Wednesday, 2 September 2015

The real purpose of central banks

One of the things that has emerged from the PQE debate is a suggestion that it is time to consider ending the Bank of England's inflation-targeting mandate. Unfortunately this got mixed up with calls for ending the operational independence of the Bank of England (Richard Murphy), or abolishing central banks (Bill Mitchell, stated in response to a question at Reframing the Progressive Agenda).

What we might call the "twin peaks" approach to macroeconomic policy-setting has been adopted the world over. Separation of fiscal and monetary policy, and independence of the central bank, have become the hallmarks of good practice. Many countries have also adopted inflation targeting, though not all have: a good many developing countries still target exchange rates, and are currently learning (painfully) that exchange-rate targeting doesn't work when everyone's currencies are depreciating madly due to commodity price falls.

But the status of the central bank and the primacy of inflation control in macroeconomic policy setting are not really related to each other. To illustrate this, here's a thought experiment.

Suppose that we did what Bill wants, and abolished the central bank. Government would become its own central bank: it would spend directly into the economy by crediting private sector bank accounts, and would drain excess money through a programme of differentiated taxes. I've noted before that taxes and interest rates are essentially the same thing but with different distributional effects. Both control the amount of money in circulation. But interest rate changes indirectly influence private sector saving and borrowing, whereas tax changes directly affect private sector spending. We might expect, therefore, that tax changes would be both more powerful and more immediate in their effects than interest rate rises - though strangely, the mainstream economic community seems to think the reverse is the case.

In theory, therefore, this could work. Inflation control would be exercised by means of tax rate changes, particularly the poorly-named "indirect" taxes (VAT, sales tax, sin taxes). Indirect tax changes have direct, immediate and powerful effects on the economy: not long ago a promising recovery was derailed in Japan by an ill-considered increase in sales tax, and in the UK the VAT increase immediately after the Coalition government came to power in 2010 probably contributed to the slackening of growth later that year.*

So we do not need a separate central bank to control inflation. Government can do that itself. But why do we want to control inflation? Indeed, can we control it? We fear it, so we want it controlled, but it is by no means clear that we have effective control of it. Central banks the world over are failing to meet inflation targets. Western economies have inflation far below the standard 2% target. Why is this?

There are all manner of theories to do with commodity price falls, weak currencies and low demand. Some combination of all of these is no doubt partly to blame. But in Europe, where low inflation is firmly entrenched despite very high unemployment, the principal reason is that the inflation target has effectively been abandoned.

The ECB has price stability as its single mandate. But the primary macroeconomic targets are not set by the ECB. They are set by the member state governments and enforced by the European Commission with (increasingly reluctant) support from the ECB. The primary macroeconomic targets in the Eurozone, and to a lesser extent the EU, are the Maastricht Treaty limits on government debt and deficit. It is slavish adherence to these that makes it impossible for the ECB to meet its inflation target.

As I noted before, changes in taxation (including government spending, which can be regarded as negative taxation) are equivalent to interest rate changes. So contractionary fiscal policy across the entire Eurozone acts like very high interest rates, sucking demand out of the economy. Also, the ECB is struggling with "zero lower bound" constraints that limit the effectiveness of monetary policy in very demand-deficient economies, Consequently, the ECB simply does not have the power to offset the depressing effect of continual fiscal austerity as countries try to comply with the too-tight fiscal restraints of the Stability and Growth Pact. It cannot get anywhere near its 2% inflation target.

I would suggest that ANY country that is attempting to hit particular targets for government debt and/or deficit has de facto abandoned its inflation target. That includes the UK, whose Chancellor is targeting zero deficit by 2018 and fiscal surplus by 2020. The Bank of England still has an inflation target, but it has no more chance of hitting it than it would have if the Chancellor were "going for growth" with a highly expansionary fiscal policy. "Monetary dominance" is a myth.

Ending the Bank of England's inflation-targeting mandate would make little difference as long as the government remained firmly wedded to balancing the books. Indeed it might make matters worse: if the Bank no longer had a target to try to meet, popular pressure might make large interest rate rises hard to resist. It should be obvious by now that interest rate rises combined with fiscal austerity would be severely contractionary, possibly disastrously so. The Bank of England's inflation target is therefore serving a protective function. There are powerful voices calling for interest rates to rise back to "historic" levels. Targeting inflation silences them.

So we might need an independent central bank to provide some protection from politicians (or fiscal councils) setting insanely tight fiscal targets. However, the Eurosystem, with its one-size-fits-all monetary policy, is not able to protect individual countries from the awful consequences of severe fiscal austerity. So if it can't hit its inflation target because of over-tight fiscal policy, and it can't offset the effect on  real economic activity of over-tight fiscal policy, does the Eurosystem serve any useful purpose at all?

It certainly isn't needed to create money. The right to create money is conferred on central banks (base money) and private banks (broad money) by government, and the value of money thus created arises entirely from the trust that people have in government. In the hydra-like Eurosystem, the authority of  the ECB and national central banks to create money comes from the governments of its 19 member states.

Even in the Eurozone, it would in theory be possible for private banks to be provided with reserves directly by Treasury departments: conversely it would in theory be possible for member state governments to be the only banks. These are extreme positions and I am not suggesting either. I merely point out that both are logically coherent. Central banks and private banks are not essential for fiat money creation.

Occasionally we find cases where the central bank is more trusted than the government, but these are unlikely to be associated with genuine fiat currency systems. For example, Bulgaria has a Euro currency board, which means that its monetary policy and to a large extent its fiscal policy too are in practice dictated by the ECB. And the people like it that way. They haven't forgotten 1996, when Bulgaria experienced hyperinflation. They don't trust their government, and they only trust their central bank because it doesn't really have control of the currency.

