Summary of Quarterly Bulletin
August 1998

Research work published by the Bank is intended to contribute to debate, and is not necessarily a statement of Bank policy.

The UK personal and corporate sectors during the 1980s and 1990s: a comparison of key financial indicators (243k)
(by Glenn Hoggarth of the Bank’s Financial Intermediaries Division and Alec Chrystal of the Bank’s Monetary Assessment and Strategy Division).
This article draws together some key indicators of financial conditions in the personal and corporate sectors, which may provide interesting insights into aspects of the behaviour of the UK economy during the course of the two most recent business cycles. Although the main focus is retrospective, this analysis could also help to assess the likely future course of important components of aggregate demand.

There are both similarities and differences in the financial positions of the corporate and personal sectors in the 1980s and 1990s. The current level of income gearing in both sectors is similar to the comparable stage of the previous economic cycle (end 1986) - debt levels are currently higher, but nominal interest rates are lower. In the 1980s, there was little change in income gearing for either the corporate or personal sectors prior to the sharp tightening of monetary policy in 1988, but the marked rise afterwards preceded the 1990­92 recession. No comparable rise in income gearing has yet been evident in the 1990s recovery, though it has risen slightly following the interest rate rises since Spring 1997.

ICCs’ capital gearing has been above the level of the mid 1980s throughout the current recovery, but so far has shown no signs of the kind of deterioration that occurred after 1987. Similarly, the stock of personal sector debt began this recovery at a higher level than in the early 1980s but, unlike then, has grown no faster than incomes and slower than wealth so far during the 1990s.

There are other contrasts between the 1980s and 1990s recoveries. With regard to lending flows, in the 1980s boom, there was a channelling of funds to ICCs and personal housing loans. But in the current recovery, lending has been channelled more towards unsecured consumer credit and to OFIs. With regard to asset prices, in the 1980s, property and equity prices rose markedly in tandem. Although equity prices have again risen strongly in the 1990s, property prices have so far risen slowly in comparison.

During the 1980s, the spread of bank and building society mortgage rates over base rate fell only towards the end of the boom and only as a result of a delayed response to the increase in official rates. In contrast, since the early 1990s, lending spreads in the mortgage market have fallen, as they appear to have done in other main lending markets. This may have contributed to the growth in lending during this recovery, but does not necessarily imply an increase in financial risk, so long as the financial status of borrowers has improved.

The evolution of the financial position of the personal sector during the 1980s probably reflected a steady response to financial liberalisation from a starting position of sub-optimal debt levels - total personal debt rose much more rapidly than incomes, and at least in line with the rapid growth in personal wealth. Although consumer credit has increased at least as much relative to incomes during the current upswing as in the previous one, it now still accounts for only around one eighth of personal sector debt. As noted above, the relatively slow growth in lending for house purchase so far during this upswing has meant that the personal sector debt/income ratio has remained flat, while the debt/wealth ratio has fallen. This suggests that the upward adjustments in personal sector debt levels that followed the 1980s liberalisation may have been completed before the current recovery.

Are prices and wages sticky downwards? (80k)
(by Anthony Yates of the Bank’s Structural Economic Analysis Division).
In this article, Anthony Yates examines the theoretical and empirical evidence for prices being sticky downwards - in other words, for the existence of downward nominal rigidities. This evidence has most commonly been cited in the context of wages - if downward nominal rigidities exist and prevent wages from adjusting fully to a shock to demand or supply, then such a shock may affect levels of employment.

The article reviews the theoretical and empirical evidence for the existence of downward nominal rigidities. It argues that, contrary to the reasoning implicit in studies by others, a concern about fairness is not sufficient to generate downward nominal rigidities in wages. Other assumptions are also needed: that there are union cartels; or that individuals/unions have no knowledge of outside wages; or that individuals/unions are highly averse to falling behind when wage contracts are staggered. A second possibility raised in the literature is that individuals might suffer from money-illusion. But they must also display loss aversion for this to be an explanation of downward nominal rigidities.

Three arguments are advanced to support the existence of downward nominal rigidities in product markets. Price cuts may confuse customers used to positive inflation (a form of money-illusion); may be interpreted as quality cuts (and buyers are subject to money-illusion); and may be inhibited by strategic behaviour between firm cartels.

Four types of empirical evidence are examined:

• the frequency of wage and price cuts, which is not particularly illuminating, since it is unknown how frequent wage and price cuts would be in a frictionless world running at a given inflation rate;
• the skewness of the distribution of wage and price changes, which should be negatively related to the mean if downward nominal rigidities were operating. This was generally found not to be the case for either wages or prices in the United Kingdom;
• survey evidence (in particular from the Bank) on how firms set prices, which shows that prices are downwardly rigid in response to some phenomena, but upwardly so in response to others; and
• evidence on the UK Phillips curve, which it has been argued is not significantly convex.

