Friday, 2 October 2015

Posts on Russia

I wrote a number of posts on Forbes about Russia at the back end of 2014. At the time, there was a lot going on with the currency, the central bank and the banks. So for ease of reference, I've collected them here, in chronological order.

Why the Russian Central Bank can't defend the ruble

Has the Russian Central Bank thrown in the towel?

The Russian Central Bank is regaining control, but for how long?

Oil, sanctions and Russian politics

How to destroy a currency, Russian style

Russia and the banks

How OPEC destroyed the Russian ruble

Russian ruble: Let it fall, let it fall, let it fall

The Great Russian Bank Bailout

Why does Venezuela think Russia is its friend?

No doubt there will be more in due course. Russia and its problems are not going away any time soon.

The "something for nothing" society

While visiting Germany in the summer, I was struck by the prevalence of adverts saying something on the lines of "Sie sparen können". I've never seen a society so obsessed with saving, not in the sense of putting money away (though they do that too) but in the sense of reducing costs. Never mind the quality, look  at the price. "You can save". Always.

Penny-pinching is by no means limited to German households. Ever since we collectively decided, on September 16th 2008, that the money had run out, we have all - households and businesses - been scrimping and saving like mad, reluctant to spend money in case we too run out. We look for bargains, delay purchases until end-of-season sales, and avoid paying for things unless we absolutely have to. We have become a "something for nothing" society.

At an individual level, this seems sensible. Most people have limited incomes, and wages have stagnated for a long time now. Businesses, too, have felt the pinch: sales have fallen, and they have been forced to reduce prices and cut costs to the bone. Money is scarce, so we must use it carefully. Thrift and prudence are the way to prosperity. Generosity is a luxury we can't afford.

But this is the madness of crowds. When everyone is cutting costs, hunting for bargains and trying to get something for nothing, no-one can make any money. And this bears down on incomes. If businesses are forced to cut prices, they won't increase wages and they may lay off staff or cut working hours. When the employed find their incomes squeezed, they stop using the services of small businesses and the self-employed. When small businesses and the self-employed can't find work, their incomes crash and many go out of business. Miserliness doesn't lead to prosperity, and deflation is not benign. It causes depression and poverty, particularly among those who lead precarious lives.

Nowhere is this more apparent than in today's internet-based small businesses. People have come to expect expect things they find on the internet to be free, or nearly so: music, writing, statistics, apps.... It has never been so easy to create and publish original material, and never so difficult to earn an income from doing so.

Journalists worry that their industry is dying, because of competition from millions of free blogposts and the growing tendency of internet surfers to dip into lots of publications rather than concentrating on a few. The days of being able to rely on subscriptions from devoted readers are over: if you put your publication behind a paywall, you lose readers. Most online journals have learned to allow access to at least some articles free. The biggest exception to this is the academic publishing world, which still manages to keep most of its publications gated. But there are moves to undermine this, as academics themselves publish ungated working papers and new sites spring up that help them to do so.

There is a real dilemma here. Information is a social good. Arguably, it should be free. After all, what is the point of academic research if the only people who can read it are those who can get past an academic paywall, which generally speaking means other academics? What is the point of data that is difficult and expensive to obtain? What is the point of articles that are only read by a few people? But if information is completely free, the labour of those who produce that information goes unrewarded. Intellectual property becomes worthless.

This has, of course, long been a problem in the entertainment world. People love to be entertained, but they really don't want to pay for it. They don't see entertaining people as "work". After all, performers love to perform, don't they? Why should we pay them for doing something that they love?

This creates a real dilemma for performers. Most do, indeed, love performing. If they refuse to perform unless they are paid, therefore, they risk not doing what they love. They also risk not eating. Whether a performer gets paid well for their work depends on two things: whether they are bloody-minded enough to refuse to perform if the pay isn't good enough, and whether they have another source of income that pays the bills, so they don't have to take badly-paid jobs. Performers who are either too devoted to their art or too poor to survive without it don't earn money.

Journalism and the performing arts are, of course, service industries. We still seem wedded to the idea that proper work is "making stuff", and working in a service industry isn't proper work so doesn't deserve proper pay. But as "making stuff" increasingly becomes the province of robots, service industries are the future of employment. And at present, we haven't got our heads round the idea that people in service industries should be well paid. It's not just in the entertainment world that making a decent income is next to impossible. The worst paid workers in society are those in the care sector and the hospitality sector. We really don't want to pay people to look after our children, our elderly parents and our sick and disabled relatives. Nor do we want to pay people to clean our houses and offices and serve us meals. Apparently we can't afford it.