It is false to claim, as some do, that the Euro has broken the link between government and currency. Nothing could be further from the truth. Successive crises have shown us that the stability of the Euro crucially depends on the credibility of its member governments. There was even hyperinflation in the Eurozone in the run-up to the closure of Greek banks, when Greek citizens dumped Euro deposits in Greek banks as fast as they could due to fears of confiscation and/or redenomination (value destruction). At that moment, as Greek broad money approached worthlessness, the Euro was fragmented. The loss of credibility of the Greek government threatened its integrity. The Euro is as dependent on trust in government as any other fiat currency.

So we do not need a central bank to control inflation. Even more importantly, we do not need a central bank to create money. All we need is a trusted government. This is the reason for Bill's call for central banks to be abolished. He thinks they serve no useful purpose.

Of course we might want to have a central bank for other purposes, like acting as lender of last resort for the banking system (though as we saw in 2008, the burden of rescuing a collapsing banking system eventually falls on government). It can be convenient to separate the support of the banking system from the support of the real economy. But in the Eurozone, it is hard to see what other useful purpose the central banks serve.

However, there is another reason for having an operationally independent central bank in a democracy. In democracies - even those that have a "fiscal council" or balanced-budget laws - fiscal policy is set by politicians. Politicians disagree on fiscal policy: indeed political parties' pitch to voters is mostly about how bad the fiscal policy of the other side is. For the party in office, the temptation to set fiscal policy to their own electoral advantage is very great: while for parties aiming to dislodge the party in office, the temptation to make headline promises to reverse existing fiscal policies is equally great. So we should expect fiscal policy settings to be significantly determined by the electoral cycle.

An independent central bank can dampen the swings in fiscal policy caused by changes in government. It can't offset them fully, especially when interest rates are close to the zero lower bound, but it can mitigate their effect. It acts, in effect, as an automatic stabiliser, anchored by its mandate: it doesn't much matter what the mandate is as long as there is one. The high inflation of the 1970s was in my view at least partly due to the loss of the Bretton Woods anchor, which resulted in ten years of confusion before a new anchor (inflation targeting) was adopted.

So it is public choice theory, not inflation control, that makes an independent central bank necessary. This, I'm afraid, fatally undermines Richard Murphy's call for the ending of the operational independence of the central bank. The last thing we need is a central bank that is ALSO driven by the electoral cycle. No central bank at all is probably better than this.

And this raises another issue. Those who think central bank governors should be directly elected should perhaps consider whether elected governors might themselves be driven by a desire to remain in office. The prospect of fiscal and monetary policy being driven by two different electoral cycles that are out of phase with each other is  too awful to contemplate.

But if the real purpose of central banks is to protect economies from the whims of politicians (including those in other countries - fiscal policy effects spill over to other economies) - and thereby help to maintain trust in government even when it doesn't deserve it - there must be serious questions about the purpose of the Eurosystem, since it is manifestly unable to dampen fiscal policy swings. There could definitely be a case for abolishing the ECB and returning responsibility for monetary policy to national central banks.

Of course, an independent central bank dampening swings in fiscal policy is smoke and mirrors. The central bank is a political institution. Its mandate is set by politicians and it is only as independent as politicians allow it to be.

There is a widespread view that inflation targeting by independent central bank prevents irresponsible management of the economy by politicians. But I would argue that the reverse is the case. The "twin peaks" model, in supposedly protecting the economy from the whims of politicians, enables politicians to be irresponsible while blaming  the central bank for the consequences of their irresponsibility. This is what is happening all over Europe. Politicians are irresponsibly driving economies into stagnation or depression through a misguided belief that debt is bad and government must "live within its means". And central banks are being held responsible for the resulting lowflation, lack of growth and high unemployment.

It is a dysfunctional model. But until there is greater understanding of macroeconomics among politicians and voters, I can't think of a better one.


Related reading:

PQE, inflation and the problem of voter power
Krugman, Bowman and the monetary financing of government
Inflation is always and everywhere a political phenomenon - Pieria

*If this is correct, then we should expect that the enormous VAT increase in Greece imposed with immediate effect under the terms of the recent bailout should have a serious negative impact on growth, since it is equivalent to a whopping interest rate hike. It's worth remembering that the Russian central bank's political decision to raise interest rates to 17.50% in November last year knocked the stuffing out of an already recessionary economy. Greece's general VAT rate has been raised to 23%, which for most industries is a rise of at least 10%. I await the Q3 and Q4 GDP figures for Greece with academic interest and personal foreboding.

Monday, 31 August 2015

A false accusation

I have been accused of libel. Publicly, and in writing. This is a very serious accusation, since libel is a civil offence under UK law and the onus would be on me to prove the accusation unfounded. I feel therefore that allowing such an accusation to pass without comment is impossible.

The alleged libel is in this post, which is a guest post on this blog. The substance of the accusation is that the title of that post, "Monetary Snake Oil", is a libellous attack on Richard Murphy. Although I did not write the post, Richard Murphy claims that the choice of title was mine and that in posting this piece I intended to defame him.

The title actually comes from this paragraph:
Jeremy Corbyn’s People’s QE offers the alluring prospect of spending more without borrowing more. Which is just the ticket, if you want to replace austerity with largesse, and cut the deficit to boot. Sadly, this appealing miracle cure is pure snake oil (although there is, perhaps, a version of the idea which might be helpful, if substantially less miraculous).
There  is no mention of Richard Murphy. Indeed the only mention of Richard Murphy in the post is in this paragraph (my emphasis):
It is not clear exactly how PQE would be implemented. The most important question is whether it would be a countercyclical tool in the hands of the BoE, or something the government uses whenever it wants to finance expenditure. Richard Murphy has suggested the Bank governor would be fired if he tried to block the policy. If, somehow, the flow of money fed into the system is forced above whatever is consistent with the BoE setting its interest rate to hit its inflation target, then we can expect inflation to rise above target. The government could spend without borrowing, if it decided to abandon the current arrangements for inflation targeting. In the extreme, if a Corbyn administration opened the monetary taps every time it thought unemployment was too high and investment too low (i.e. all the time), and neutered the BoE’s ability to offset, then warnings about inflation might start to look warranted.
The citation in this paragraph is supported by evidence in published media.

