buffer do the banks sit?
  4. Use your answer to 3) and economic concepts to analyse the impact on competition in the UK market for retail deposits of raising the threshold.
  5. What are the risks for financial stability of raising the threshold?
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Crude oil – a volatile market

The market for crude oil is usually a volatile one. Indeed, in the last few months, the market has seen prices rise and fall due to various supply and demand influences. Crude oil is coined the ‘King of Commodities’ due to the impact it has on consumers, producers and both the micro and macro economy. The price of crude oil affects everything from the cost of producing plastics, transportation, and food at the supermarket.

This makes the market for crude oil an economic powerhouse which is closely watched by businesses, traders, and governments. To gain a full understanding of the movements in this market, it is important to identify how demand and supply affect the price of crude oil.

What influences the demand and supply of crude oil?

The law of demand and supply states that if demand increases, prices will rise, and if supply increases, prices will fall. This is exactly what happens in the market for crude oil. The consumer side of the market consists of various companies and hundreds of millions of people. The producer side of the market is made up of oil-producing countries. Collectively, both consumers and producers influence the market price.

However, the demand and supply of crude oil, and therefore the price, is also affected by global economic conditions and geopolitical tensions. What happens in the world impacts the price of oil, especially since a large proportion of the world’s biggest oil producers are in politically unstable areas.

Over the past five years, global events have had a major impact on the price of oil. The economic conditions created by the impact of the COVID pandemic saw prices plummet from around $55 per barrel just before the pandemic in February 2020 to around $15 per barrel in April 2020. By mid-2021 they had recovered to around $75 per barrel. Then, in the aftermath of Russia’s invasion of Ukraine in February 2022, the price surged to reach $133 in June 2022. More recently, geopolitical tensions in the Middle East and concerns about China’s economic outlook have intensified concerns about the future direction of the market. (Click here for a PowerPoint of the chart.)

Geopolitical tensions

In the first week of October 2024, the price of crude oil rose by almost 10% to around $78 per barrel as the conflict in the Middle East intensified. It unfortunately comes at a time when many countries are starting to recover from the rise in oil prices caused by the pandemic and the war in Ukraine. Any increase in prices will affect the price that consumers pay to fill up their vehicles with fuel, just when prices of diesel and petrol had reached their lowest level for three years.

The Governor of the Bank of England, Andrew Bailey, has said that the Bank is monitoring developments in the Middle East ‘extremely closely’, as the conflict has the potential to have serious impacts in the UK. The Bank of England will therefore be watching for any movement in oil prices that could fuel inflation.

The main concerns stem from further escalation in the conflict between Israel and the Iran-backed armed group, Hezbollah, in Lebanon. If Israel decides to attack Iran’s oil sector, this is likely to cause a sharp rise in the price of oil. Iran is the world’s seventh largest oil exporter and exports over half of its production to China. If the oilfields of a medium-sized supplier, like Iran, were attacked, this could threaten general inflation in the UK, which could in turn influence any decision by the Bank of England to lower interest rates next month.

Supply deficits

This week (2nd week of October 2024) saw the price of crude oil surge above $81 per barrel to hit its highest level since August. This rise means that prices increased by 12% in a week. However, this surge in price also means that prices rose by almost 21% between the start September and the start of October alone. Yet it was only in early September when crude oil hit a year-to-date low, highlighting the volatility in the market.

As the Middle-East war enters a new and more energy-related phase, the loss of Iranian oil would leave the market in a supply deficit. The law of supply implies that such a deficit would lead to an increase in prices. This also comes at a time when the US Strategic Petroleum Reserve has also been depleted, causing further concerns about global oil supply.

However, the biggest and most significant impact would be a disruption to flows through the Strait of Hormuz. This is a relatively narrow channel at the east end of the Persian Gulf through which a huge amount of oil tanker traffic passes – about a third of total seaborne-traded oil. It is therefore known as the world’s most important oil transit chokepoint. The risk that escalation could block the Strait of Hormuz could technically see a halt in about a fifth of the world’s oil supply. This would include exports from big Gulf producers, including Saudi Arabia, UAE, Kuwait and Iraq. In a worst-case scenario of a full closure of the Strait, a barrel of oil could very quickly rise to well above $100.

Disruption to shipments would also lead to higher gas prices and therefore lead to a rise in household gas and electricity bills. As with oil, gas prices filter down supply chains, affecting the cost of virtually all goods, resulting in a further rise in the cost of living. With energy bills in the UK having already risen by 10% for this winter, an escalation to the conflict could see prices rise further still.

China’s economic outlook


Despite the concern for the future supply of oil, there is also a need to consider how the demand for oil could impact price changes in the market. The price of oil declined on 14 October 2024 in light of concerns over China’s struggling economy. As China is the world’s largest importer of crude oil, there are emerging fears about the potential limits on fuel demand. This fall in price reversed increases made the previous week as investors become concerned about worsening deflationary pressures in China.

Any reduced demand from China could indicate an oversupply of crude oil and therefore potential price declines. Official data from China reveal a sharp year-on-year drop in the producer price index of 2.8% – the fastest decline in six months. These disappointing results have stirred uncertainty about the Chinese government’s economic stimulus plans. Prices could fall further if there are continuing doubts about the government’s ability to implement effective fiscal measures to promote consumer spending and, in turn, economic growth.

As a result of the 2% price fall in oil prices on 14 October, OPEC (the Organization of the Petroleum Exporting Countries) has lowered its 2024 and 2025 global oil demand growth. This negative news outweighed market concerns over the possibility that an Israeli response to Iran’s missile attack could disrupt oil production.

What is the future for oil prices?

It is expected that the market for oil will remain a volatile one. Indeed, the current uncertainties around the globe only highlight this. It is never a simple task to predict what will happen in a market that is influenced by so many global factors, and the current global landscape only adds to the complexity.

There’s a wide spectrum of predictions about what could come next in the market for crude oil. Given the changes in the first two weeks of October alone, supply and demand factors from separate parts of the globe have made the future of oil prices particularly uncertain. Callum Macpherson, head of commodities at Investec, stated in early October that ‘there is really no way of telling where we will be this time next week’ (see the first BBC News article linked below).

Despite the predominately negative outlook, this is all based on potential scenarios. Caroline Bain, chief commodities economist at Capital Economics suggests that if the ‘worst-case scenario’ of further escalation in the Middle East conflict does not materialise, oil prices are likely to ‘ease back quite quickly’. Even if Iran’s supplies were disrupted, China could turn to Russia for its oil. Bain says that there is ‘more than enough capacity’ globally to cover the gap if Iranian production is lost. However, this does then raise the question of where the loyalty of Saudi Arabia, the world’s second largest oil producer, lies and whether it will increase or restrict further production.

What is certain is that the market for crude oil will continue to be a market that is closely observed. It doesn’t take much change in global activity for prices to move. Therefore, in the current political and macroeconomic environment, the coming weeks and months will be critical in determining oil prices and, in turn, their economic effects.

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Questions

  1. Use a demand and supply diagram to illustrate what has happened to oil prices in the main two scenarios:
    (a) Conflict in the Middle East;
    (b) Concerns about China’s economic performance.
  2. How are the price elasticities of demand and supply relevant to the size of any oil price change?
  3. What policy options do the governments have to deal with the potential of increasing energy prices?
  4. What are oil futures? What determines oil future prices?
  5. How does speculation affect oil prices?