But pushing down prices in service sectors has unfortunate consequences, not just for those working in that sector but for society as a whole. If everyone expects to pay rock-bottom prices, or preferably nothing at all, price is no longer an indicator of quality and Gresham's Law prevails. Why put in the time and effort to produce good writing or deliver good care? You won't be paid for it. There is no point in being more than perfunctory. If you love your work, and feel that you can make a difference by doing a good job, you will simply be exploited. Might as well sell lemons.

The tendency for poor work to drive out good when prices are very low degrades service industries. We decry the declining quality of online articles and long for something better written and researched, not seeing that this is the inevitable consequence of avoiding paying for good writing (I confess, I avoid paywalls too). This is bad enough. But in the care sector, reluctance to pay for quality is disastrous. When good quality care is driven out by bad, the result is abused children, neglected elders and suffering among the sick and disabled. And when benefits are cut because well-off people with good jobs object to those less fortunate than themselves apparently getting something for nothing, suffering is amplified. Miserliness creates misery.

Scrimping and saving in the private sector can be offset by generosity in the public sector. When people and businesses won't spend, government must. But we have now convinced ourselves that government has run out of money too, and so must scrimp and save like us. When government becomes as miserly as the private sector, the only source of income becomes external trade. This can work well if other countries are enjoying the good life, as Germany discovered in the mid-2000s. But when the whole world decides that there is no money left and everyone - government, business, households - must scrimp and save, the result is global misery.

When every country in the world is pursuing an export-led growth strategy, export-led growth becomes impossible. We simply end up with competitive monetary easing as countries try to steal demand from each other, falling global trade and declining global growth. That is where we are now. Historically, such a position has been followed by growing use of tariffs and barriers to trade and restrictions on the movement of goods and people. And since everyone likes to find someone else to blame for their own problems - and governments are particularly keen on this - global miserliness tends to lead to social and political unrest, cross-border skirmishes, local conflicts and outright war.

We desperately need a change of attitude. And I think that attitude change must come from the micro, not the macro, level. From individuals changing their behaviour. We need to stop scrimping and saving and learn to enjoy the good life again.

So if you are in the habit of bargain hunting and trying to get something for nothing, think again - especially if you are fortunate enough to be in a secure well-paid job. Look for quality, not price. Expect to pay for quality goods and services. And be generous. It is generosity, not miserliness, that creates prosperity.

Related reading:

IMF World Economic Outlook - IMF

Image (unsurprisingly) from Since they are advising people on how to get something for nothing, I didn't pay for my use of the image. I'm sure they won't mind, will they?

Thursday, 1 October 2015

Capital, liquidity and the countercyclical buffer, in plain English

The FT reports that due to “modest but rising credit growth”, the Bank of England’s Financial Policy Committee (FPC) considered raising banks’ countercyclical capital buffer. According to the FT's Caroline Bingham:
This measure requires lenders to build up capital in good times to draw down in more challenging times. 
And she goes on to say this:
The prospect of yet more capital that banks must set aside would come on top of capital rules on a European and global basis that lenders must implement. They complain that these ever-increasing buffers weigh on their profits and therefore lending ability.
No, Caroline, no. Banks do not "build up" or “set aside” capital. Capital is an integral part of the balance sheet structure. As the Bank of England explains, it is a form of funding:
It can be misleading to think of capital as ‘held’ or ‘set aside’ by banks; capital is not an asset. Rather, it is a form of funding — one that can absorb losses that could otherwise threaten a bank’s solvency.
 And you really shouldn't listen to the complaints of banks. They talk their books. 

Like any corporation, a bank’s balance sheet is made up of assets, which are principally but not exclusively loans, and liabilities (debt), which are principally but not exclusively deposits. The equity of the bank (shareholders’ capital) is the difference between assets and liabilities. The bank is solvent if total liabilities are less than total assets. It is insolvent if total liabilities exceed total assets. This can happen if asset values collapse rapidly, as they did in the 2008 financial crisis. Note that a bank run, in which deposits rapidly leave the bank, does not by itself cause insolvency. It is the associated asset value collapse as the bank is forced to sell assets at fire sale prices to raise cash to fund the run that causes insolvency. I’ve explained this previously – see links at the foot of the post.