However, the link in the first paragraph goes to a post on Murphy's own blogsite in which he claims credit for Jeremy Corbyn's "People's QE" :
That’s why he’s borrowed my ideas on quantitative easing, renamed them as People’s Quantitative Easing, which is just fine by me, and has said, as I have done, that this mechanism could be used to fund our future.
So is this true? Is Richard Murphy the sole originator of Jeremy Corbyn's "People's QE" scheme? If he is, then he might have a case for libel, since it would be his idea that was described as "snake oil"and therefore it might be reasonable to draw the inference (as he does) that he is a snake oil salesman.

It is by no means clear that he is the sole originator of Corbyn's People's QE. Proposals for central banks to finance direct spending into the economy, whether in the form of investment spending or simply as helicopter drops, have a long and impressive pedigree. Indeed, I was one of 19 signatories to a letter in the FT in March 2015 which called for "Quantitative Easing for the People" in the depressed Eurozone and specifically said that central bank financing of capital investment was one way of doing it:
There is an alternative. Rather than being injected into the financial markets, the new money created by eurozone central banks could be used to finance government spending (such as investing in much needed infrastructure projects); alternatively each eurozone citizen could be given €175 per month, for 19 months, which they could use to pay down existing debts or spend as they please. By directly boosting spending and employment, either approach would be far more effective than the ECB’s plans for conventional QE.
.Richard Murphy was not one of those signatories. Perhaps I have a better claim to be the originator of "People's QE" than he does?

Nor does Jeremy Corbyn himself regard Richard Murphy as the sole originator of "People's QE". This is from his "Economy in 2020" presentation on July 22nd 2015 (my emphasis):
One option would be for the Bank of England to be given a new mandate to upgrade our economy to invest in new large scale housing, energy, transport and digital projects: Quantitative easing for people instead of banks. Richard Murphy has been one of many economists making that case.
If Richard Murphy is not the sole source of Jeremy Corbyn's scheme, then he can have no claim for libel arising from my guest's description of Jeremy Corbyn's scheme as "snake oil". Jeremy Corbyn might, but he is a politician standing for office and therefore fair game.

Richard Murphy's public accusation of libel has no basis and is therefore itself libellous. He must withdraw it.

UPDATE. Richard has apologised:
Shall we draw a halt to this? You published what I thought to be a deeply offensive comment. I explained why. You have now explained why you think I published an offensive comment in exchange. I think your logic does not stack, and you don’t think mine does. That’s fine: I am sorry (in the simple straightforward sense) if you are upset. That was not my intent: why should it have been?  But I would hope you can see why I took umbrage: disagreement on the argument I can happily accept, but to malign my motives as fraudulent was wholly unnecessary. I hope you can agree with that. 
In which case can I suggest we move on? This really is a storm in a tea cup. You say the job of those who oppose austerity and want more investment in infrastructure is to make that case. We apparently share that objective: all we do not agree about is when a technique I have proposed and which you appear to have endorsed might be best used.
Shall we focus on that real issue instead now?
In reply, I have posted the following comment on Richard's blogpost:
Apology accepted. With some relief, as we have a lot in common and the anti-austerity campaign really should be presenting a united front. 
This is from Paddy:
“There is absolutely no reason to think that Richard understands why PQE wouldn’t work as he thinks it would – that never crossed my mind – he is obviously sincere, not knowingly selling false goods” 
I did not doubt your sincerity either. I will be more careful to think through the implications of guest comments in future.
Richard has not yet published this comment but I hope that he will do so - after all, blocking me from commenting on his blog is hardly "moving on".

Comments on this post are now closed.

Sunday, 30 August 2015

PQE, inflation and the problem of voter power

I have repeatedly said that I do not support Jeremy Corbyn's "People's QE". But there seems to be considerable confusion about what exactly I oppose. And that is for one simple reason: the deliberate conflation of government investment spending and QE by the architect of this scheme.

PQE is composed of two separate and distinct strands:

1. Government spending to finance investment in infrastructure, innovation, R&D and housing

2. Bank of England purchases of government bonds. 

Despite the insistence of the scheme's creator that one is impossible without the other, these two strands are actually not interdependent. In fact they are unconnected. As the UK is a member of the EU and a signatory of the Lisbon Treaty, it is not possible for Strand 1 to be directly financed with money from the Bank of England. But there is nothing to stop the government issuing "Corbyn bonds" to the UK private sector for Strand 1, either directly itself or via a National Investment Bank. It would therefore be entirely possible for Strand 1 to proceed on its own, and indeed many people - including me - think that it should. 

So why do we need Strand 2?

Strand 2 appears to be based upon the following assumptions:
  • there would be insufficient demand in the UK private sector for the bonds
  • the interest rate that would have to be paid to the private sector for the bonds is too high
  • the UK economy will soon need a QE programme
None of these assumptions are warranted. 

Firstly, very low market rates tell us that there is plenty of demand in the private sector for UK government bonds. I find it hard to believe that say 2bn of 30-year Corbyn bonds at 3% per annum (just above the current yield on 30-year gilts) would not sell.

Secondly, the cost argument is entirely spurious. Interest paid to the UK private sector is simply new money which will be spent into the economy either now or later. We can regard it as tax credits or a basic income. It is not in any normal sense a "cost" for the government: it should properly be regarded as another form of stimulus, akin to "helicopter money". The interest rate is therefore irrelevant. Personally I would offer bonds directly to small UK-resident savers at above-market interest rates. 

Finally, it really isn't possible to forecast either the timing or the depth of UK recessions. We do not know what effect, if any, the problems in China will have on the UK economy, but the Bank of England isn't predicting a downturn at the moment. I have argued that an austerity programme of the scale planned by the Conservative government would be likely to cause a recession: but the Chancellor's plans already envisage fiscal easing towards the end of the parliament, so it may be that the UK would be on its way out of any recession by the time of the election. If so, then waiting for the Bank of England to do QE before increasing investment expenditure would be like waiting for Godot

The truth is that there is no operational justification for Strand 2 at all. The "QE" part of PQE is wholly unnecessary. It is the investment spending that matters. 

