Tuesday, 28 February 2012

The many shades of default

Last night, S&P downgraded Greece to "selective default". This followed on from Fitch's description of Greece last week as in "restricted default". Both passed almost unnoticed, didn't they? No twitterstorms, no flash news reports, no extended analysis. Everyone knew some form of default was going to happen, no-one is at all surprised and it doesn't change anything. Markets have already priced in default anyway. So has Germany, if recent statements from the great and the good are to be believed. There was a short, bored statement from the Greek government last night and a slightly longer and equally bored statement from the Eurogroup president. The first sovereign "selective default" in history is a total non-event. Remarkable how things can change in a few short weeks.

More important is today's announcement that ISDA will decide on Wednesday whether or not Greece's retrospective insertion of Collective Action Clauses (CACs) into existing Greek-law bonds is grounds for a credit event. S&P clearly think it is - their downgrade statement makes it clear that the PSI in their view constitutes a distressed debt restructure. But it isn't their decision.

I find it difficult to see how a 75% net present value (NPV) loss for private sector bondholders can be interpreted as anything other than a default, especially with the element of coercion that the CACs introduce. But ISDA works in mysterious ways, and it is possible that they will find some excuse not to call a credit event. This would in my view be very unwise. As someone posted on a previous blog of mine, "ISDA may call a credit event just to stop everyone laughing at them". If they fudge it this time, they will have no credibility left - and neither will credit default swaps (CDS). Doing everything to avoid CDS trigger destroys its usefulness as a hedge, which to many people is its sole purpose. Remove that, and all that is left is speculative trading of an instrument with a VERY tarnished reputation. How long would the CDS market survive? It really isn't in ISDA's interests not to call a credit event. And there is no doubt markets are expecting it and have already priced it in. There is no reason not to do it that I can see.

Looking ahead, the next key date is March 12th, when Greece expects to have completed the PSI deal. It is not clear at present whether it will get anywhere near the sort of participation that it needs. If it doesn't, then as S&P puts it, "outright default will immediately follow". If it succeeds, then S&P will upgrade it a couple of notches. Big deal, frankly. It would still be shut out of the markets, would still be saddled with a mammoth pile of unsustainable debt and would still be trying to implement measures to reduce its deficit that simply drive its economy further into recession and wreck the lives of its people, particularly the young.

Personally I hope it doesn't succeed. If I could ill-wish the PSI deal, if I could throw some curses its way, I would. I think outright default and exit is far and away the best option for Greece now and the sooner that happens the better for everyone.

But the deal could still be scuppered by other interests. One hurdle was cleared today - the Bundestag agreed to the deal. But other nations have still to decide whether they will support the bailout package. And the IMF seems to be doing its best to undermine the whole thing.

There is no doubt in my mind that the IMF is increasingly irritated with the stance of the Eurozone leadership, and the Germans in particular, regarding the destructive austerity measures imposed not only on Greece but on other countries as well. Recent reports from the IMF, as well as comments from Christine Lagarde, suggest that the IMF would much rather see the Eurozone soften its fiscal stance and adopt pro-growth policies. Leaking the unrelentingly pessimistic Debt Sustainability Report on the very day that the EU leadership were trying to thrash out the details of the deal looks very much like a wrecking tactic. As does announcing AFTER the deal was agreed that it won't contribute any money unless the Eurozone itself (mainly Germany) coughs up a lot more.

The G20 is following the IMF's lead. The Osborne/Geithner double act has made it clear that they will not agree to any more external funding for the Eurozone (and in the US's case, any more funding for the IMF, either), until the Eurozone comes up with a bigger bailout fund. Meanwhile the German coterie still insist that a bigger fund is not needed - at least, not from them. Unquestionably their reason for saying this is due to political pressures at home: a recent poll indicated 62% of the German people oppose any more bailout funding, and Merkel had a hard time getting the current bailout deal through the Bundestag.  This standoff could last for some time, although there are some signs of softening in the German camp. Sales of popcorn are at an all-time high and bookies are offering odds of 9-4 on Osborne/Geithner to win the day.

The trouble is, there isn't any time left. The Eurozone leadership were talking vaguely about more money being made available in April, maybe. That is TOO LATE. If Greece does not raise the money by at the very latest March 27th, there will be a disorderly default and Greece will be forced out of the Euro. I am amazed by the languid language of the Eurozone leadership. Anyone would think they were managing a cruise down the Rhine, not a possible catastrophic collapse of the Eurozone.