What we call “capital” for banks is actually various forms of equity and near-equity. It comes in two flavours: Tier1 capital, which is shareholders' funds, and Tier2 capital, which is debt that can be converted to equity (so-called “convergent contingent” bonds (Co-Cos) and other forms of subordinated debt) and various forms of capital reserve.

Tier1 capital is split into two parts. The largest portion is "Common Equity Tier1", which as the name suggests is entirely equity. The smaller portion, "Additional Tier1", may include perpetual preferred stock.

In the event of the bank suffering losses due to bad loans, it is Tier1 capital that is wiped out first. Shareholders of the bank always lose their money before anyone else. If the bank’s losses are so severe that Tier1 capital is entirely wiped, Tier2 capital is next in line.

Tier1 and Tier2 capital therefore protect creditors from losses. A bank’s creditors are unsecured bondholders, unsecured depositors, insured depositors, secured bondholders (including repo funding from other banks) and the central bank. In the event of a major bank failure, they are wiped in that order.

Clearly, the greater the proportion of capital to debt that a bank has – or, if you like, the greater the “gap” between assets and liabilities - the more losses it can absorb before creditors are affected. 

Capital and leverage ratios define the minimum size of the gap between assets and liabilities that is consistent with providing reasonable protection to creditors against losses. They do so in slightly different ways: the capital ratio (capital/risk weighted assets) uses a view of the asset side of the balance sheet that takes into account the risk of each asset, while the leverage ratio (capital/total assets) ignores risk.

But why not protect creditors completely? Why not force banks to keep the gap between assets and liabilities sufficiently wide to absorb all potential losses from risky lending?

Some people argue that banks should do exactly this. Advocates of “full reserve banking”, in its strictest form, want bank lending to be funded only from banks’ own capital, not from deposits. Their view is that deposits should not be placed at risk. So they want banks to match their stocks of deposits with equally large stocks of risk-free assets – cash “reserves” or government bonds.

Cash reserves are not capital. They are cash deposits at the central bank which are maintained by banks to enable depositors to withdraw funds. Since, generally speaking, depositors don’t all withdraw their funds at the same time, the amount of ready cash that banks keep on deposit at the central bank is usually well under 100% of customer deposit value. In the USA banks are required to keep reserves equivalent to 10% of eligible customer deposits - this is the "reserve requirement ratio" (RRR) . But in Canada and Denmark, the RRR is zero, and banks borrow reserves as needed to settle deposit withdrawal.  In the UK, prior to the advent of QE, the required reserve ratio (RRR) was tailored for each bank individually: however, since QE forces banks to maintain much larger cash deposits at the central bank than they need, the UK’s RRR is currently also zero.

Gold and government bonds are not capital either. They are safe liquid assets. They can be sold quickly and easily to meet depositor demands for withdrawals, reducing the likelihood of the bank needing to borrow emergency funds either from markets or from the central bank.

The “Liquidity Coverage Ratio” defines the proportion of safe liquid assets that banks must hold (in this case “hold” is the correct terminology, whereas it is incorrect for capital) to cover short-term outflows. This is how the Basel Committee explains it:
The objective of the LCR is to promote the short-term resilience of the liquidity risk profile of banks. It does this by ensuring that banks have an adequate stock of unencumbered high-quality liquid assets (HQLA) that can be converted easily and immediately in private markets into cash to meet their liquidity needs for a 30 calendar day liquidity stress scenario. The LCR will improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy.
So, to summarise: capital requirements influence the overall structure of the balance sheet, and in particular the gap between assets and liabilities, while liquidity requirements influence the structure of the asset side only.

Now, about that countercyclical capital buffer (CCB). The CCB and the RRR serve similar purposes, but on opposite sides of the balance sheet: the RRR affects the asset side of the balance sheet, while the CCB affects the liability side.