Strand 2 would, however, mean that the debt incurred as a result of the new investment spending did not appear on the Government's balance sheet. The way this works is this. The Bank of England is wholly owned by the UK Government. Its balance sheet can therefore be consolidated into the Government balance sheet in the same way as a subsidiary is consolidated into a parent company. Indeed the Whole of Government Accounts do consolidate the Bank of England with the rest of government. 

When a subsidiary is consolidated with a parent, debt owed by the parent to the subsidiary or vice versa "disappears". After all, you can't owe a debt to yourself. So the Bank of England's holdings of gilts, which are government debt, simply vanish in the consolidation. As the Bank of England currently holds around 30% of gilts in issue, this has the effect of significantly reducing nominal debt on the Government's balance sheet. However, after consolidation the Bank of England's liabilities, which are base money (currency and bank reserves) remain in full on the Government balance sheet. The effect is therefore that government debt has been converted into money. We call this "debt monetisation".

Central banks around the world have monetised debt in this fashion ever since the financial crisis and in some cases (Japan) for far longer with no impact on inflation. It is therefore unlikely that monetisation of Corbyn bonds would cause inflation. What could cause inflation is the investment spending itself. But as Paddy implied in the now infamous "snake oil" post, a determined central bank with an inflation-targeting mandate would simply raise interest rates to counter any inflationary effect of government spending. It would do so even if compelled to buy the investment bonds. Indeed, it would be answerable to Corbyn's Chancellor if it failed to do so. 

Of course, inflation is well below target at the moment, so any inflationary effect from investment spending would be welcome. And the inflation target could be raised to say 4%, allowing more room for investment spending without monetary offset. The possibility of inflation is emphatically not a reason for failing to increase government investment spending. 

The author of the scheme says that the purpose of Strand 2 is to enable the Government to increase investment spending substantially without it appearing on the Government's books. Personally I regard this as underhand. I am disappointed that anti-austerity politicians and policy makers are too scared to confront the current hysteria around debt and deficits directly, so are resorting to smoke and mirrors to evade it. I would rather have openness, honesty and transparency. But perhaps more importantly, I don't think this will work as a political message. 

The principal drivers of the austerity agenda are older voters, who are terrified that high government debt and deficits will mean the loss of their wealth. But they lived through the last serious inflation in the UK. They are equally terrified that inflation will erode their wealth. Any proposal that fails to take inflation seriously is therefore unlikely to be welcomed.

But in order to justify the "QE" element of his scheme, the author has suggested (comments) that the Bank of England's inflation mandate should be ended and its operational independence eliminated:
So let’s get the rest clear. First, I would have thought it obvious if I did not believe in BoE independence that I did not also believe in the primacy of inflation as an economic target, but maybe I am guilty of not having spelt this out sufficiently: I would do so, and soon.
How this is supposed to encourage people to vote for Corbyn I don't know. The principal reason for the Bank of England's inflation target is the fact that an awful lot of people are very scared of inflation, and the principal reason for its operational independence is the fact that an awful lot of people don't trust government to keep inflation under control. 

If the views of voters on government debt are too entrenched to be challenged, then surely the views of voters on inflation are too. This scheme tries to assuage popular fears about high government debt by adopting a technique that is popularly associated with high inflation, while removing the principal obstacle to high inflation. I fail to see how this can be a vote winner.

Related reading:

Green QE and the Juncker Plan

Image: "Waiting for Godot" at The Albany, courtesy of

Friday, 28 August 2015

Monetary Snake Oil

Guest post by Paddy Carter.

Jeremy Corbyn’s People’s QE offers the alluring prospect of spending more without borrowing more. Which is just the ticket, if you want to replace austerity with largesse, and cut the deficit to boot. Sadly, this appealing miracle cure is pure snake oil (although there is, perhaps, a version of the idea which might be helpful, if substantially less miraculous).

The basic idea behind People’s QE is to finance public spending by printing money. This is actually something that happens all the time, and it is by understanding how, and why, that we shall see why People’s QE, as sold, is an empty promise.

As the real economy grows, the money supply has to keep up. Suppose we wanted zero inflation then, as a first approximation, we would expect the money supply to grow at the same rate as the real economy. If the economy grows at 2 per cent a year and base money (reserves and bank notes) grows at the same rate as the broad money supply (debit accounts etc.) then the newly printed money implied by expanding base money at 2 per cent is government revenue. The word for this is seignorage and for PQE to enable spending without borrowing, it must increase the long-run rate of seignorage.  

Over the short run, the base money supply ebbs and flows as the Bank of England (BoE) goes about its business. The BoE does not directly target the money supply, instead it sets the interest rate and lets the money supply do whatever is needed to meet demand at that rate. The process is rather convoluted and involves banks setting targets for the amount of money on reserve over a certain period. There is not a neat relationship between the interest rate and money supply growth, so you cannot say that when the interest rate is low the money supply is expanding, and vice versa. But you would not go far wrong to think that when the interest rate is stimulating the economy, the rate of seignorage grows, and shrinks when monetary policy is tightened (potentially becoming negative).

And here’s why People’s QE (PQE) is snake oil. So long as the BoE is still targeting inflation, it will still be pushing and pulling money in and out of the system, as required to meet demand for money at the interest rate it has set. If the BoE is still targeting inflation, then whatever money PQE puts into the economy on one hand, the BoE is going to be taking out with the other. Or, if the BoE happens not to take the money out, that implies it would have been putting it in, anyway. And that means that over the long run the rate of seignorage, or the extent to which the government is able to spend without borrowing, is not affected by PQE.