The biggest issue in this entire sorry tale has been the political failure at the heart of the Eurozone. Nick Panyatopoulos commented on the "political malaise" in the Northern states. Their complacency threatens the survival of the European project even more than fiscal mismanagement in the southern states. An attitude change is needed from Eurozone politicians. Unless that happens, I fear that the dominoes will continue to fall, one by one, until the whole Eurozone - including the mighty Germany - is brought to its knees. And with it, perhaps, the economy of the whole world.

Monday, 27 February 2012

Spot the difference

The UK's Bank of England is on a splurge. It is spending newly-created money like it is going out of fashion. It is buying up the UK's own gilt-edged securities, which it is putting safely in a vault with the intention of selling them again sometime, maybe, if the mice haven't eaten them first. The institutional investors it buys those gilts from then go and spend that money, or they put it in a bank deposit account, or something. Anyway, one way or another that money finds its way into bank deposit accounts, simply because all money at some point comes to rest in a bank deposit account......So banks have higher deposit balances. Does that mean they lend more? No, it doesn't. Deposits don't belong to them - they are debt. What banks need is capital (because regulators insist they need it), and they haven't got enough of that. So although they are awash with deposits, they aren't lending, because lending uses capital. UPDATE - And because, as Ann Pettifor points out in the comments on this post, their chances of getting loans repaid are diminishing by the day. Result, a lot of money sloshing around in the banking system doing very little, and a lot of government debt sitting in the central bank doing nothing.

Now let's look at Europe. In December, the Euroean Central Bank (ECB) created 489 bln new euros and lent it out as cheap three-year loans to European banks - the Long-Term Repo Operation (LTRO). The banks didn't get it for nothing, of course - central banks won't lend anyone anything unless they have collateral. And in the olden days (i.e. prior to sovereign debt crisis), that collateral had to be pretty darn good - triple-A rated government securities, that sort of thing. But those are becoming increasingly hard to come by and very expensive, which is putting them out of reach of cash-strapped banks. So these days the ECB will accept almost anything as collateral against its lending - junk Greek bonds, rubbish commercial loans, toxic mortgages, you name it. UPDATE 28th Feb - Now everything EXCEPT junk Greek bonds. Defaulted bonds are too much even for the ECB to swallow! *** Further update 26th March - But NEW Greek bonds are fine, even though they are trading at much the same sort of yield as the old ones. Where's the Genie, I want to know?

But, you say, LTRO is lending, whereas QE is asset purchase. Obviously they are different, aren't they?

Well, not very. In fact the difference is vanishingly small.  In the financial world, lending and sale/purchase transactions are pretty much the same thing. For those unfamiliar with the financial jargon, let me explain how a "Repo" works.

A "repo" is a Repurchase Agreement. You sell the bank the contents of your attic for far more than they are worth, and you enter into an agreement with the bank that in three years' time you will buy back your attic contents for even more than they will be worth by then. In the meantime the bank can do what it likes with the contents of your attic - flog 'em to someone else, hold a boot sale, that sort of thing. Provided that it can obtain something that looks and smells exactly like the contents of your attic when you come to repurchase them, you need never know what has happened to them in the meantime.  The practice of "selling on" or "re-pledging" assets provided as "collateral" for a repurchase agreement or secured loan is known as rehypothecation.

So when people talk about "collateral" in relation to repos, it is not quite what we normally mean by that. After all, if you pawn your watch for a month, you don't give the pawnbroker the right to sell on that watch to someone else for that month, do you? But that's what happens with repurchase agreements and other forms of "collateralised lending" in the financial world. The assets aren't "pledged", they are effectively sold.

Now, because you have a legal commitment to repurchase your aunty's fur coat (complete with mothballs) after a specified period of time, a repurchase agreement is normally treated as a loan rather than a sales transaction. But this is questionable because of the treatment of collateral that I described above, and there have been several examples of repurchase agreements being accounted for as sales, of which the most notorious was Lehman Repo 105. The advantage from the bank's point of view of accounting for a repo as a sales transaction is that when combined with rehypothecation it does not expand the bank's balance sheet. It is just a purchase of securities which are then sold on, not a term loan, so the proceeds go to profit & loss and there is no impact on the balance sheet. And the future purchase and sale - well, that's in the future, innit? Although arguably it should at least be accounted for as an accrual.... Anyway, the Repo 105 scam enabled Lehman to hide its future financing needs and overstated its real income. It was a major contributor to Lehman's failure. And it looks as if MF Global has been doing something remarkably similar.