Raising the RRR forces banks to hold more of their assets in the form of reserves, reducing their lending capacity. It does NOT mean they have less money to “lend out”. Banks create deposits when they lend: every time a bank lends, therefore, the RRR forces it to increase cash reserves at the central bank by a percentage of the value of the newly created deposit. Clearly, the higher the RRR, the greater the proportion of the balance sheet that is made up of reserves, and the less room there is for other loans. This is how raising reserve requirements discourages bank lending. China makes extensive use of the RRR to control bank lending. 

If the RRR were raised to 100%, banks would have to obtain new reserves from the central bank in advance of lending to ensure that the new deposit was immediately matched 100% by reserves: the new loan asset would be matched by capital or by forms of debt not subject to the RRR. This is “full reserve lending”. Strict "full reserve lending" or "narrow banking" should therefore perhaps be called "full capital lending". 

Historically, central banks have tended to use the RRR to lean against banks’ tendency to over-lend in good times. But since banks’ balance sheets are currently stuffed with excess reserves, the CCB is now a more effective measure.

The CCB is not a “reserve” built up in good times that can be “drawn down in more challenging times”. It is an additional capital requirement that regulators can add to or deduct from the basic Common Equity Tier1 capital requirement, depending on the state of the economy and the behaviour of banks. The European Commission explains it thus:
As the name indicates, the purpose of this buffer is to counteract the effects of the economic cycle on banks’ lending activity, thus making the supply of credit less volatile and possibly even reduce the probability of credit bubbles or crunches. It works as follows: in good times, i.e. where an economy is booming and credit growth is strong, it requires a bank to have an additional amount of CET1 capital. This prevents that credit becomes too cheap (there is a cost to the capital that a bank must have) and that banks lend too much.
When the economic cycle turns, and economic activity slows down or even contracts, this buffer can be “released” (i.e. the bank is no longer required to have the additional capital). This allows the bank to keep lending to the real economy or at least reduce its lending by less than would otherwise be the case.
So the purpose of the CCB is to dampen credit booms and busts.

Bank lending amplifies the natural business cycle, and as we have seen in recent years, can cause disastrous credit crunches and major crashes. Banks enthusiastically lend more and take more risk when times are good, then cut back hard when there is a downturn. As lending increases, the total size of the balance sheet increases but the proportion of equity to total assets (leverage) diminishes. And as banks “risk up”, the proportion of equity to risk-weighted assets (capital ratio) also diminishes. Conversely, when banks cut back, capital ratios rise precipitously. The CCB therefore “leans against” the tendency of capital and leverage ratios to reduce in good times and rise in bad times.

More importantly, the CCB influences lending activity. Banks profit from the spread between the return on their assets and their cost of funds. Equity funding is more expensive than debt, not least because of preferential tax treatment of debt. Increasing the CCB therefore raises banks’ funding cost, forcing them to raise rates to borrowers and/or tighten credit standards. Conversely, the CCB can be reduced in a downturn, lowering banks’ funding cost and therefore encouraging them to reduce interest rates and relax credit standards. 

This, of course, explains why banks complain about the CCB. After all, raising their cost of funding by forcing them to use equity instead of debt hurts their profits, poor darlings, and makes them less willing to lend. That, Caroline, is its purpose. 

Related reading:

The equivalence of debt and equity
Anatomy of a bank run
Cleaning up the mess
Liquidity matters
Bank capital and liquidity - Bank of England
CRD IV: Frequently asked questions - European Commission
The Bankers' New Clothes - Admati & Hellwig (book)

I've expanded the section on Tier1 and Tier2 capital slightly after complaints from some readers that it was over-simplified in the original version of this post. However, I've still kept it simple and have deliberately not gone into detail about the additional capital layers in CRD IV, of which the CCB is one. For a more detailed explanation of CRD IV regulatory capital structure, please read the European Commission's Q&A in the links above.  

Monday, 28 September 2015

Investment is needed everywhere

And particularly in Europe, as this chart shows:

The ratings agency Standard & Poors has called for governments everywhere to increase investment spending. It also says they need to improve the efficiency of the spending they are already doing. 
Private sector investment spending all over the world fell after the 2008 financial crisis. In Europe, where the crisis started earlier, it started falling in 2007. And it has not recovered. Private sector investors remain risk-averse and fearful of losses, chasing safe havens and unwilling to invest long-term in infrastructure, skills and R&D.