But why would the BoE want to remove whatever money PQE puts in? After all, we just put £375bn of freshly printed money into the economy, without causing inflation. Conventional QE is an entirely different animal from PQE. Conventional QE merely swapped one asset (bonds) for another (cash). This did not much affect banks’ ability to lend nor the demand for borrowing, so that cash has merely accumulated on reserve. Conventional QE works by changing - only by a little - the returns on assets so that they become a little less attractive and spending relatively more so. This probably only had a modest impact on the economy. PQE, in contrast, is there to directly finance spending, pay wages, purchase goods. The whole point is to boost aggregate demand. For PQE inflation is a feature, not a bug. Now it’s true that there may be some slack in the economy and some of the things the envisaged PQE-financed National Development Bank would do might raise productive capacity, so there might be some scope to raise demand without inflationary pressure. But step beyond that and either the BoE would neutralise it, or, if prevented from doing so, we’d get inflation. Judging by campaign rhetoric, I think we can expect a Corbyn administration would err on the side of too much spending.

It is not clear exactly how PQE would be implemented. The most important question is whether it would be a countercyclical tool in the hands of the BoE, or something the government uses whenever it wants to finance expenditure. Richard Murphy has suggested the Bank governor would be fired if he tried to block the policy. If, somehow, the flow of money fed into the system is forced above whatever is consistent with the BoE setting its interest rate to hit its inflation target, then we can expect inflation to rise above target. The government could spend without borrowing, if it decided to abandon the current arrangements for inflation targeting. In the extreme, if a Corbyn administration opened the monetary taps every time it thought unemployment was too high and investment too low (i.e. all the time), and neutered the BoE’s ability to offset, then warnings about inflation might start to look warranted.

None of this says we currently have the best possible system. The failure to exploit low interest rates to finance infrastructure investment during the great depression has been particularly egregious. Perhaps a version of PQE could have a role, as a countercyclical tool in the hands of the BoE, in solving that problem and combating deflationary pressure. In theory PQE is entirely unnecessary and governments can finance investment during downturns by borrowing when rates are low. In practice, some short-run seigniorage earmarked for public investments might help the system overcome its reluctance to do so and deliver countercyclical fiscal policy via a monetary backdoor. But that’s not what Corbyn is selling.

Paddy Carter is really a development economist but has been brainwashed by years of teaching undergraduate macroeconomics and absorbing more by osmosis, briefly having had an office down the hall from Tony Yates. A long time ago he was a journalist. His academic research can be found here:

Thursday, 27 August 2015

Europe's Shame

I am temporarily departing from my usual finance & economics slant to write about something that I consider utterly shameful: the response of European countries, including my own, to the refugee crisis on their borders.

This photo was taken on the Macedonian border today:

Herbert Mayrhofr tweeted this with a comment, "This is not the Europe that I want to live in".

I wholeheartedly agree. What kind of society is it that will threaten toddlers with police batons?

Many argue that Europe cannot afford to accommodate the number of "migrants" currently streaming in. But the countries of the EU are by-and-large rich countries. They can always find resources for the things that are politically important. My own country found the resources to fight wars in Libya and Afghanistan - but apparently is now so poor that it must repel with razor wire and tear gas the refugees from the war zones it has created. What appallingly skewed priorities.

Others say that the volume of migrants is so large that it "threatens their way of life". They point to books like this in support of their argument. But this report from the Guardian gives  the lie to their scaremongering. The number of migrants that have arrived in the EU this year is 0.027% of the  EU population. Please don't tell me the EU can't accommodate this, and indeed far more than this.

Still others say that these are just "welfare tourists" who come to sponge off generous European benefits systems. This view is particularly prevalent in France and the UK. But there is absolutely no evidence to support it. Firstly, 60-70% of these people are refugees fleeing war zones. They endure extraordinary hardships in the hope of getting to a country where they can be safe. And secondly, even economic migrants are mainly young skilled people who expect to work for their living. Those who bring older people and children with them expect to work to support those dependents.

International rules say that refugees should apply for asylum in the first safe country they travel to. But the countries nearest the conflict zones - such as Lebanon, Turkey, Egypt - are already bursting at the seams. Greece is struggling with a major fiscal crisis. And Italy's economy is flatlining. Where is the financial support that these countries will need if they are to accommodate large numbers of refugees? There is none. It is hardly surprising therefore that they help migrants to move on to richer countries. For the richer countries to turn refugees away on the grounds that they should have applied for asylum in the poorer countries, while denying those poorer countries the resources needed to resettle refugees, is an utter disgrace.

There are in reality only two reasons why EU countries say they can't accept migrants. They have tied themselves in a fiscal noose which prevents them from releasing the resources needed to resettle migrants, and they have convinced themselves that migrants are someone else's problem. Neither explanation is remotely credible, and both show a shocking disregard for the human rights of migrants. I suppose we should be thankful that we are not now leaving migrants to drown "pour encourager les autres" - though many still are dying en route to Europe. But denying them the basic means to live is no better.

The UN High Commission for Human Rights has now weighed in. Its Special Rapporteur on the rights of migrants has castigated the EU's inadequate response: "Let's not pretend Europe's reponse is working", he says. And he calls on the European Union to establish a human rights-based, coherent and comprehensive migration policy which makes mobility its central asset, saying that this is the only way in which the EU can reclaim its border, effectively combat smuggling and empower migrants. 

The Special Rapporteur emphasises the utter futility of harsh methods aimed at deterring migration:“Building fences, using tear gas and other forms of violence against migrants and asylum seekers, detention, withholding access to basics such as shelter, food or water and using threatening language or hateful speech will not stop migrants from coming or trying to come to Europe,” he says. And he criticises remarks from politicians and media, including the UK's Prime Minister David Cameron: 
“Talking about ‘flows’, ‘marauders’, and ‘swarms’ is an unsubtle way of dismissing the legitimacy of the asylum seekers and migrants’ claim to human rights, by creating images linking them to toxic waste or natural disasters. We are talking about men, women, children and even babies, who have faced traumatic experiences. These are people just like you and me, and none of us have the moral high ground to say that we would never do the same if we were in their shoes.”
In treating our fellow human beings with such inhumanity, we make ourselves less than human. I am ashamed of my country's leaders.