Much of the empirical evidence is only consistent with and not proof of downward nominal rigidities, and tests have not revealed the existence of downward nominal rigidities in countries or time periods in which prices were falling. Moreover, there are theoretical models that predict that at positive rates of inflation, we are more rather than less likely to detect empirical relationships that reveal an apparent downward nominal rigidity.

In short, the theoretical arguments for downward nominal rigidities are more complex than much of the literature would have us believe. The empirical evidence leaves the case for downward nominal rigidities at best unproven.

Why has the female unemployment rate in Britain fallen? (194k)
(by Phil Evans of the Bank’s Structural Economic Analysis Division).
In this article, Phil Evans examines recent trends in male and female unemployment, and finds that the fall in aggregate unemployment between 1984 and 1993 is wholly accounted for by a decrease in female unemployment. This lower female unemployment rate is almost fully explained by a fall in the rate at which women become unemployed; this fall is uniform across skill groups and is particularly significant among women with young children. He suggests that increased workplace assistance to women with young children has reduced the frictions in the female labour market, and may have lowered the natural rate of female unemployment.

The article suggests that certain frictions in the female labour market, especially those associated with having young children, lessened in the late 1980s and early 1990s, and explain much of the fall in female inflow rates. Identifying reduced frictions is particularly important because it implies that the natural rate of female unemployment may have fallen, perhaps accounting for some of the increase in earnings growth at given unemployment rates during the 1990s.

The preferred explanations given focus on the restrictions on the set of available jobs that are acceptable to women, mainly due to the presence of young children. When mothers are considering a return to work after childbirth, they have to search the set of available vacancies, which takes time and effort. But many firms have increased flexibility and other provisions that help mothers of young children return to their previous employer, and these offers are immediately apparent without the need for job search. So returning mothers, on average, now face fewer frictions in finding work after childbirth.

Though the analysis presented suggests that falling female unemployment has lowered aggregate unemployment, more needs to be known about how much of the fall has simply displaced male workers. But this article does set out some of the stylised facts on female unemployment, and offers some suggestive evidence on what might explain these trends.

Testing value-at-risk approaches to capital adequacy (643k)
(by Patricia Jackson and William Perraudin of the Bank’s Regulatory Policy Division and David Maude of the Bank’s Monetary Assessment and Strategy Division).
This article looks at the nature of whole-book value-at-risk models, and describes how the Bank of England set out in 1995 to assess their performance in accurately predicting risk and in providing a basis for reliable trading-book capital calculations.

The article sets out the results of the tests carried out by the Bank to assess the accuracy of the risk-measurement models used by firms to evaluate risk on their trading-book portfolios. The main conclusions from these tests were as follows:

• Different VaR models performed more or less well in supplying unbiased measures of the value at risk. (For some VaR models built with a 99% confidence level, significantly more than 1% of losses exceeded the value-at-risk estimate.)
• Simulation-based VaR models met this test better than parametric VaR models based on normal distributions, because of the severely fat-tailed nature of reasonably diversified fixed-income exposures. Most banks’ trading books are made up largely of such exposures.
• Use of short data samples (or a weighting scheme that places heavy weight on recent data) worsened the biases in the VaR estimates for parametric models.
• The extra safeguards around the use of the VaR models (the requirement that a firm must meet the higher of the estimated VaR, or three times the 60-day moving average of the current and past VaRs) would probably mean, for market-risk models of the kind tested, that only extremely risky portfolios would fail to be covered by sufficient capital.
• The back-testing requirements incorporated in the Basel approach are likely to lead to some banks holding higher capital. A bank holding the portfolios employed in the study could find its capital requirements adjusted upwards from time to time if it used the parametric approach.

The cyclicality of mark-ups and profit margins: some evidence for manufacturing and services (183k)
(by Ian Small of the Bank’s Structural Economic Analysis Division).
This article reviews how price-cost mark-ups and firm profit margins in UK manufacturing and services behave over the business cycle, to see whether they move pro-cyclically. Movements in mark-ups and margins are important because of their effect on prices: pro-cyclical changes might suggest that price pressures increase during recovery periods and decrease during recessions.

The article aims to extend the existing work by examining whether mark-ups and profit margins are pro-cyclical not only in manufacturing, but also in non-manufacturing industries, particularly retailing.

It looks at the cyclicality of mark-ups, using Haskel et al’s extension to Robert Hall’s method of estimating mark-ups. It then looks at the cyclicality of firm profit margins, using Machin and Van Reenen’s model of firm profitability, to see if profit margins are still pro-cyclical even after adjusting for other factors that vary with time. Using these two different approaches and datasets acts as a test on the reliability and robustness of the results.

The article presents evidence that both mark-ups and profit margins are pro-cyclical in services as well as in manufacturing. This suggests that price pressures may move in line with the business cycle, increasing during the recovery period and decreasing during recessions.