Monday, 31 December 2012

The end of the road

I write this post with some sorrow for what must end, and with both trepidation and curiosity (and, I admit, also with some excitement) about what the future holds.

Ten years ago I left the high-pressure world of banking and finance, I thought forever. I had intended to leave years before, but the need to support a young family when my husband was out of work overrode my personal desire to - in the words of my little boy - "stay at home and do my big singing". But in 2012, following the breakup of my marriage, I decided that the time was right to leave. I was already teaching singing part-time and doing some professional singing, and I had gained my Royal College of Music Associateship in Singing Performance. Encouraged by my new partner, I took the plunge. I ended my consultancy at RBS and concentrated on building up my singing and teaching career.

It worked stunningly well. Or at least the teaching did. All too well, actually. I quickly found myself working in schools during the day and teaching adults in the evenings and at weekends. Right from the start most of my work came through word of mouth - recommendations from people who had either heard me sing or seen me teach. Within three years of cutting loose from banking, I was afloat as a self-employed singer and teacher.

But there was a downside. I soon found that the amount of teaching I had to do to earn enough money to pay the bills was having a bad effect on me physically. My voice was constantly tired during the school term and I started to lose high notes. I recovered during school holidays, when my schools work stopped (although my private work continued) - but then I didn't have the money to pay the bills. I started to dread Christmas and summer holidays, because I knew that there would not be enough money. And I started to dread solo engagements during school terms, because I didn't know if my voice would work well enough. As the schools teaching increased, I gradually stopped even looking for solo work.

The physical problems associated with teaching have got steadily worse over the last ten years. I accompany my students at the piano when I teach, which means sitting on a backless piano stool for hours on end: the remuneration level from teaching is not enough to allow me to employ an accompanist, and I don't like the inflexibility of backing tracks. The ergonomics of school practice rooms are frankly dreadful: it is always a beaten-up old upright piano, always with its back to the wall (so I have to face the wall) and there is seldom a correctly-positioned mirror so I don't have to twist round to see my students. I started to get pain and stiffness in my back, neck and shoulders, which kept me awake at night, interfered with my voice and reduced my ability to sustain long phrases. I now have regular chiropractic to straighten me out, but I am still tired and in pain a lot of the time during the school term. I've loved the piano all my life, but it has become an instrument of torture.

At the beginning of December 2012 I did a concert with a choral society that I have worked with many times. In their programme they advertised their next two concerts, both of which are works I know well, have sung before and which suit me vocally. But I won't be doing them.

It appears that a friend of mine who arranges teams of soloists for concerts had been engaged by the director of this choral society to book the soloists for the next concerts. But my friend had not booked me. I was very upset to discover this, so I emailed him to ask why. He said I am not strong enough vocally now to match the other people he was booking. The last time he heard me, which was in the summer of 2011 when I was doing 36 hours a week singing teaching, I was so tired that I simply didn't make enough noise.

I was horrified. I left banking to be primarily a singer, not a teacher. Losing professional singing work because teaching wears me out is far too high a price to pay for household solvency. And in the end, if my physical and vocal health is destroyed, teaching too will become impossible. You can't be an effective teacher if you can't sing well yourself.

I don't know if this is the end of the road for my professional singing. I hope it is not, and that I can continue to do some solo work, though I don't expect it to pay the bills. But it has to be the end of the road for full-time singing teaching.

So this New Year, for me, really is the end of the old and the beginning of the new. I have changed career before, but last time I knew where I was going. This time I don't..........or maybe I do. For the last two years I have been spending much of my time writing and talking about banking, finance and economics.  So far I have done this entirely in my spare time, for fun and for nothing. But maybe that will change. Maybe the wheel is turning, and the banking and finance I thought I had left forever is calling me back.

Singing will always be a part of my life. And perhaps teaching can be too, though on a much reduced basis. But what will plug the gap that teaching will leave? I don't know. Writing, perhaps, or consultancy? I would welcome suggestions.

I am holding to the belief that somehow, the way will become clear. After all, the end of one road is always the start of another.



Friday, 28 December 2012

Why do we never learn?

I found a fascinating report today. It dates from 1996 and is the Bank of England's report into the functioning of the Deposit Protection Scheme, the predecessor of the current Financial Services Compensation Scheme, which provides a measure of compensation to bank depositors and other small financial investors in the event of bank failure.

A Deposit Protection Scheme was one of the provisions of the 1979 Banking Act. But it was not the only provision of that Act, and in many ways not the most important. In the words of the Bank of England (my emphasis):
Before the introduction of the first Banking Act in 1979 there was no statutory requirement that a bank or similar deposit-taking institution be authorised to accept deposits or undertake banking business in the UK. There were disclosure requirements (Protection of Depositors Act 1963) on those institutions that advertised for deposits, including the obligation to include in their accounts prescribed information, which were examined by the Board of Trade. However, banks and discount houses were exempt from these requirements.
In other words, pretty much anyone could set themselves up as a deposit-taker and lender. Banking licences were granted by the Board of Trade without consideration of standing or conduct, and banks were not obliged to accept the Bank of England's supervision. Consequently there were a large number of effectively unregulated and unsupervised small banks, competing with each other for increasingly scarce deposits and lending mainly for property purchase.

The Secondary Banking Crisis of 1973-5 saw the near-failure of about 60 small lenders which had borrowed heavily on the wholesale money markets to fund mortgage lending. The Treasury, then responsible for monetary policy, had raised interest rates into double figures to fight inflation, and this caused a sudden crash in property prices and a spate of mortgage defaults. Concerned about systemic stability, the Bank of England opted to provide liquidity support for these banks to prevent their failure, a decision which cost it about £100m. No depositors lost any money, but there was widespread recognition that depositors' money had been at risk, and the excessive risks taken by these banks needed to be curbed. Following extensive consultation, the 1979 Banking Act was passed, which for the first time mandated the Bank of England to issue banking licences and supervise banks.

The Deposit Protection Scheme created by the 1979 Banking Act came into effect in 1982, and was almost immediately followed by a series of depositor compensation claims arising from the Bank of England closing down banks that didn't meet the criteria for either a full banking licence or a deposit-taker's licence (the 1979 Act distinguished between the two). But what happened later was much more interesting.

The report I found today examines 22 banks that failed and created potential claims on the Deposit Protection Scheme between 1984 and 1996. Most of these were small banks, but five were large enough to cause systemic disruption, and two - BCCI and Barings - are now household names. The fall of Barings remains one of the worst "rogue trader" events in history, and the extent of the BCCI fraud was exceeded only by Enron. Until recently, that is - the mortgage fraud in the US that underpinned the financial crisis looks set to be the worst corporate fraud in history, and the LIBOR rate-rigging scandal will run it a very close second. Or vice versa. Either way, BCCI and Enron now look like minor blips. But I digress.

The remaining three larger banks that failed were not known to me, so I looked them up. And what I found was fascinating and instructive. We simply do not learn from our past history: even though we put in place regulatory and supervisory measures to curb the excesses that lead to failures like National Mortgage Bank and Johnson Mathey Bank, over time we forget about them and we make the same mistakes again.....

National Mortgage Bank (NMB) was extraordinarily like Northern Rock. It borrowed on the wholesale markets to fund high-risk mortgage loans (yes, subprime existed in the 1980s!) which it then packaged up and sold on in an early form of securitisation. When BCCI failed, nervous money market lenders reduced wholesale lending, and NMB was forced to go to the Bank of England for emergency funding in February 1992. It all sounds horribly familiar, doesn't it? Except that Eddie George, then deputy Governor, kept the press at bay: the Bank of England resolved NMB swiftly and quietly, there was no panic and no run on the bank. What a contrast to the inept handling of the Northern Rock failure by an inexperienced Treasury team and emasculated Bank of England. The chairman of the restructured NMB, Ian Hay Davison, makes it very clear that in his view the separation of the Bank of England from bank supervision was the reason for the relatively poor handling of Northern Rock. But what I want to know is - given that the Secondary Banking Crisis was caused by high-risk property investments funded by volatile money market borrowing, and the failure of NMB was caused by high-risk property investments funded by volatile money market borrowing, why did the Northern Rock failure happen at all? Why didn't these failures teach regulators to monitor and control retail banks' propensity to over-borrow and over-lend when property prices are rising? Why are we STILL not making any attempts at all to moderate retail banks' risky behaviour?