But the inhumanity shown to these refugees has its origin in the inhumanity displayed to citizens of European countries. Unemployment in the EU is over 10% despite low rates in countries such as Germany and the UK. Youth unemployment is more than double that. These migrants are predominantly young, skilled people, many with children. Accommodating them could go some way towards solving Europe's demographic problems - falling birth rates and a growing proportion of elderly. But because EU policies prioritise balancing government budgets ahead of ending the scourge of unemployment, European countries - with the notable exceptions of Germany and Sweden - dare not accept migrants for fear of making the unemployment problem worse. We are not only behaving inhumanely towards people both outside and inside the EU, we are squandering the human capital on which our future prosperity depends. This is utter insanity.

Let's stop this now. Relax the destructive fiscal tightness that is wrecking economies all over Europe. Prioritise full employment over budgetary discipline. And let the wellbeing of people - including those who come to our countries as refugees and migrants - become our primary concern.

Monday, 24 August 2015

Making the case for public investment

Jeremy Corbyn’s “People’s QE” scheme has been extensively discussed in the media. In fact it has caused something of a storm. The FT’s Chris Giles did an excellent balanced analysis of it, and there have also been useful contributions from – among others - Oxford University’s Simon Wren-Lewis, The Economist’s Buttonwood and FT Alphaville’s Matt Klein. The extent of discussion is far more, in my view, than the scheme deserves.

The scheme envisages that the Government, via a public investment bank, would issue bonds for infrastructure development, which would then by bought by the Bank of England as part of a QE programme. The architect of the scheme, Richard Murphy, suggests that to avoid accusations of monetary financing of government – which is a breach of the UK’s obligations under the Lisbon Treaty – the bonds would be issued to the private sector initially at a price set by the Bank of England, which would then hoover them up in (presumably compulsory) secondary purchases. I find it hard to see how this complies with the spirit of Article 123, but I’ll let that pass. My real objection 
to this scheme lies elsewhere.

The need that this scheme ostensibly addresses is the desperate need for investment in infrastructure, R&D, skills and social housing. Few, I think, would disagree with this. Private and public sector investment in Britain have both been well below levels in most other developed countries for a long time. The Coalition government not only reversed the modest investment spending increases of the previous Labour government, it made deep cuts: halving the deficit between 2010 and 2015 was achieved in part by halving investment spending. Despite interest rates at unprecedentedly low levels, government investment in the future of the economy is now at its lowest for over a decade (ONS, 2014):

Not only is investment desperately needed, safe assets are too. Savers suffer from cripplingly low returns on their savings in part because the supply of government debt – which makes up a substantial part of pension investments - has been restricted by QE, raising its price and hence depressing its yield. The Bank of England currently owns about 30% of the UK’s stock of gilts. Of course, the loss in yield is offset by the gain in price. But for those who live on the returns on their pensions, this is cold comfort. The last few years have been grim, and there is no end in sight: interest rates remain on the floor and the Bank of England shows no signs of unwinding its QE purchases. The Coalition government offered some relief to pensioners with its Pensioner Bonds, which enabled retirees with liquid savings to buy government bonds at above market rates. But this is a drop in the ocean.

The fact is that there is plenty of demand among UK residents for UK government debt, including longer maturities, and plenty of potential public sector investment projects that could be funded by long-term government debt. Government debt is the safest form of saving available to UK residents, as well as an important anchor in the financial system. There is absolutely no reason from an investment point of view to restrict its supply.

But a toxic narrative has grown up around government debt. Because of events in the Eurozone and some unhelpful academic research, we have learned to regard it as something bad to be eliminated – a burden on future generations, a drag on growth, a source of fiscal vulnerability. At very high interest rates, this would be true. But at today’s very low interest rates, the return on the vast majority of investments would far exceed the cost, even if bonds were issued at a premium to market rates as the Pensioner Bonds were. Tomorrow’s pensioners would be supported by the returns on their investment today, while their children and grandchildren benefited from modern infrastructure, better education and a higher standard of housing. And importantly, businesses of the future would benefit from investment in R&D and innovation. We need to stop regarding government debt as something malign, and start regarding it as a social good. It is the investment of today’s citizens in their own future and the future of those they love.

How the Government should organise the financing of public sector investment projects is a matter of some debate. Richard Murphy envisages a public investment bank, capitalised by the government, which would issue bonds to fund itself and lend funds to suitable projects. But the government is already its own bank: it could simply issue bonds directly to the public to fund specific projects. The UK has historically funded wars by issuing War Bonds directly to the public. Why should it not finance infrastructure projects, R&D, education and social housing construction by issuing Development Bonds?

An alternative would be a leveraged Sovereign Wealth Fund, which would fund itself by issuing bonds which it would use to purchase assets. This could include taking equity stakes in housing, infrastructure developments and - possibly – innovative start-ups.  Clearly such a fund would take risks, but importantly these risks would not be passed on to the people whose life savings would be funding it. Government can eat losses much better than small savers. Anyway, there is no particular reason why a leveraged sovereign wealth fund should lose money overall if it is properly managed, even with a scatter of project failures.  

The arguments of those who object to public sector investment on the grounds of inefficiency usually rest on the belief that government does not evaluate projects properly or manage them effectively. They ask how “malinvestment” would be prevented. There are, of course, examples of project failure in the public sector, some of which have caused major losses. But this is to ignore the many projects that do deliver on time, to budget and deliver the required returns, particularly in local authorities. 

