Asset prices, bubbles and quantitative easing
Transcript
What has happened to the price of assets since the start of last year?
This time last year asset values were falling precipitously. The FTSE 100, the main index for the UK’s leading shares, lost almost half its value between its peak in the middle of 2007 and March last year, and house prices were declining fairly rapidly. As we know now, in the first three months of 2009 the UK economy shrank more than it did during the whole of the 1990s recession. Large falls in asset prices added to the misery.
But since then things have picked up: equity prices have risen by over 50%, and house prices, after reaching a trough in March, are now back up by around 7%.
Why does this matter?
The price of assets, and in this case the price of stocks and shares, and of the homes we live in, matter because they are directly related to wealth, and changes in personal wealth affect the spending and saving decisions of individuals and companies.
The wealth of a person or business depends directly on the value of the assets they possess. During the recession, as the price of assets fell, household and corporate wealth also fell. In fact it took a pretty big hit. In the UK household wealth fell by about £1.1trillion. This put households in a position of needing to repair their balance sheets and restore this lost wealth.
Thus it impacted on spending and investment decisions. In a broad sense we base these decisions on how wealthy we feel - spending more when we’re feeling flush and saving the pennies when things are a bit tight. This hit to wealth made the average person on the street about 20% worse off. As a result we cut back spending and started saving more. The paradox of this kind of behaviour is that lower spending means the economy can support fewer jobs, so more people are made unemployed. Spending less and saving more actually made the country poorer in the short term and exacerbated the downward spiral of the recession.
Rising asset prices helped stem this tide, reducing the pressure on consumers to pull back on spending by partially restoring their lost wealth. Asset values are still below their peak so there will still be a drag on spending, but it won’t be half as bad as it was.
What is quantitative easing and has it played a part?
Quantitative easing was introduced by the Bank of England in March last year to help boost growth in the economy. The way it works is the Bank of England creates money electronically and uses this to buy government bonds from the private sector. This reduces the yield on these bonds – equivalent to the interest the government has to pay – which in turn reduces the yield on riskier assets, like corporate bonds and equities. The idea is that companies, for example pension companies, sell government bonds to the Bank of England and uses the cash to buy these other assets.
By encouraging private companies to buy bonds and shares this boosts their price, increases wealth and restores collateral values. So yes, quantitative easing has definitely played a part in increasing asset prices.
Evidence of its effect on economic activity is less clear cut, but it is encouraging that the economic contraction ended in the last three months of 2009, suggesting the recession has come to an end and a recovery may soon get underway.