Turning now to Johnson Mathey Bank. JMB was the banking services arm of a major precious metals company. Originally it was purely a bullion dealer and a member of the London Gold Fixing. But in the early 1980s, JMB expanded its activities into corporate lending, quickly building up a huge portfolio. The scale of its lending dwarfed its capital and it was heavily exposed to a small number of borrowers, some of whom turned out to be fraudulent. The decision to bail out JMB was made on the grounds of its importance in a very concentrated bullion business and worries about contagion causing panic in the wider banking industry. The Bank of England bought JMB for a nominal £1 and later sold it to Westpac. The concentration and riskiness of JMB's corporate lending portfolio led directly to the tightened reporting requirements for large exposures in the 1987 Banking Act. Yet if we fast-forward to 2008 - what caused the failure of HBOS? Yes, it was corporate lending: high-risk and fraudulent loans concentrated in particular sectors, dwarfing the bank's capital and funded by volatile wholesale borrowing. So given that the failure of JMB actually did lead to regulatory changes, how was HBOS allowed to happen? And since the cry at the moment is for banks to increase risky lending to risky businesses in order to "get the economy moving", what chance is there of anyone learning from this failure, either?

The third one was British & Commonwealth Holdings. Here is the first paragraph of the House of Lords judgement regarding Soden vs British & Commonwealth Holdings:

In 1988 British & Commonwealth Holdings P.L.C. ("B.& C.") purchased for some £434 million the whole of the share capital of Atlantic Computers P.L.C. ("Atlantic"). The acquisition proved to be disastrous. Atlantic went into Administration in 1990. The Administrators of Atlantic are the appellants in your Lordships' House. B. & C. is also in Administration. It has brought proceedings against, inter alia, Atlantic ("the main action") for damages for negligent misrepresentations said to have been made by Atlantic so as to induce B. & C. to acquire its shares. B. & C. has also brought proceedings against Barclays de Zoete Wedd Ltd. ("the B.Z.W. action") for damages for negligent advice given in relation to the acquisition of the Atlantic Shares. B.Z.W. has issued third party proceedings against Atlantic for contribution and damages.
Yes, you're right. B&C was bankrupted by an unbelievably stupid acquisition of a company already riddled with debt and technically insolvent, without doing proper due diligence and with fraudulent misrepresentation of the share price. The House of Lords finally dismissed Atlantic's appeal in 1997 - but by that time B&C had been dead for 7 years. The B&C failure happened in 1990. In 2008, RBS failed due to an unbelievably stupid acquisition of a company already riddled with debt and technically insolvent, without doing proper due diligence and probably with fraudulent misrepresentation of the share price. Whatever was learned from the B&C failure had evidently been forgotten by the mid-2000s.

In fact all the lessons from the bank failures of 1982-96 had been forgotten by the mid-2000s. I am not hopeful that the lessons of the failures of Northern Rock, HBOS and RBS will be learned either. The Bank of England's report into the 22 bank failures identifies five main causes of bank failure. In order of importance, they are as follows:

- Bad management (18 of 22)
- Poor asset quality (16 of 22)
- Liquidity problems (9 of 22)
- Fraud  (7 of 22)
- Dealing losses (2 of 22)

You will note that dealing losses comes last on the list. But which one are we paying the most attention to? Yes, dealing losses - hence that ridiculous ring fencing idea that gets far too much air time, and calls for structural separation that would achieve nothing but make everything more expensive. Why is no-one paying much attention to the top two - which are bad management and poor asset quality (i.e. highly risky lending)? These were by far the commonest cause of bank failure in the 1982-96 period. In fact they have ALWAYS been the top two causes of bank failure. 

Those who wish to return to some kind of "golden age" when there were lots and lots of little banks might like to ponder on the findings of the 1996 report:
Another relevant factor, but one which is not highlighted, is size. All banks are affected by macroeconomic conditions. But smaller less-diversified banks do appear — not surprisingly — to be generally more vulnerable to changes in market conditions than large banks which are diversified across a number of sectors and income sources.
So breaking banks up, restricting their size and limiting their range of activities DOESN'T make them safer. It makes them more likely to fail, not less. And the Secondary Banking Crisis shows us that when there are a lot of small banks all operating in the same sector, together they can create considerable systemic risk.

The message I am trying to give is this. Almost everyone seems to have an opinion about "how to fix banking". And some radical ideas are being considered. But no-one seems to be looking at what actually went wrong, either recently or in the past. If they did, they might come to different conclusions. For me, breaking banks up, separating retail & investment banking, full reserve backing for deposits - all of these miss the point. What is needed is consistent long-term regulation of the dull & boring activities of banks - deposit-taking and retail lending - and continual supervision of bank management. That's where the risks build up unnoticed. That's where the cause of most failures lies. Let's focus on controlling those, and stop worrying about the fruitcake stuff. It's really not important.



Friday, 14 December 2012

Who pulled the switch?

One of the interesting features of financial and economic crises is their suddenness. It's as if the world is happily strolling along a well-trodden path on which someone has built a man-trap. We don't see the crash coming and we walk straight into it. Yet when we look back on what happened, we see all too clearly that the signs were obvious - we just didn't notice them.

Economists have made numerous attempts to explain this apparent blindness without a great deal of success. The fact is that financial crises do not come out of the blue, and some people do see them coming. The world is warned about its folly, but chooses to ignore. Those who shout "WATCH OUT - THERE IS DANGER AHEAD" and try to suggest alternative courses of action are dismissed as Cassandras and their thinking is excluded from mainstream academia and the corridors of power. This suggests that the cause is more psychological than economic - it is rooted in people's behaviour. Like a Greek tragedy, the end is inevitable because of the nature of the players.

In this post I shall attempt a psychological explanation of the behaviour that leads to financial crises. I am not a psychologist, but I do have some training and experience in Transactional Analysis (TA) and it is that theory that I shall use in this post.

Economists are familiar with "Game Theory", but perhaps less so with the TA idea of psychological games. Yet the pattern of behaviour that leads to a financial crash looks to me very much like the sort of thing that goes on when people play psychological games - as we all do, all the time.

The creator of the concept of psychological games, Eric Berne, defined them thus:
"A game is an ongoing series of complementary ulterior transactions progressing to a well-defined, predictable outcome. Descriptively, it is a recurring set of transactions... with a concealed motivation... or gimmick."
Games have a characteristic pattern: all players participate willingly in what appears to be a mutually satisfying serious of exchanges until someone breaks the rules ("pulls the switch") and the game comes to an abrupt end, accompanied by confusion, panic and anger as all participants are forced to face the truth they have been avoiding.  In TA, games have one purpose only, and that is to avoid what Berne calls "intimacy" and we might call "reality". And they are anything but fun. Psychological games range from mildly upsetting to downright vicious and even murderous. Someone always gets hurt.

Despite their painful nature, psychological games tend to be repeated. Rather like a rugby player who gets injured every time he plays and yet continues to play, people have preferred games that they play again and again, even though they get hurt every time. Getting hurt in a psychological game is preferable to facing reality.

So if the 2007/8 financial crisis was caused by someone pulling the switch in a massive psychological game, what was that switch and who pulled it? I am indebted to Liam Byrne for unwittingly defining it, though he personally did not pull it. After he lost his job as Treasury Secretary in the UK General Election, Byrne famously left a note for the next incumbent which said "There's no money left". And that, in a nutshell, defines the belief switch that caused the financial crisis.

In the run-up to the financial crisis, the prevailing belief was "We will never run out of money", and more and more of it was created to satisfy demand. I'm not going to get into arguments about whether credit money created by financial institutions is "real" - as far as the participants in this particular game were concerned it was real, because they could use it to buy stuff and have a good time. But in 2007, someone highly influential indicated that the supply of money was running out. I don't know exactly who this was, though I'd regard the Fed's decision to raise interest rates as a fairly strong signal - raising interest rates does restrict the supply of money. Anyway, investors started to withdraw their funds. This caught out the Bear Sterns hedge funds, which collapsed in August 2007, at which point banks scared of losing their money stopped lending it to smaller banks. Smaller lending institutions such as the UK's Northern Rock suddenly found themselves unable to borrow money from the interbank market to fund their lending: American lenders were bailed out by the Federal Housing Association, but Northern Rock was forced to seek emergency funding from the Bank of England. The tragedy for Northern Rock was not that the Bank of England was operationally unprepared to provide emergency liquidity - the Treasury gave permission for the funds to be provided - but that someone at the Bank of England told the press that Northern Rock had run out of money. Suddenly the game was up and there was a very public run on Northern Rock as scared depositors queued up to withdraw their money. And the rest is history: unable to recover from the loss of both wholesale funding and deposits, Northern Rock was eventually nationalised. But the run on shadow banks continued for another year, ending with the collapse of Lehman Brothers and bailout of banks all over the world as the prevailing belief changed from "We will never run out of money" to "There's no money left".

It is wrong to assume that the first statement - what Berne calls the "gimmick" - is false and the second - the "switch" - is true. Actually neither is true. The switch is as false as the gimmick: the entire game is illusion. And notice what happened next. Instead of confronting the reality of global economics (to which I will return shortly), the world embarked on a new game, called "Austerity".