When the private sector will not invest, the job falls to government. And immediately after the financial crisis, governments did step up, increasing investment spending as private sector investment fell. Some governments have continued to invest ever since, notably China, which still spends about 8.5% of GDP every year (much of it outside its borders), and India, which is spending about 4.7%. But most governments have cut back investment spending in order to consolidate their budgets. The result is a widespread investment chill that is depressing growth and keeping unemployment elevated in far too many countries......
Read on here.

Related reading:

Making the case for public investment

Sunday, 27 September 2015

The Great Yield Divergence

When a former Bank of England deputy governor gives a presentation entitled "Are Low Interest Rates Natural?" to a extraordinarily high-powered audience of academics and monetary policymakers, you can bet he will come up with some great charts. Charlie Bean's historical analysis of long-term real and nominal yields in the UK is amazing:

It is very evident that for most of the last 200 years, nominal and real consol yields have been pretty much pinned together. Charlie said that the gold standard prevented rates deviating by keeping the price level under control. But I am unconvinced by this.

Firstly, let's look at the historical record. In 1717, Isaac Newton, then Master of the Mint, changed from defining the value of the pound in silver as had traditionally been the case to defining it in gold. At that time, most banknotes were issued by commercial banks: the Bank of England issued notes in return for deposits, but for high denominations only and the amounts were variable. After the Bank Charter Act of 1844, which ended the issuance of banknotes by commercial banks in England and Wales (though not in Scotland or Northern Ireland), the Bank of England gradually moved to issuing notes for fixed amounts and lower denominations. But for much of the century, banknotes were issued in high denominations only and were not widely used, except in Scotland where a £1 note was popular (as it still is today). Most people used coins for everyday transactions, principally small-denomination silver coins. For all practical purposes, therefore, what Britain actually had during this time was bimetallism, rather than a gold standard as we would understand it now.

But no matter. War destroys gold standards, whether bimetallic or paper. Even though the gold standard only really applied to high-denomination bank notes, not the common currency used by the people of Britain, when Britain went to war with France in 1793, gold convertibility came under increased pressure as investors retreated into outright holdings of gold. The Bank of England eventually suspended gold convertibility in 1797 after a series of runs on the Bank threatened to drain its gold reserves. Convertibility was not restored until 1816 after the ending of hostilities with France.

And yet the fact that gold convertibility was abandoned for nearly twenty years barely creates a ripple on Charlie Bean's chart. Both nominal and real rates rose, but in parallel with each other.

It also isn't the case that prices were under control during this period. Inflation was very high - in 1800 it touched 36% - and volatile:

And the price level rose during this period:

(both charts from the Bank of England)

Price level rises are common during and after wars because of supply-side destruction coupled with very high government spending: the price level rise during and after World War I is also very evident on this chart. The price level rise is sufficient to explain rising yields during the French Wars. But it doesn't explain why real and nominal yields didn't diverge during a period of high inflation and suspended gold convertibility. There must have been some strong nominal anchor keeping them pinned together. It certainly wasn't inflation targeting. Anyone hazard a guess as to what it was? I reckon it was a fixed exchange rate, but I could be wrong.

But the real story on this chart is, of course, the Great Divergence of real and nominal yields. Ever since the Great Depression, nominal yields have been persistently above real yields, often by a substantial margin. Even during Bretton Woods, a period of relative financial stability (and a quasi-gold standard), nominal yields were somewhat above real yields. Yet in the previous 200 years, despite periods of fiat currency and high inflation, real and nominal yields didn't diverge. Why do they now?

This is not just an idle question. The yield on consols (interest-bearing government perpetuals) is a proxy for the risk-free rate of interest. If nominal yields are persistently above real yields even in the absence of significant inflation, then something is massively askew in the pricing of risk-free assets. Today, inflation is hovering around zero, but Charlie's chart shows us that nominal yields are about two percentage points above real yields. I thought the post-crisis period was supposed to have euthanised rentiers? This chart suggests that they are doing better than ever.

Perhaps what this divergence tells us is that our expectations of future returns are persistently skewed to the upside. We therefore undervalue safe assets (hence high nominal yields) and overvalue risky ones. As Andy Harless says, safety is a scarce and valuable asset. Arguably, it should be a lot more expensive than it is. Perhaps we don't really think it is necessary - or we don't really think these assets are safe.