Professional project evaluation and management is as necessary in the public sector as it is in the private sector. Potential projects should be subject to rigorous cost/benefit evaluation with sensible hurdle rates of return. Of course it can be difficult to establish tangible benefits for social projects, but not even to attempt to do so is lazy. Government projects should aim to deliver real returns just as private sector ones do. And they should be properly managed. The mistakes that led to the cancellation of the NHS project - and other expensive failures - were elementary project management errors. These are as common in the private sector as the public sector: but private sector project failures are swept under the carpet, whereas public sector ones make headline news. The possibility of failure should not deter investment in the public sector any more than it does in the private sector.  

Of course, borrowing for investment does have limits. When governments are very highly indebted, investors start to get worried and bond yields start to spike. But we are nowhere near that limit. Japan currently has debt of over 200% of GDP. For much of the last century, the UK’s public debt was well in excess of 100% of national income, as indeed it was for much of the previous century too (Ritschl, 1996):

Neither Japan nor the UK has ever defaulted on public debt. Indeed, Japanese government bonds and UK gilts are regarded as among the safest investments in the world. Even quite a sizeable increase in public debt for investment purposes would be unlikely to change this, especially if investors knew the Bank of England stood ready to buy bonds if necessary to stabilise yields. Having a trusted and effective central bank guarding your back makes a huge difference to sovereign creditworthiness. It is this that the Eurozone lacks, and it is for this reason that comparisons with say Greece are invidious.

But there is an additional problem. The UK is still running a fiscal deficit of 5.5% of GDP. How can a substantial investment programme be undertaken without vastly increasing this deficit?

I don’t wish to dismiss the deficit as unimportant. But it is not relevant to the discussion of investment spending. The present situation is that what we might call the “day-to-day” spending of the government exceeds its revenues. I am personally of the opinion that trying to reduce this directly has untoward effects and it would be better to focus on measures to improve productivity and wages, but I recognise that to many people a persistent deficit spells disaster. But judicious investment spending can be expected to raise national income and therefore both increase government revenue and reduce its spending. For example, investment that results in higher productivity feeding through into higher wages means more tax revenue for government AND lower welfare bills. Investment spending has long-term benefits on both sides of the public balance sheet. Indeed, that is its purpose! 

Failing to invest in projects which have clear positive returns on the grounds that it would increase the current deficit is a false economy. So investment spending should not be counted as part of the “current” deficit at all. This is the strongest argument in favour of a public investment bank or sovereign wealth fund rather than direct public investment. It makes the distinction between current and investment spending crystal clear and forces the real returns from investment spending and asset acquisition to be recognised in public accounts.

The UK needs investment spending. Restricting investment spending while interest rates are so low is not “responsible management” of the economy. Unfortunately, none of the candidates for Labour leadership have so far pointed this out. All of them – including Mr. Corbyn – have tacitly accepted that eliminating the deficit is top priority and government debt serves no useful purpose. I find this depressing. And I find it even more depressing that Mr. Corbyn, who at least acknowledges the need for investment spending, fails to address this poisonous narrative head on, preferring to propose a form of financial engineering that would deny Britain’s savers the opportunity to invest in their future for better returns than they currently get. In this respect, “People’s QE” it is not.

It would of course be perfectly acceptable for the Bank of England to buy “Development Bonds” as part of a QE programme in a future recession. Richard Murphy believes that in 2020 there will be a recession. If he is right, then a Jeremy Corbyn-led government could indeed do “People’s QE” as he outlines it. But I fail to see why investing in the future of the economy should be dependent on there being a recession. And I fail to see why it has to wait for 2020, either. Her Majesty’s Opposition should get its act together and make the case for investment NOW. 

A shorter version of this post was published in the FT on 24th August 2015.

Related reading:

Image from The Independent.

Saturday, 22 August 2015

The Co-Op Bank: too high a mountain?

The Co-Op Bank has revealed its 2015 half-year results. And they are not pleasant reading. It has made a statutory loss before taxation of £204m, considerably worse than the £77m loss reported in the 2014 half-year accounts. And the Board advises that the bank will not return to profit for another couple of years.

The background to this horrible report is the Bank of England's stress tests last autumn. I didn't bother to look at the results at the time, since it was always obvious that the Co-Op Bank was not going to pass the tests. They came too soon for it to have made serious improvements to its balance sheet after its near-collapse and traumatic recapitalisation in 2013. But I should have looked. The stress test failure was far worse than I had realised:

The table shows that the adverse stress scenario, which modelled a severe property market crash, completely wiped out the Co-Op Bank's capital, leaving it insolvent. This is a major failure. Really, the Co-Op Bank should have been closed down. It is only still alive because the PRA agreed to its capital-raising plan:
The PRA Board’s expectation of The Co-operative Bank’s capital buffer is being re-set to take into account the additional assessment provided by the stress test. In light of that, the PRA Board has required The Co-operative Bank to submit a revised capital plan, which has been accepted by the PRA Board. That plan envisages a reduction in the risk profile and size of the bank’s balance sheet, as a means of reducing its capital requirements. If executed, the plan will deliver a level of resilience commensurate with a bank of its future size and business model. The PRA Board will continue to monitor The Co-operative Bank’s progress against the plan.  
The Co-Op Bank is now a ward of the PRA. Its continued existence depends on successful completion of the plan agreed with the PRA. This is why the PRA recently decided not to impose a richly-deserved penalty of £121m. The Co-Op Bank is already hanging on by its fingernails. Imposing that penalty would amount to stamping on its fingers.

The principal components of the £204m loss just reported arise from the scale and pace of the capital plan.  The Co-Op Bank has taken £38.2m losses on Non-Core asset sales, of which a significant proportion comes from the recent securitisation of £1.5bn of Optimum mortgage assets. The Co-Op is trying to dispose of its Optimum portfolio of subprime residential mortgage loans as quickly as possible, since it significantly adds to balance sheet risk and eats capital. But although it has reduced the Co-Op Bank's risk-weighted assets and therefore improved its capital position, the securitisation was not entirely successful, since the bank has had to retain 65% of the senior tranches. Hanging on to senior tranches of subprime securitisations is not the wisest move for a distressed bank, so I assume this was because of lack of buyers. These Class A notes are now held as "available for sale". Anyone fancy a flutter?