What is depressing is that the world has played this sequence of games before: "Profligacy" ("we will never run out of money") followed by "Austerity" ("there's no money left"). The last time this sequence was played in earnest, it caused enormous suffering across the developed world and ended in world war. We played a milder version in the 1970s and 80s, which ended with the collapse of the Soviet Union and wars in Eastern Europe. Perhaps the "switch" in the Austerity game is popular uprising and replacement of political regimes - but as Orwell described in "Animal Farm", one political regime looks much like another.....

But it is unnecessary. The Austerity game is as much an avoidance of reality as the preceding Profligacy game. We do not have to cut support to the poor and vulnerable. We do not have to increase people's tax burden. We do not have to pour money into banks in the hopes that they will lend to people who already have too much debt. We do not have to suppress interest rates to extract money from savers. We do not have to bail out foreign creditors at the expense of domestic production (are you listening, Greece?). And above all, we do not have to accept that money is scarce. If it is scarce, it is because we have made it so. And in the developed world, where goods are anything but scarce and can be produced at very little cost, it is a disgrace that people are increasingly poverty-stricken because of shortage of money. I am reminded of Steinbeck's description of fruit, fallen from the trees and left to rot because consumer prices had fallen so low it was not worth farmers' while to pick it, being ruined with petrol to prevent the starving migrants from the drought-stricken American Mid-West from taking it. Nowadays, of course, we wouldn't use petrol - it's too expensive - but there are other ways of preventing people from getting the necessities of life for nothing.

What is needed is for economists and politicians to put their various ideologies to one side and take a hard look at how the economy ACTUALLY works, and what is really going on. Shortage of money is not the problem: allocation of money is the issue. Money is being created, but it is not going where it is needed, and this leads to unnecessary shortages of goods that actually are in abundant supply. That is the defining characteristic of both games - Profligacy as much as Austerity. The underlying reality is gross inequality and misallocation of resources. Until the world recognises this, we are doomed forever to play out the same sequence of games.

UPDATE December 16th 2012: I think we've discovered who pulled the switch in 2007 (thanks to @Hatti_Fattener on Twitter). This NYTimes report from August 9th, 2007 discloses that BNP Paribas suspended three of its funds because it was unable to value subprime MBS used as collateral. The press report of BNP's decision alone would have been sufficient to trigger the repo collateral margin calls that according to Gary Gorton forced banks to sell assets at fire sale prices, triggering a general collapse of asset prices. Further digging reveals that, according to the NY Fed, this was actually a run on ABCP, which started when the sponsor of a single-seller mortgage conduit, American Home, declared bankruptcy and three mortgage programs extended the maturity of their paper; in response to this BNP Paribas halted redemptions at two of its mortgage-affiliated programs due to being unable to value ABCP paper. DTCC data shows that this triggered a run on over 100 investor programs, not all of them directly connected with subprime. This was a third of the entire ABCP market, and caused the closure of the MBS market. So it seems the switch-puller was a Fed primary dealer. 



Wednesday, 12 December 2012

The strange world of negative interest rates

There has been considerable discussion recently about central bank interest rate policy, and in particular, what further monetary easing they can provide when interest rates are at or close to zero. Central banks have been using a range of unconventional tools, of which quantitative easing is the best known, to depress market interest rates. I have serious reservations about the effectiveness of these for the real economy, and in a recent post suggested that QE is not only ineffective but actually toxic for the real economy. But there is evidence that central banks are starting to consider negative rates as a policy instrument, so in this post I shall consider what would be likely to happen if central banks reduced rates to below zero.

There are two types of rate that central banks could reduce to below zero. One is the policy rate itself, which is the rate at which the central bank will lend to banks against collateral. The other is the interest rate that the central bank pays on excess reserves. I shall return to the policy rate later, but first I wish to discuss the effect of reducing interest rates on excess reserves to below zero.

Banks currently have rather a lot of excess reserves, since the unconventional tools themselves have caused reserves to build up, so reducing interest rates on excess reserves looks like an attractive policy. After all, if maintaining higher balances in their central bank reserve accounts than they need to becomes expensive, banks won't do it, will they?

Let's consider what negative interest rates on excess reserves actually are. There are two ways of looking at them:

- Negative interest rates on reserves are a charge to banks for placing money on deposit in a fully guaranteed deposit account. They are equivalent to a safe deposit charge.

- Negative interest rates on reserves can also be regarded as a tax on deposits. As with all taxation, the burden of that payment does not fall on the bank itself. I shall discuss shortly where the burden actually falls.

The thinking behind charging banks for safe deposits at the central bank is that banks will choose to lend that money out for a positive return instead of suffering erosion of principal in return for safety. This unfortunately demonstrates the misunderstanding of lending that underlies the failure of modern macroeconomics to explain or prevent financial crises. Banks lend if they choose to - if the balance of risk versus return works in their favour. If it doesn't, no amount of reserves will make them lend. They will hoard money instead. And the fact is that the balance of risk versus return at the moment is so horrible that banks do not wish to lend except to the most creditworthy borrowers. Banks are seriously damaged and very, very scared of losses: they are already carrying high levels of risky loans against which they have insufficient loss-absorbing capital, and governments are withdrawing the implicit guarantee that enables them to maintain risky lending against insufficient capital. And the world is a risky place for banks at the moment: there is a severe credit crunch in the European periphery due to the ever-growing sovereign debt crisis there, and creditworthy borrowers are thin on the ground everywhere due to damaged household and corporate balance sheets.

Not only that, but there is evidence that creditworthy households and corporates don't want to borrow, either. Borrowing and spending is out of fashion, saving and thrift is in.  The Bank of England's "Trends in Lending" report says risky borrowers such as SMEs can't get the finance they want at the rates they want to pay, but it also notes that lenders complain about low demand and lack of creditworthy borrowers.

There is general risk aversion among investors, too. Yields on highly-rated government debt are at historic lows: in some countries this is partly due to QE, but German bunds have had no QE and yet were recently trading at yields at or below zero. Traditional safe haven currencies such as the Swiss franc are under such exchange rate pressure that the Swiss National Bank has intervened to prevent the franc's appreciation damaging the Swiss economy. Deposit account interest rates are on the floor, and some banks in the US are imposing negative interest rates on large sums of money in FDIC-insured deposit accounts.

It's worth remembering, too, that reserves are created by the central bank, not by commercial banks, and that commercial banks have no power to reduce the total amount of reserves in the system. That can only be done by the central bank. So if commercial banks were discouraged by negative interest rates from holding excess reserves, but there were still excess reserves in the system, banks would look for ways of passing on those excess reserves to other banks. Excess reserves would become something of a hot potato, with no bank wanting to be caught with excess reserves at the end of the day. I suppose that might improve the velocity of money, but I could see it leading to all manner of stupid investments.

So, if - say - the ECB imposed negative interest rates on excess reserves in a world which is both risky and risk-averse, how would banks behave? I can't see any reason at all why they would increase lending. They would be more likely to look for other "safe" investments as an alternative to parking deposits at the central bank. And they wouldn't have far to look. The debt of countries like Germany, the US and the UK is explicitly  backed by government guarantee just as central bank reserve accounts are. If the yield on these bonds were higher than the negative interest rate charged by the ECB, banks would purchase these with their surplus deposits. There might also be round-tripping from banks seeking to arbitrage the difference between sovereign debt yields and central bank negative interest rates. The inevitable effect would be downwards pressure on the yields on "safe" government debt in much the same manner as QE.

But negative interest rates on reserves could have an even more toxic effect too. For this we need to look at the experience of Denmark, which introduced negative rates on excess reserves in response to the ECB's cutting of rates to zero. Denmark was forced to do this because it is maintaining a currency peg to the Euro, and interest rate parity with the Eurozone would place that peg under pressure due to capital flight from the stressed areas of the Eurozone. Denmark's banks complained that their margins were being squeezed. The Danish central bank's rather unsympathetic response was to suggest that Danish banks could simply raise their rates to borrowers. Which the Danish banks duly did.

Now, Denmark is experiencing some inflationary pressure due to capital inflows from the Eurozone, and its currency is under pressure, so raising interest rates to borrowers helps to dampen this down - which is why the Danish central bank was unimpressed by the banks' complaint. But consider what would happen if an economy experiencing deflationary pressure introduced negative interest rates. The squeeze on the margins of already-damaged banks would inevitably lead to higher rates to borrowers and reduced lending volumes. This is monetary tightening, not easing, and the effect would be contractionary. It would make the recession worse.