But why did everything change in the Depression? I don't buy the gold standard argument. Rather, I think that the cataclysmic shocks of the 20th century have weirdly distorted our view of financial reality. The fact is that a significant proportion of the human race now expect to receive returns on financial assets that are far removed from the real ability of the economy to generate them. I don't know why this is, but in my view we should be looking at things like labour market dynamics, longevity and pension expectations.

And we need to look at them as a matter of urgency. Such divergence between nominal and real rates suggests that there is a continual drain of resources from workers to rentiers, from young to old and from poor to rich. This shows itself as rising indebtedness among the young and poor, and increasing fragility of the global financial system. It cannot possibly be sustainable.

In his presentation, Charlie Bean reviewed an array of measures that might give central banks more control of nominal rates at the zero lower bound,such as raising the inflation target, negative rates and eliminating or charging interest on cash. But he concluded:

"It would be better to find ways of raising the natural rate through structural and fiscal policies."

Indeed, somehow we have to bring nominal and real rates back together. Ideally this would be through raising the natural rate. But I suspect the post-Depression natural (real) rate is lower than we would like it to be, and it's just taken us best part of a century to understand this. If so, then this is not simply a matter of getting fiscal and structural policies right. It raises serious questions about the ordering of society. After all, a large number of people depend on there being significantly positive real returns on essentially risk-free assets. If significantly positive real returns on risk-free assets are a thing of the past, we owe it to those people to stop pretending we can restore their lost returns through "confidence-boosting fiscal adjustment" and "growth-friendly structural reforms". They simply aren't going to be able to live comfortably in their old age on the interest on risk-free savings.

The truth is we do not know when, or if, positive real returns on risk-free assets will return. If the future path for growth in future is low to zero, then they may never return. If this is the case, then the solution to the "Great Divergence" must be for nominal risk-free rates to drop. Permanently.

Related reading: 

Weird is normal - Pieria
No, you can't have your risk-free returns back - Tomas Hirst, FT Alphaville

Thursday, 24 September 2015

Oh dear, Volkswagen.....

That cliff edge feeling.....

Yes, that's Volkswagen's share price. I was amused by the UBS advert. And just to rub salt in the wound, here is Carole King:

Anyway, Volkswagen is in deep, deep brown stuff. Here are links to my posts so far on this. I will add more as I write them.

1. The Car Manufacturers' Libor Scandal. Rigging emission tests will prove extremely expensive for Volkswagen. But I doubt if VW is the only vehicle manufacturer guilty of nefarious practices. I reckon it's an industry-wide disease not unlike the benchmark rate rigging scandals in banking.

2. Volkswagen's CEO has resigned, but that doesn't solve its problems. Volkswagen is too big too manage. Actually most global corporations are. And their CEOs are far too keen on avoiding blame. Not many do the decent thing and resign promptly, as VW's Winterkorn did. But was he told to by the Executive Committee?

Wednesday, 23 September 2015

GDP transactions in secondary markets

There is a widespread view that much bank lending is unproductive, i.e. does not raise GDP – or if it does, it does so in an unsustainable way by inflating asset prices or increasing inflation, rather than by increasing production.  Many proposals for bank reform therefore envisage restricting banks to “productive” lending, by which usually seems to be meant business finance and short-term consumer credit. Financial transactions on secondary markets, and the purchase of second-hand property, are regarded as unproductive.

This appears attractive. Banks do indeed lend far more for property purchase than they do for business finance, and most of the properties purchased are second-hand. So, the thinking goes, if we could eliminate unproductive housing finance, banks would lend more to businesses, and that would mean higher GDP in the longer term.

But I’m afraid there is a serious fallacy here. Lending for secondary market purchases does contribute to GDP, and not just in unhealthy asset price inflation. Without secondary markets, primary markets are diminished, and – by extension – so is GDP.

Here is an example. Suppose I buy a brand-new house off plan. Clearly, the building of my new house employs a significant number of people in various trades, who collectively create a “product” – a house - so my purchase is a GDP transaction. The bank that lends me the money to buy my house has therefore lent productively. Few in the UK would disagree with this. But in Spain or Ireland they might see things differently: after all, building houses there became a wholly unproductive activity prior to 2008.