Unwinding over-optimistic fair value adjustments from the Britannia Building Society acquisition in 2010 cost the bank another £54m, The remainder of the loss arose from increased expenditure on restructuring, including IT system replacement: this suggests cost over-runs, but it may simply be due to the PRA's insistence on a faster pace of change.

The counterpart to the loss is the capital gain. Largely because of the securitisation, the Co-Op's Core Equity Tier 1 capital ratio (CET1) has improved to 14.9%. But this is only temporary. Because there are further losses to come, the CET1 ratio is set to fall again, and remain below the PRA's required level for the Co-Op Bank (its "individual capital guidance" level) for some time to come. In other words, the Co-Op Bank is still in regulatory insolvency, two years after its initial collapse and restructuring, though admittedly this is principally because the regulator has moved the goal posts. Unsurprisingly, the report focuses far more on the measures the bank is taking to improve its capital than on the headline losses.

But the fact is that the Co-Op Bank has a simply enormous mountain to climb. It is still haemorrhaging depositors, though at a much slower rate. Its credit rating remains on the floor, making its cost of funding uncompetitive compared to other banks. Its costs are far too high, despite recent rationalisation of its branch network. And its balance sheet is highly risky. For example. 26% of core retail secured lending and the majority of the Optimum portfolio is interest-only (though this is less than in 2014):

Most of the core retail interest-only lending is buy-to-let, of course. But the high proportion of interest-only lending makes the bank vulnerable to housing market downturns - hence the stress test failure.

Not only does the bank have business risks, it has operational ones too. The report notes:
across the Bank's IT infrastructure there are varying levels of resilience and recoverability and whilst a basic level of resilience to technical component failure is in place, the Bank does not have a proven end-to-end capability to recover from a significant and prolonged data centre outage.
The FCA has formally notified the Co-Op Bank that this is a breach of its Threshold Conditions - which means the bank does not have adequate resources to be in the business of banking. This is further justification for closing it down, since lack of IT resilience is even more risky for customers than lack of capital. But once again, the Co-Op Bank has been reprieved. The IT systems are being replaced, though this is a high-risk project which will take some time to complete.

I am wondering how many more reprieves the Co-Op Bank will be given. The regulators are astonishingly generous to it, considering the scale and nature of its problems. It is the most damaged bank in Britain by a long way. I suspect that, were it not for an exceptionally loyal customer base - which it does not deserve - and a crucial role as clearing bank for a significant proportion of the UK's small building societies and credit unions, it would have been wound up long ago.

But the whole capital project is high risk. The bank admits that it is not at all sure the plan will work:
The Bank’s plan to focus on becoming a smaller Core Bank is unproven and is in the early stages of implementation. The Bank does not have a track record in successful execution of the large scale change necessary.
 And it identifies the following  specific risks (my emphasis):
  • Worsening economic and market conditions and/or increasing interest rates and/or a fall in house prices could result in the Core and Non-core assets suffering from more than expected impairments which would adversely impact on the Bank’s operating results and retained earnings; 
  • The Bank needs the ongoing acceptance of the PRA regarding projected ICG deficit in moving forwards with its plan. To the extent this is not forthcoming or to the extent that the Bank does not perform in line with its plan, additional capital may be required over and above that included in the plan in order for the Bank to remain a Going Concern. This could also be the case if there are increases in regulatory capital requirements as a result of changes to international regulations or other changes to legislation or other market wide regulatory requirements or a change in regulatory risk appetite. The plan assumes additional non-CET1 capital will be raised within the plan period; 
  • The inability of the Bank to deleverage its Non-core assets in a controlled and capital efficient manner may have a negative impact on the Bank’s operating results and financial position and its regulatory capital position. In addition, any greater than expected costs or delays in deleveraging the Non-core assets may divert funding from and adversely impact the longer term development and growth of the Core business;
  •  Inability of the Bank for whatever reason to execute on its plan.
The Risk Management section tries to explain what the bank is doing to manage them. But some risks just are not manageable. Point 2 bluntly states that the Co-Op Bank might not remain in business. The plan faces considerable headwinds and slippage seems distinctly likely. If, as a result of this, PRA orders the bank to raise more capital and it is unable to do so, it is dead.

This has been noticed by the bank's auditors:

Oh dear. The last time there was a statement from the auditors that cast doubt on the Bank's ability to remain in business was in the 2013 interim results. And we all know what happened next.

So what is the way forward? Well, the Co-Op has raised £250m of additional capital. And there is talk of the Co-Op Group selling its remaining 20% stake: this might be a welcome relief to the Co-Op Group, which is itself still in intensive care after a major restructuring. There seems little doubt that selling is the Co-Op Group's eventual intention, since it has for the last two years listed the Co-Op Bank under "discontinued operations" in its annual reports. But the question is the timing, and the implications. The Co-Op Group is not going to get a good price for its stake at present, given the uncertain future of the bank. And once the Co-Op Group no longer had any interest in the bank, how much longer would the Secretary of State allow the bank to keep its name?

An IPO has also been discussed. But despite the cautious optimism expressed by its Chief Executive Niall Booker, I can't see how Co-Op Bank can have a future as a small independent retail bank. The extent of change is just too great and the risks too high. I suspect that the real purpose of the capital plan is to dress it up for sale. Indeed the FT reports that Booker has already mentioned the possibility of merger with another bank:
The chief executive added the bank could take part in the consolidation of smaller banks through a potential merger. “We’ve always said that we think there will be some consolidation in the challenger market. We talk to people from time to time,” he said.
In a particularly poignant twist, this would place the Co-Op Bank on the same footing as TSB, the Lloyds Bank carve-out it had hoped to buy, which has just been sold to Banc Sabadell.

But sale to another bank would mean the ignominious end of a venerable institution, and the demise of the hopes of those who wanted to return it to cooperative ownership.

La commedia รจ finita.