This is also consistent with my description of negative rates on excess reserves as a tax on deposits. I've described it as monetary tightening, but it could also be seen as a fiscal tightening since central banks are part of government: one of the strange effects of very low interest rates is that the distinction between monetary and fiscal policy is becoming ever more blurred. And the Danish experience shows where the incidence of that tax would fall. It would not fall on banks, which would find a way of passing on that cost to people: nor would it fall on savers. It would fall initially on borrowers, as lending rates were raised: then, as lending volumes fell in response to higher rates, it would fall on shareholders in the form of lower returns, and employees in the form of lower wages. And the overall effect on the economy would be deflationary, due to reductions in both credit and income for businesses and households.

So negative interest rates on excess reserves would be counter-productive. Fortunately the Fed seems to be wise to this and has ruled them out, at least at present: but unfortunately the classical macroeconomic bias of the Eurosystem leadership appears to have rendered them incapable of understanding the contractionary effect of negative interest rates on reserves, even though they have an example on their doorstep. At a press conference the other day the head of the ECB, Mario Draghi, appeared to suggest that negative interest rates might come soon. Heaven help the Eurozone if that goes ahead.

But what about cutting the policy rate itself to below zero? This would in effect mean central banks would pay commercial banks to borrow from them.

A negative policy rate would be a direct subsidy to banks. And if it actually worked to improve lending volumes and bring down rates for riskier borrowers, it might be a worthwhile subsidy, too. But in a world that is both risky and risk-averse, I don't think it would have that effect. Remember that banks only lend if the risk versus return profile works for them. And people and corporates only borrow if they wish to spend - which at the moment they don't, much. The failure of QE as an economic stimulus to the real economy demonstrates that throwing money at banks doesn't make them lend. Why would paying banks to borrow be any more effective?

A negative policy rate could be effective as a bank recapitalisation. The central bank lends against collateral - typically its own sovereign debt and sometimes other sovereign debt too. Suppose the central bank pays banks to borrow against collateral of the sovereign bonds they already hold, on which they are receiving interest. They then use that money to purchase more sovereign bonds to repo back at the central bank for more funds. And they receive interest both on the borrowing and the purchases, all of it effectively paid by taxpayers (since central bank payments are guaranteed by government). That is state-funded bank recapitalisation by the back door. Nice.

There is no doubt that banks need recapitalising. But why on earth do it by such a roundabout route? And what is to stop them paying out their earnings from this sovereign round-trip in the form of shareholder dividends and employee bonuses?

Like negative rates on reserves, negative policy rates could actually have a toxic effect on the real economy. Across Europe, including the UK, many loan rates - especially mortgages and business loans - are tied to the policy rate. So if the policy rate were cut to below zero, lenders would find their margins squeezed on existing lending: they could even find themselves receiving negative returns on these loans. Realistically they cannot cut their deposit rates to savers to below zero (savers would stuff mattresses instead), so their only option is to RAISE lending rates to new borrowers, widening credit spreads. Exactly the same effect as negative interest rates on reserves, in fact - and the same effect as QE. Existing floating-rate borrowers would of course find their borrowing costs eased: but would they spend this money? Many of them are highly indebted, and many more of them are suffering erosion of their savings due to very low real interest rates. I suspect they would use the windfall from lower borrowing costs to pay off debt, or to top up their savings, rather than spend. In which case the overall effect on the real economy of a negative policy rate would be contractionary, not expansionary.

So cutting policy rates to below zero would be as counter-productive as cutting interest rates on reserves. And it would be unpopular. I can't imagine any electorate, wounded as they are by the behaviour of banks, tamely accepting bank funding being subsidised while interest rates to new borrowers soared and the economy crashed.

But suppose, in a world gone mad, central banks decided to cut both interest rates on reserves and the policy rate to below zero. This is where things become very, very strange. Government (via the central bank) would pay banks to use state funds to settle lending while taxing them if they attempted to self-fund. The effects would be extraordinary.

Firstly, banks would be actively discouraged from holding excess reserves at the central bank. But they would have an increased need for government securities. So initially they would try to reinvest excess reserves in government securities, driving down yields. Thereafter, any further need for collateral could be met by using central bank funding to buy securities.

Both the unsecured interbank market and the repo market would die, because it would be far cheaper for banks to borrow from the central bank than from funding institutions - even with the cost of holding increasingly expensive safe assets for collateral. Banks would become completely dependent on central bank funding.

Rates to commercial depositors would crash, as banks would no longer have any incentive whatsoever to seek deposits. In fact as they would be charged to hold them, either directly through the tax on excess reserves or indirectly through negative yields on assets purchased with those deposits, they would actively discourage them by cutting interest rates. As commercial deposit rates approached zero, savers would start hoarding cash instead, or investing in physical assets such as gold.  There might also be a flood of money into National Savings if the interest rate were favourable. And as returns on various kinds of wealth fund including pensions, already low, turned negative due to crashing yields on safe assets, they would close their doors and savers would be forced to turn to cash or physical assets.

Banks' aversion to holding deposits could have very weird consequences for the real economy, as the Fed notes. For example, if they imposed negative interest rates on ordinary deposits including current accounts, people would stop using banks and we would return to a cash-based economy: or they might even turn to alternative currencies such as e-credits on mobile phones. I have no doubt that e-credit suppliers would be only too happy to see their currencies take the place of sovereign currencies for day-to-day transactions.

Theoretically, recapitalisation of banks coupled with low-cost funding should encourage banks to lend. But their balance sheets are still stuffed full of risky loans. Even if they had more capital and cheap funding, they wouldn't want to take on more risk lending. No, they would go for safe assets and cash. Nowhere in this bizarre scenario is there ANY incentive for banks to increase risk lending.

Theoretically, too, deposit rates crashing to zero or below and falling rates on floating-rate loans to existing borrowers should encourage households and businesses to spend instead of saving. But not when they are highly indebted and suffering erosion of principal on existing savings. No, they would pay off debt and increase their savings. Nowhere is there any real incentive for households and businesses to spend instead of saving.

And it gets worse. As safe collateral became scarce, central banks would inevitably extend the range of acceptable collateral to other bank assets, such as mortgages.....eventually all forms of lending would be pledged to the central bank in return for funding. Banks would no longer carry the risk of that lending: in the event of default, the loss would rebound to the central bank to whom the asset was pledged, and the state - not the bank - would take the loss. The ECB is already a long way down this path even without negative rates.

So the final outcome of a complete negative-rate policy would be a state-recapitalised banking system, funded entirely by the state and with lending risk borne by the state. Effectively, that is nationalisation of the banking system - but without the control that would force banks to use state funding productively to benefit the real economy. It would be the worst of all possible worlds.....except one in which the sovereign currency was rejected in favour of private-sector alternatives because of the cost of holding it. If the sovereign currency is rejected because people have to pay to use it, how long will government and the rule of law last?

Wednesday, 5 December 2012

The elusive tax haven definition

The Tax Justice Network's October podcast gleefully announced that Helsinki had "declared itself a tax haven-free zone". According to its presenter Naomi Fowler, "companies who use or have links to tax havens will no longer be able to bid for contracts providing goods or services to the public. This month, city councillors voted to sever ties with such companies".

I was slightly puzzled by what they meant by this, not least because according to some Finland is itself a tax haven, so it is difficult to see how it can become a tax haven-free zone. And Richard Murphy's explanation didn't shed any light. So I went hunting for an explanation of exactly what Helsinki had agreed to do, and in particular, what they meant by a tax haven.

The first thing I found was a press release, which among other things purports to include a link to the actual resolution. But as far as I can see it doesn't: the link is indeed to a list of Helsinki city council resolutions, but tax havens don't seem to be mentioned anywhere. However, the press release does define what it means by a tax haven:
Tax havens are either territories or countries whose authorities allow businesses or individuals to deposit their wealth at very low tax rates or, in some cases, pay no taxes at all.
And it goes on to provide a link to the Tax Justice Network's list of the top 10 tax havens in the world. I shall discuss this list shortly, but first let's consider the definition of a tax haven according to that press release.

If low taxes alone were the sole reason for boycotting companies based in or linked to a country, that would undermine the right of sovereign states to define their own tax rates. In effect, a sovereign country that chose to operate very low tax rates in order to attract business would be regarded as criminal and subjected to international sanctions. But the fact is that we do not have international laws that define "acceptable" tax rates for sovereign states. Even cooperative groupings of countries such as the European Union (EU) do not have harmonised tax rates. In fact the EU includes several countries that meet the definition of "tax haven" according to that press release. As an EU member itself, Finland can't boycott them without falling foul of EU law, which allows companies to base themselves wherever they wish and trade wherever they wish without barriers. Clearly the press release is using the term "tax haven" much too loosely.