But suppose I buy a listed building with no roof, rotten floors, shattered windows and holes in the walls, which I then restore for subsequent sale?  For the restoration, I employ a significant number of people in various trades, who collectively create a “product” – a refurbished house – that can be sold for a much higher price than the original dilapidated shell. Clearly, this contributes to GDP. It also brings into use a house that previously was not suitable for habitation. Please tell me why the borrowing to finance this should be regarded as “unproductive” when the borrowing to buy a brand-new house is not?

Perhaps, though, this is too obvious an example. Suppose I buy a house owned by an elderly lady who has lived there for 50 years. The house is not in poor condition, but the décor is not to my taste and it needs modernisation. I could do it up gradually, paying for improvements entirely from earned income. But I choose to front-load the upgrade by taking out a Home Improvement Loan. This is consumer credit that I would not have taken out if I had not bought the house. Because I borrow to do up the house, I provide employment to assorted tradesmen, revenue to the suppliers of kitchen & bathroom equipment and income to the staff on the tills at B&Q. And when I have finished decorating, I buy new carpets and furnishings, probably also on consumer credit. None of this would have happened if I had not bought the house. So although buying a house in good condition on the secondary market does not itself contribute to GDP, since the house was built long before I was born, the things I do after buying it to make it a place I like to live in do contribute to GDP. Is financing a secondary market house purchase of this type “unproductive”? I don’t think so.

In fact most people purchasing second-hand houses decorate and refurnish them, and most do so using consumer credit. The second-hand housing market gives considerable impetus to GDP through these consequential transactions.

And there is another side to this. What happens to the money I pay to buy the house?

In my first example, I pay a deposit up front, and my final payment when the house is completed and all snags resolved. The money goes to the builder, who pays down the loan he has taken out to fund the building of the house. So the money I borrow simply refinances the builder’s loan. Is this a contribution to GDP? No. It is the original builder’s loan that contributes to GDP. My subsequent mortgage does not, directly – though without people like me borrowing to buy houses, builders would quickly default on their loans, as Ireland’s banks discovered.

In my second example, I pay for the shell house up-front. The person I buy the shell from, hugely relieved to have got rid of the unproductive millstone round his neck, splashes out some of the money on a much-needed holiday in the Seychelles, and uses the rest to buy a brand new top-of-the range BMW. Does this contribute to GDP? Clearly yes, though the holiday mostly contributes to the GDP of the Seychelles and the BMW to the GDP of Germany. So my shell purchase is productive in more ways than one.

In my third example, the elderly lady is going into residential care, and the money raised from the sale of her house will go towards paying for her care. The sale of her house therefore funds employment in the care sector, which contributes to GDP.

But even if my elderly lady were only buying a retirement flat, the transaction would still contribute to GDP, since my house is worth more than her retirement flat and she can use the difference to top-up her consumption spending.

So secondary market purchases of property DO contribute to GDP, in lots of ways. In fact the refurbishment example is the most GDP-enhancing of these purchases, and the elderly lady example is arguably the most socially useful. Surely the lending to finance these should be regarded as "productive"?

All secondary market transactions are potentially GDP enhancing. This is because of their “pull” effect on primary markets. For example, consider someone who owns a 5-year-old BMW. He wants to buy a brand new car, but he needs to sell his current one in order to afford a new one. So he trades in his car. If there were no secondary market for cars he would be unable to do this: he would drive his BMW until it fell apart, rather than buying a new one every 5 years. True, car manufacturers might respond by cutting the prices of new cars to entice purchases, and they might run a scrappage scheme for cars older than 5 years: but could this really be called “productive”?

As a general rule, when there is no secondary market for long-dated assets, the issue of new assets in that class is limited by the availability of new entrants to the market and the expiry of existing assets. Secondary markets are essential to maintain liquidity: restricting finance for secondary markets actually diminishes, rather than increasing, primary market activity.

So the idea that secondary market purchases are “unproductive” is thus incorrect on many counts. Restricting finance for secondary market purchases, whether cars, houses or financial assets, puts downwards pressure on GDP.

Related reading:

Ann Pettifor, there will be no shortage of money - Positive Money
Quantitative Easing and the Quantity Theory of Credit - Richard Werner
Co-op community marks 30 years of building a better life - Co-Op News

This post was prompted by a discussion on Twitter about what "lending for GDP transactions" really means in practice. It first  appeared as a guest post at RWER