The OECD specifically rules out no or low taxes as a sufficient definition of a tax haven. It identifies four criteria (my emphasis):
Four key factors are used to determine whether a jurisdiction is a tax haven.  The first is that the jurisdiction imposes no or only nominal taxes. The no or nominal tax criterion is not sufficient, by itself, to result in characterisation as a tax haven.  The OECD recognises that every jurisdiction has a right to determine whether to impose direct taxes and, if so, to determine the appropriate tax rate.  An analysis of the other key factors is needed for a jurisdiction to be considered a tax haven.  The three other factors to be considered are:
  • Whether there is a lack of transparency
  • Whether there are laws or administrative practices that prevent the effective exchange of information for tax purposes with other governments on taxpayers benefiting from the no or nominal taxation.
  • Whether there is an absence of a requirement that the activity be substantial
Transparency ensures that there is an open and consistent application of tax laws among similarly situated taxpayers and that information needed by tax authorities to determine a taxpayer’s correct tax liability is available (e.g., accounting records and underlying documentation).
This is clearly a much more rigorous definition. In fact it is so rigorous that at the time of writing, NO country in the world meets these criteria. The OECD's "black list" of uncooperative low-tax jurisdictions currently has not a single member: the last three were removed in 2009. Even its "grey list" - those jurisdictions that have agreed to improve their transparency and reporting standards but haven't got round to doing anything about it yet - consists of only three tiny countries: Nauru, Niue and Guatemala. So if the OECD's definition of tax havens, and its assessment of countries according to that definition, are to be believed, what on earth is the fuss about - and where on earth is Finland boycotting?

The Tax Justice Network's Top 10 Tax Havens suggests that their definition is nothing like the OECD's - or, for that matter, the press release's. The list includes Germany (no.9), Japan (no.8), Singapore (no.6), the USA (no.5) and Hong Kong (no.4). None of these are known to have "no or nominal taxes" - in fact the USA has one of the highest corporation tax rates in the world, at 39%.  A bit more digging reveals that these are the top ten countries on TJN's "Financial Secrecy Index", which lists 71 countries, of which 16 are European Union members (this excludes self-governing dependencies of the UK and the Netherlands). Yet almost none of these appear on the OECD's black or grey lists, even though the OECD has criteria for transparency and openness. Clearly what TJN means by a "Financial Secrecy" jurisdiction is far more wide-ranging than the OECD's definition of a tax haven.

So exactly what is TJN's definition of a tax haven? Well, it's not exactly clear. They have provided an explanation of their complex methodology. It's too long to reproduce here in full, but here are the key points as far as I understand them.

TJN use the terms "tax haven" and "secrecy jurisdiction" interchangeably. Their definition is:
Loosely speaking, a secrecy jurisdiction provides facilities that enable people or entities escape or undermine the laws, rules and regulations of other jurisdictions elsewhere, using secrecy as a prime tool.
Loose it certainly is. Almost any country that aimed to entice business to its shores could find itself falling foul of some part of that definition. And in fact further down the page TJN comments that 
"....every country in the world exhibits at least some elements of secrecy."
Indeed they do. No country is going to reveal all its financial and tax affairs to the world while tax remains a source of competitive advantage. So every country in the world is a tax haven, really. Blimey. 

Anyway, TJN then go on to provide a 2-page summary explaining this definition. It doesn't add much, frankly. But there are two features that I find simply nonsensical:
  • They claim that a key feature of secrecy jurisdictions is "lack of democratic accountability". So every tin-pot dictatorship in the world is presumably on their list simply because it isn't a democracy? Then why isn't North Korea on the list - or China (except Hong Kong), for that matter? Actually, democracy has nothing to do with this. More than half the world isn't democratic in the Western sense - but that doesn't mean that more than half the world is a tax haven.
  • They further claim that lax regulation in secrecy jurisdictions forces other countries to deregulate their economies too in order to "staunch the outflows of capital". This is extraordinary. Deregulation ENCOURAGES movements of capital, rather than staunching them. If countries want to staunch capital outflows, they either need to make their own regimes more attractive so the capital doesn't want to leave (perhaps that's what TJN mean by deregulation?), or they have to impose some form of capital controls. Neither of these necessarily involves dismantling essential regulation, though making the economy more attractive to investors might involve getting rid of unnecessary bureaucracy. Sadly TJN does not distinguish between beneficial regulation and harmful red tape. 
Further down the article there is a list of the countries evaluated by TJN, each with a link to TJN's report. There are 73 countries listed here, though the "Financial Secrecy Index" itself omits France and Nauru - apparently for legal reasons. Hmm. But the most astounding comment in the whole piece - and the explanation for the inclusion of some of the largest economies in the world in TJN's Top 10 - is this (my emphasis):
The original 2009 FSI contained 60 jurisdictions (see our original methodology here) but we have expanded this to 73. We filled it out by ensuring that the updated list contains:
  • All 20 jurisdictions with the highest share of financial services exports (so we have added France, Canada, Japan, Germany, Italy, Denmark, India, Korea)
  • Countries not previously included but with known secrecy jurisdiction characteristics: Ghana, Botswana, Guatemala and San Marino.
So the countries with the largest financial services sectors are automatically assumed to be tax havens. 

I found this absolutely astonishing, so I looked back through the piece for an explanation for this extraordinary assumption. And here it is - from the introduction:
.....the illicit financial flows that keep developing nations poor are predominantly enabled by rich OECD member countries and their satellites, which are the main recipients of these illicit flows......
.....It is OECD countries, which receive these gigantic inflows, which set the rules of the game.
So now we know. The OECD's definition of tax havens is inadequate because OECD countries have a vested interest in not defining them. And OECD countries benefit from capital inflows from poorer countries via tax havens. Citizens of rich OECD countries, you are all guilty. Oh, by the way, India, that includes you.

But this leaves a problem, doesn't it? After all, Helsinki's boycott of companies with links to tax havens is  supposedly because
".... tax evasion [sic] undermines the capacity of municipalities to provide social services"
Finland is a rich OECD country. As is France, which has also introduced local boycotts of companies with links to tax havens. So flows to tax havens, which according to TJN ultimately benefit rich OECD countries, are to be stopped because they prevent rich OECD countries from providing social services. You couldn't make it up.

But after all this investigation, I still don't know which definition of "tax haven" Finland is using for its boycott. Is it the OECD's grey list? Is it the list of 18 mainly Caribbean countries boycotted by the French administrative region Ile-de-France? Or is it TJN's Top 10 - or their whole list? Does anyone know?

And finally. The UK campaign group Ethical Consumer have produced procurement guidelines for UK local authorities which amount to a boycott of companies involved with tax havens. The proposed policy wording is as follows:
1. This authority will not make large (over £100,000) contracts for services with or make purchases from any company:
(a) registered in a country on our current list of tax havens
(b) which is part of a company group where the ultimate holding company is registered in a country on our current list of tax havens
2. Companies tendering for contracts will receive positive marks in our supplier ranking system if:
(a) they are not part of a company group of more than one related company, or
(b) if they are part of a company group, no subsidiaries in that group are registered in a country on our current list of tax havens, or
(c) if they are part of a company group with subsidiary companies registered in tax havens they publish sales, profits and tax paid on a country-by-country basis.
"Our current list of tax havens" is TJN's Financial Secrecy Index. The UK is listed at number 13. So if they adopted this proposal, UK local authorities would boycott UK firms. You couldn't make that up, either.













Thursday, 29 November 2012

OSI, PSI, the IMF and fantasy

After much intense negotiation, it seems there is a new deal for Greece. Or at least that is how it has been presented in the media. But what sort of deal is it, and does it solve the Greek problem?

The wording of the Eurogroup's statement does not suggest that there is a "deal", as such. All it says is that the official sector - the ECB and Eurogroup - may be prepared to accept poorer returns on their holdings of Greek debt. The specific measures that they "would consider" are the following:

  • 1% reduction in interest rates on the loans made available under the "Greek Loan Facility" (the first bailout)
  • 0.1% reduction in the fees paid by Greece for EFSF guarantees of its debt
  • deferral of interest for ten years on EFSF loans (the second bailout)
  • extension of maturities on EFSF and bilateral loans by fifteen years 
  • repatriation of interest paid by Greece to the ECB and national central banks (the "Eurosystem")
These measures are conditional on Greece maintaining its commitment to the deflationary fiscal programme imposed by the Troika AND successfully buying back some of the debt currently held by the private sector. I will return to the buyback shortly. But first, let's consider what these measures would actually mean for the official sector creditors and for Greece if they went ahead.

None of these measures is "officially" a writedown of Greek debt. The face value of the debt will remain the same, which will enable politicians in creditor countries such as Germany to claim that Greece is not being "forgiven" its debt. But this is misleading. The value of debt is given not just by its face value, but by the return that it generates. Cutting the interest rate (and, in the case of the Eurosystem, refunding interest paid) reduces the return on debt. This is because over time, money loses value due to inflation, so the face value of a 10-year bond is less in "real terms" at maturity than it is at issue: the interest on the bond compensates for this loss in value, plus the opportunity cost to the lender of not having that money available for other things. Cutting the interest rate reduces the compensation to the lender, and if the interest rate falls below the inflation rate during the lifetime of the bond, the lender actually loses money as the value of the principal is eroded. Extending the maturity of debt also effectively reduces the return to the lender, since that money is "tied up" for longer, increasing the risk of principal loss. Therefore these measures constitute a writedown of the value of Greek debt held by the official sector, in  much the same way that Brady Bonds reduced the value of Latin American debt in the 1980s.

For Greece, the effect is a reduction in the anticipated debt burden by 2020. Now this is something of a moving target. Sovereign debt is usually quoted as a percentage of GDP, and this is how the Greek debt burden is presented. So it is not just the actual amount of debt in euros that matters, but the performance of the Greek economy.

Each time a bailout deal has been agreed for Greece, estimates of its expected GDP over the next 10 years have been produced. But every estimate has been wrong - and not just slightly wrong, but totally wrong in both the scale and the direction of GDP growth. As this graph from Zero Hedge shows, every estimate has assumed a return to strong positive growth and creation of a primary budget surplus within a year or two of the deal:


















But the reality is that the Greek economy has been falling down a recessionary black hole: with each year that passes, economic activity declines, tax revenues fall and the prospects for return to positive growth, let alone a primary budget surplus, recede futher into the distance. The swingeing cuts Greece has made to its budget to meet Troika demands have singularly failed to make any significant dent in its deficit: all they have done is trash its economy.  And the debt pile grows ever larger, both in reality as Greece is forced to borrow more money to meet its essential spending commitments and service its debt, and as a percentage of GDP, as GDP falls ever lower.

The estimates on which this deal depends are that Greece returns to strong growth by 2015 and runs a primary budget surplus (i.e. after debt service) of at least 4.5% from 2016 onwards. If they manage to achieve this AND both the debt buyback and the official sector NPV haircut go ahead, their debt will be at 124% of GDP in 2020, which is supposedly sustainable - although many people would doubt that this is sustainable in practice. Without those measures, the debt level would be 144% of GDP, which is almost certainly unsustainable, and if Greece fails to achieve the growth and budget targets then the level will be even higher - some estimates have put it as high as 190% of GDP.

The significance of keeping debt at "sustainable" levels is that the IMF, which is a contributor to the bailout funds agreed in March 2012, cannot lend to countries with unsustainable debt. Therefore the bailout ALREADY AGREED depends on reduction of the debt burden to a "sustainable" level. You may ask how on earth the bailout was agreed in the first place if the debt wasn't sustainable. But remember what I said about GDP estimates far exceeding reality? The debt itself hasn't risen much more than expected. But GDP is far lower. Therefore a debt that in March was expected to be "sustainable", has turned out to be anything but.

So are the latest estimates of GDP any more reliable than the previous ones? I seriously doubt it. The Greek economy is now in its sixth year of deep recession and shows no signs of recovery. I suspect that Greece's GDP is falling back to where it was when Greece joined the Euro, since the whole of its economic growth during its Euro membership has been generated by debt-fuelled consumption rather than increased production of real goods and services. In fact since the Greek economy has actually lost competitiveness compared to its neighbours, its GDP may have to fall even further. In which case this chart shows that it still has an awfully long way to go:


Note: the flattening of the GDP line in 2010-11 does not indicate that GDP is static, it means that the World Bank does not have up-to-date figures. The ZeroHedge chart above shows that GDP has been on a steeply downward trend since 2008.

If I am right, there is little chance of recovery any time soon. And this also makes the target of a 4.5% primary surplus from 2016 highly unlikely. But even if Greece by some miracle managed to achieve this, the terms of the bailout are that all of that surplus plus 30% of any excess must go towards debt reduction, rather than being invested in the Greek economy. It is very, very hard to see how the Greek economy can possibly return to strong growth if all its deficit reduction efforts simply enrich its creditors. Sadly, I think it is far more likely that Greek GDP will continue to shrink, achieving primary surplus will drift further and further out of reach and the debt pile will grow ever larger. And both official and private sector creditors will eventually have to accept that Greek debt simply is not repayable. Further writedowns will inevitably follow. Not that there will be much scope for further reduction of private sector holdings; the private sector took losses of around 75% of NPV on its bond holdings earlier this year, when the Greek government coercively swapped  "new  bonds for old". And the debt buyback in the current deal is redemption of those new bonds at 28% of face value. That really doesn't leave much Greek debt in the private sector. The media headlines have focused on the official sector's contribution this time: but the private sector is being asked to take a much larger hit.

Not surprisingly, the private sector is fighting back. The Greek banking lobby has protested that the buyback at 28% would bankrupt them (link h/t @Alea_), and called for additional EFSF funding to restore their capital levels if they sell their holdings - which they feel psychologically bound to do, even though it seems unlikely that the government could impose a second coercive debt restructuring on the private sector.

This sounds odd to me. The redemption price is the average market price of those bonds at close of business on 23rd November. The bonds should already have been marked to market if they are held for trading purposes, so the banks should already have taken the hit on their profit & loss accounts. If they haven't, then either the bonds were intended to be held to maturity or they have not been marked to market properly. If the former, then redemption at such a discount would indeed cause serious losses - although it could be argued that holding distressed government debt at par, even to maturity, is perhaps not the wisest investment strategy. But I suspect the latter. The market price for Greek bonds has indeed fallen by 70% since the new issue, but the market has been thin for quite some time, which tends to make market prices volatile. Holders of Greek bonds are therefore likely to have marked them to some kind of model, no doubt using parameters that flatter the value of the holding. This is similar to the methods used for valuing CDOs in the run-up to the financial crisis, and the outcome might well be similar too.

So the debt buyback could cause widespread bankruptcy of Greek financial institutions. This seems utterly counter-productive, given that the bailout funds were partly intended to recapitalise the Greek banking system. I don't have a great deal of sympathy for financial institutions that take a grossly unrealistic view of the value of their bond holdings, but collapse of the Greek banking system as a consequence of the debt buyback would be ludicrous.

It is also by no means clear where Greece will find the money for this buyback. Ollie Rehn insists that Greece will have "all the money it needs" for the buyback, but there is no new money on the table, the 2nd bailout funds have not yet been disbursed and the "additional measures" - including the refund of Eurosystem interest payments, which seems the most obvious source of funds - are conditional on successful completion of the buyback. Maybe I'm missing something, but I can't see how this buyback can succeed with nothing but imaginary money.

In fact the whole deal looks like fantasy. A debt buyback funded from thin air and possibly resulting in bankruptcy of a newly-recapitalised banking system: yet more wishful thinking on GDP figures: official sector involvement that is dependent on meeting impossible conditions. And above all, no recognition of the reality of the Greek situation. Greece's debt is unpayable and and its economy is falling off a cliff. It needs comprehensive debt forgiveness and the equivalent of a Marshall plan to restore its economy to health, not fiscal "reforms" that drive it further into the ground with large amounts of Eurofudge to keep its official creditors sweet while stiffing the private sector.

The IMF is evidently uncomfortable with the hard line taken by the Eurogroup and the ECB, and this is the closest it has ever come to pulling the plug on the whole deal. I really wish it had done so. This Greek tragedy must be brought to an end before it becomes a global disaster.


Tuesday, 13 November 2012

About those UK CPI inflation figures....

The UK's CPI inflation figure for October 2012 rose by 0.5% to 2.7%. A small rise had been predicted, but this was much larger than expected. The ONS attributed the rise to increases in tuition fees, food and transport costs. I shall discuss the implications of these components shortly.

Not surprisingly, the inflation hawks were out in force. Market Oracle led with a "shock, horror" headline:
UK CPI Inflation Soars Despite Bank of England Deflation Propaganda, Shocks Academic Economists
 And they showed this chart as evidence of what they called an "inflation mega-trend":

UK CPI Inflation

(for larger version, click here)

And Andrew Sentance, in a news release from Price Waterhouse Coopers, made the following pessimistic prognosis:
"UK inflation remains stubbornly above the 2% target. And with further energy and food price rises in the pipeline, it could rise further in the coming months. This would reinforce the squeeze on UK consumers and add to concerns about the Bank of England's ability to achieve its price stability objective. If above target inflation persists through next year, it will add to the pressure on the MPC to raise interest rates sooner rather than later."
Well, his first statement is correct. UK inflation has remained stubbornly above 2% since 2010. But this chart from Trading Economics shows that in fact it has been above 2% on average since 2005:

Historical Data Chart
(for larger version, click here)

So given that, what on earth is the tearing hurry to bring it down to 2%?

Now, I will admit that this chart does show that there has been high inflation in the last two years - as indeed there was in the run-up to the financial crisis (really the BoE should have been paying more attention to the trend!). But since the peak of 5.2% in October 2011 the trend has been sharply downwards. In fact CPI inflation has been falling nearly as sharply as it did in 2009. Yes, there have been a couple of spikes, but there is no doubt that the underlying trend for the last year (at the time of writing) has been deflationary.

There are two possible ways of viewing the current spike. One is that it is just that - a spike - which will not affect the overall downward trend. If this is correct, then we should expect CPI inflation to fall again in November or December. In support of this argument, the ONS notes that of the 0.5% rise in CPI, 0.3% is due to a substantial increase in student tuition fees that has just come into force: this would unwind itself in due course. And as it also does not affect "ordinary" consumers, it is arguably a distortion. That leaves an increase of 0.2% due to externally-driven food and fuel rises partially offset by price falls in other sectors. If price-cutting continues in other sectors, CPI inflation may well return to trend even if world commodity prices continue to rise.  

The alternative view is that this increase in CPI is a trend reversal - that the September figure was the turning point and this is the start of a rising trend in CPI inflation similar to that in 2010. This is clearly Sentance's view and it may also have been the reason for the MPC's decision to end the QE programme. Clearly the 0.3% rise due to tuition fees cannot be regarded as a trend reversal, since it is a one-off change. However, Sentance is probably correct that food and fuel will continue to rise in price, because the world price of essential foodstuffs is rising due to drought affecting supply, and the oil price is also rising due to world economic conditions. Furthermore, utility bills are expected to rise substantially in the next few months. If this is a trend reversal, price-cutting in other sectors will not be enough to offset inflation in these key sectors.

So it is by no means clear what the direction of CPI inflation will be over the next few months. What is clear, however, is that this month's CPI inflation increase is not due to pressure from a growing domestic economy. Here's the UK's GDP growth rate since 2008:


(for larger version, click here)

In the last quarter, the UK economy managed to grow by a measly 1%. Inflationary growth? Hardly. No, the CPI inflation increase is due to Government policy (the tuition fees increase) and external factors (rising price of commodities). So despite Sentance's gloomy prognosis, raising interest rates would not help. In fact it may make things worse. Many households and businesses are interest rate sensitive at the moment: a 50bps rise in the base rate, at a time when real incomes are falling, would increase the level of serious financial distress, with consequent impact on business production and consumer spending. Really it would not be clever to try to choke off a possible inflation trend reversal at the price of UK economic growth. 

The Bank of England should hold its nerve and continue to support economic growth. Even if this is a trend reversal, inflation really is not the main issue at the moment.  

Monday, 12 November 2012

A sensible marriage (of politics & economics)

On Friday 9th November in a letter to the Governor of the Bank of England, the Chancellor of the Exchequer changed the rules of the game for the Bank of England's Quantitative Easing programme (QE). (Yes, I know that the day before the MPC decided not to continue with QE - I'll come to that in a minute.)

QE involves the Bank of England purchasing and holding gilts (UK government debt) on the open market through its Asset Purchase Facility (APF). Gilts are interest-bearing securities, so the Government pays interest on the Bank of England's holdings of gilts. Up till now, the Bank of England has kept that interest on deposit. But now, the Chancellor has decided that the Bank of England should return those interest payments to the Treasury.

This is an eminently sensible decision. As the UK has a fiscal deficit, the Government has to borrow money to pay the interest on existing government debt. It does this by issuing more gilts or treasury bills to make coupon payments on gilts in circulation. If you think this is a Ponzi scheme, you are right. Obviously there is no alternative regarding gilts held by the private sector (other than eliminating the fiscal deficit so that interest can be paid from tax revenues). But it is frankly ridiculous that the Government is borrowing money so that the Bank of England can hoard it. Other national central banks (the Fed, the Bank of Japan) already remit coupon payments back to their respective treasuries.

So, if remitting these coupon payments back to the Treasury is a) eminently sensible b) consistent with how other countries behave, what is the issue? Why has there been such a kerfuffle about it, with claims that this is an accounting "fudge" and will cost the country more in the long run?

Firstly, there is a great deal of confusion about the accounting. There is no net profit or loss to either the Exchequer or the BoE from coupon payments on QE. It is purely a matter of cash flows between two components of the public sector. The Bank of England is wholly owned by the Treasury and its accounts are consolidated in the Whole Government Accounts (WGA). Both the BoE's holdings of gilts and the interest it receives on them are eliminated against Government debt in the consolidated accounts. An internal transfer between the Bank of England and the Treasury will make no difference whatsoever to public sector finances.  It's a wash.

The pricing is a wash, too. Basically the Government has now redefined all gilts held by the Bank of England under the APF as zero-coupon, whereas the price the Bank paid for them would have included expectation of coupon payments. In theory, therefore, the Bank should suffer an immediate (unrealised) capital loss. But these gilts will still be marked to market as interest-bearing securities. Unless the price of gilts drops as a consequence of this decision - for which there would be no rational reason, since the Government will continue to pay coupons on private sector holdings - there can be no capital loss in reality. And even if there were, the expectation is that the Bank would eventually sell the gilts back to the private sector at the coupon-inclusive price. As I said, it's a wash.

Unrealised mark-to-market profits are excluded from the proposed transfers, which are to happen quarterly. But Osborne allows the Bank to retain cash from the coupon payments to cover unrealised mark-to-market losses. This is slightly odd, since the effect of QE is to raise the gilt price: I suppose he is concerned about a future speculative attack on gilts. Allowing the Bank to retain cash to cover unrealised losses would protect its balance sheet.

The argument against the Bank returning its coupon payments rests on the idea that the market price of gilts would have dropped by the time they are sold. This is likely, as unwinding QE would be done in a growing economy in which interest rates would be at a more normal level. So the Bank of England would indeed suffer real losses on its holdings of gilts and could reasonably expect the Government to indemnify them for these losses - which as both Osborne and King note, would effectively mean return of the coupon payments. The pessimistic OBR assumes that this would have to be covered by new gilt issuance. But as Britmouse points out, an economy in better shape would have better tax revenues. Any loss incurred by the BoE would be offset to an unknown extent by increased Government income. So the Treasury might not have to issue debt to compensate the BoE for trading losses on its gilts portfolio. It could be yet another wash.

In fact there's nothing to look at here, really. Except for one little snippet in King's reply to Osborne that makes me wonder if King is losing his marbles. Osborne says:
"net coupon income transferred from the APF to HM Treasury should be used solely to benefit the public finances and to reduce debt". 
So, no fiscal easing then. But in his reply, Mervyn reinterprets this:
"your intention is to use any funds transferred to the Exchequer to reduce the stock of outstanding government debt."
Er, no, this can't be right. The UK has a fiscal deficit. Total outstanding debt CANNOT be reduced. All that can be done with this money is either fiscal easing (which Osborne rules out) or deficit reduction. Now admittedly Osborne has not made his meaning entirely clear - "reduce debt" must mean issue less debt, not reduce existing debt - but really King should know better.

King then concludes on this basis that remitting this interest is equivalent to a small monetary easing, because the private sector will hold less government debt and more money. And in deciding to end the QE programme, the MPC seems to have bought King's view that gilt coupon remittance amounts to monetary easing. So are they right?

Well, if Osborne does use the money to reduce the fiscal deficit, yes they are right - there would be a small monetary easing. Not because any of the EXISTING stock of debt would be reduced, but because less would be issued in future, so the private sector would be forced to hold more cash or make riskier investments - which is the same effect as QE. Fiscal easing - increasing government spending and/or cutting taxes - which is Osborne's other option, would also release this money into the economy, but without reducing debt issuance.

And this brings me to my final point. The timing of this announcement is remarkable. Osborne is in danger of missing his fiscal reduction targets because of the poor state of the UK economy and collapsing tax revenues. This money is a political windfall to him, enabling him to claim that he has reduced the fiscal deficit despite difficult economic circumstances. And he can follow this up at a later stage with a fiscal boost just nicely in time for the 2015 General Election. This little piece of chicanery is from the same stable as his cutting of the top rate of tax earlier this year, which as I pointed out at the time was purely aimed at improving the Conservatives' chances of re-election in 2015.

However, it is still sensible economics. For once, Osborne's political instincts and the needs of the UK economy make a happy marriage. We should not criticise this move.

Thursday, 8 November 2012

The illusion of safety

I have recently been reviewing various proposals for making the financial system "safer". Most of them involve some kind of full reserve banking, while one (Gary Gorton's) looks at improving the safety of the shadow banking system without subjecting it to the same rules as licensed banking. But all of them rest on the idea that there is such a thing as a "safe" asset.

The concept of "safe" (i.e. risk-free) assets has existed for a long time. Pricing models base themselves on the "risk-free rate". The instrument that is usually used as the proxy for "risk-free asset" is the United States Treasury (UST), but until recently all sovereign debt was regarded as risk-free, at least for bank capital adequacy requirements.

This led to banks loading up on the debt of Greece, Spain, Portugal etc. because those assets required no capital allocation but gave a better return than German bunds or UK gilts. They should have paid more attention to the yield. Yield is a much better indication of real risk than any regulatory view of an asset class. "If it pays better, it's riskier" is axiomatic in financial markets. It is unfortunate that in recent years investors and banks alike forgot this basic rule and believed that they could get high returns for zero risk. And even more unfortunate that retail bank depositors thought so, too.

Gary Gorton notes that one of the main drivers of the 2007/8 financial crisis was the failure of supposedly "safe" assets created by the private sector. This is a much neglected matter. The popular perception is that mortgage backed securities and their derivatives were known to be risky assets that banks and others chose to trade because they believed they would be bailed out if the assets went sour. The last statement here is correct - the financial sector did indeed believe it would be bailed out. But the first statement is not. The financial sector believed that these instruments were safe, because they were backed by property which (in the US) had been a stable appreciating market for a very long time. The UK does of course have a history of property market crashes, so it is slightly surprising that banks in the UK were fooled: perhaps they thought that the US property market was not subject to the same instability as the UK - or perhaps they just had short memories.

So Gorton argues - correctly - that it is not possible for the private sector to create safe assets. But he then states that only governments can create "safe" assets. This is in my view where he comes unstuck, for reasons that I shall explain shortly.

Gorton is not the only one who thinks government debt is "safe". John Kay also thinks so - or at least he used to. His "narrow banking" proposal would back all bank deposits with gilts. However, in his recent evidence to the Banking Standards Committee at the House of Commons, he was questioned about this by former Chancellor of the Exchequer  Lord Lawson, and was forced to concede that gilts could not be regarded as 100% safe.

A quick look at the history of sovereign debt defaults gives the lie to the idea that sovereign debt is in any way "risk free". However, there is no doubt that some sovereigns are "safer" than others: the UK and the US have never defaulted on their sovereign debt. So why shouldn't their debt be regarded as "risk free"?

There are two risks with sovereign debt. The first is sovereign debt default, which for the UK and US is a pretty low risk, though not zero. But the second - a much more serious risk as far as the US and UK are concerned - is variation in value. Gilts and USTs are actively traded and their price varies day-to-day. That creates a problem when using them to back customer cash deposits. As the whole point of holding these instruments would be to liquidate them quickly if necessary in order to meet deposit withdrawal requests, they would have to be marked to market daily. If  the bank was legally required to maintain 100% government securities backing, the bank would therefore have to trade gilts and/or USTs itself on a daily basis. A sharp drop in the value of government securities and/or freezing of the markets could bankrupt it in much the same way that writedowns of mortgage backed securities bankrupted banks worldwide in the financial crisis.

On the face of it, this weakens Kay's proposal and gives greater weight to cash-based 100% reserve banking proposals such as those from the IMF and Lawrence Kotlikoff. And although it doesn't completely wreck Gorton's ideas (since UK and US government debt is probably safer than private sector assets) it does mean that absolute safety of cash deposits in the shadow banking system cannot be guaranteed.

But a quick look at the inflation records of the US and the UK gives the lie to the idea that cash is "safe" either. Some people argue that "safe" means "won't suffer loss of principal" rather than "won't decline in value". But since the sole purpose of cash is to buy real goods and services, if £1 buys you a large loaf of bread today but only a small one tomorrow, the effect is that you have lost half your money. You still have £1, but you can only buy half as much with it. The value of cash depends on the willingness of government (via its central bank, usually) to control inflation. And that depends on a range of political and economic factors.

And it's not just cash whose value is affected by inflation. The value of government debt is, too. I've noted before the equivalence between yields on government debt and the inflation rate. Generally speaking, the higher the inflation rate, the higher the yield on government debt (and therefore the lower its value). This equivalence doesn't hold on daily basis, of course - government debt and currency values fluctuate independently of each other - and it doesn't hold in fixed currency systems such as the Eurozone, but over time it is a useful rule of thumb for floating exchange rate systems with no restrictions on movement of capital.  

So is anything safe? Well, proponents of gold think so. Those who support gold as a currency point to the stability of the "true" Gold Standard period of the late 19th century as a time when cash held its purchasing power. But in this article from Economic History (EH), the author questions why the gold standard during that time was stable, because on the face of it it shouldn't have been - and he concludes that there were two reasons: firstly, there were no major wars at that time, and secondly, both the private sector and the principal governments involved were fully committed to ensuring its stability. In other words, gold ITSELF is no more stable in value than any other sort of currency - as indeed the gold price chart shows. It is the backing of governments and trust from private agents that makes it so. EH notes that the "backing of governments" involves a commitment to settle trade deficits in gold: but the UK defaulted on its international trade obligations when it abandoned the gold standard in 1931, and the US did likewise when it ended the Bretton Woods system in 1971. The UK and US may not have defaulted on sovereign debt, but that doesn't mean they have never defaulted.

We also know from history that gold standard currencies don't survive major economic shocks, such as wars. The gold standard was suspended in the UK during the Napoleonic Wars, the First World War and the Depression: in the US during the Civil War, the First World War and the Depression: in France during the French Revolution and the First World War....I could go on, but do we need more evidence? Wars and major economic shocks need governments to create money in large quantities, which they can't do if they are locked into a gold standard - or any other kind of fixed currency regime, for that matter. And wars and major economic shocks disrupt international trade, which also undermines the gold standard. Returning to the gold standard at the pre-shock price is almost never achievable in reality. Abandoning the gold standard - which inevitably happens when there are major exogenous shocks - results in debasement of cash savings.

Those who support gold as an investment, but not as a currency, point to the rising value of gold over time. It is true that over the long term, gold does tend to appreciate in value - though so do property and land. But as a short-term investment it is volatile, which makes it completely unsuitable as collateral in a fast-moving financial marketplace or as backing for transaction accounts. And as a vehicle for personal savings it carries another risk - it is a target for thieves. In those countries where for cultural reasons people tend to put their savings into gold, theft (often violent) is a constant threat - which is why the World Bank is trying to encourage people to put their savings into banks rather than gold or cash. To the people of the West, scarred by recent events and fearful of bank failures, this looks like madness. But in developing countries, banks are definitely safer places to keep savings than mud huts. Gold stashed under the mat may not lose its value, but it can be lost.

So, over the long-term there may be assets that can be regarded as "safe".....but on a short-term basis, there is no such thing as a completely safe asset. Which brings me to my final concern about the search for assets that are "safe".

The belief that certain assets are "safe" encourages risk-averse investors to buy them. This pushes up the price and reduces the return on these assets. We saw in the run up to the financial crisis how the demand for assets that were considered "safe" drove production of these assets, leading their creators to take on more and more risk. The nature of the asset changed: it was no longer low-risk, but the investors did not know that, so continued to buy it until the rising tide of defaults in the underlying property portfolios caused a massive price correction. Once the true risk of these assets was fully exposed, their price collapsed and they became worthless.

The same is possible if either government debt or currency is produced in sufficient quantities to meet demand without domestic production rising to match. If this happens to government debt, eventually the price drops and the yield rises: if it happens to currency, the exchange value drops and there is high inflation.

However, I want to make it clear at this point that I do not believe we are anywhere near this state of affairs in Western economies generally at the moment, except for some members of the Eurozone. We have the opposite problem, namely that governments are unwilling to produce either debt or cash in sufficient quantities to satisfy the demand for "safe" assets, so we are seeing the price of government debt and the value of currency rising (and yields on debt and trend inflation falling) in those countries that are considered "safe havens".  Once yields are in negative territory, investors LOSE MONEY. And that is what is happening at the moment. Investors are so concerned not to lose their principal that they are loading up on supposedly "safe" assets which actually cost them money to hold. Remember I said that, for cash, loss of value due to inflation is just as real a loss as principal wipeout in bank default? In the same way, negative yields on government debt are just as real a loss as principal wipeout due to government debt default. No way are they "risk free".

And one final thought. We do not know what causes asset bubbles, but Austrian theory of business cycles suggests that the next bubble starts to form during the aftermath of the bursting of the previous one. In the aftermath of a major crash, investors are understandably risk-averse - as we are seeing at the moment, with their flight to traditional "safe havens" and their willingness to accept principal erosion rather than risk total wipeout. That suggests that, rather than greed and the hope of a high return, it may be fear and the search for safety that drives the creation of asset bubbles. In seeking the illusion of safety, investors may set up the very disaster they wish to avoid.