I'm sure by now you have worked out why this post is called "spot the difference". The UK's BoE is explicitly buying assets, with no repurchase date, for newly-created money. The ECB is also explicitly buying assets for newly-created money - but it will sell them back after three years. It's the same thing, really, isn't it?

Well, not quite. It's all a question of what flavour of fudge you like. You see, the Bank of England doesn't like taking on credit risk, and because banks in the UK are unpopular it doesn't want to be seen to be funding banks directly. But it doesn't have any qualms about buying its own government debt. So it limits its purchases to very safe triple-A rated sterling-denominated UK Government securities, which as the UK has rather a lot of debt are not too difficult to come by - nothing like as difficult as euro-denominated European government triple-A rated securities. And it buys those securities from institutional investors rather than banks. The money finds its way into banks, of course, as I described above. But it is an indirect flow.

Conversely, the ECB doesn't like buying government debt in the secondary market - German disapproval of this practice is palpable. But it is very happy to lend to banks. It regards itself as responsible for maintaining the liquidity of the banking system, and it is also helpfully (egged on by Sarkozy) providing an indirect way of funding governments. You see, the LTRO money was used to some extent by COMMERCIAL banks to buy up their governments' debt. That got the ECB nicely off the hook while still bailing out debt-distressed countries. It massively increased the balance sheet risk of the commercial banks concerned, of course, especially in Italy - but as long as the ECB keeps providing money, they will stay afloat and so will their sovereigns.  The snag is that to participate in LTRO they have to provide collateral, but unless they participate in LTRO they are really quite likely to go bust, as European banks are generally in pretty poor shape. Which is why the ECB will accept just about any old rubbish as collateral these days.

The next LTRO is on 29th February, and this time there is a twist. The money will be distributed via national central banks. European banks this time will go to their own central banks, who will create brand-new euros and dish them out in return for any old junk. This will leverage up national central banks instead of the ECB. This is A Good Thing, because it means that when the European banks can't repay the money in three years' time and the assets turn out to be worthless, it is the taxpayers of the banks' OWN countries that will get hit for the inevitable bailouts - not the Germans (who provide most of the capital to the ECB).

So the LTRO is a disguised bailout of both banks and sovereigns. And it is the biggest can-kicking exercise in history. It provides huge amounts of money to distressed banks that are poorly capitalised and over-leveraged, on the back of junk collateral and with absolutely no certainty that these banks will be able to repay the money anyway. And there are still NO moves to do anything about European banks' desperate lack of capital and appallingly risky balance sheets. I think I know EXACTLY when - and where - the next major banking crisis will be, don't you?

So those of you who think the UK is taking huge economic risks with its QE programme, just take a look across the channel. The UK's monetary policy looks like a model of prudence compared with Europe's.  And all of this to avoid directly bailing out countries or forcing Germany to support weaker Eurozone members. It is total madness.

Accounting and reality

In a few posts recently, Richard Murphy argued that because the Bank of England is wholly owned by the Treasury, the government debt (gilts) that it has bought under the Quantitative Easing programme is effectively cancelled because it would be eliminated from both sides when the Bank of England's accounts were consolidated with the Treasury accounts. This is correct from an accounting point of view. It leaves a large cash liability on the Treasury's accounts which represents the additional base money now in circulation and is exactly equal to the amount of the debt purchased. But the debt itself disappears. Murphy's worked example showing how this works is here.

But in the real world, things don't just disappear like that. Locked away in the Bank of England's vaults are a large number of pieces of gilt-edged paper. And tucked away in bank deposit accounts, or floating around somewhere in the financial system, is the additional money that the Bank of England created to buy the gilts.

Now those gilts have maturity dates. When they expire, they have to be repaid. So when those pieces of paper locked away in the Bank of England's vaults reach their maturity date, the amount of money they represent must be removed from circulation.

But this is really quite difficult to do. How on earth are you supposed to remove money from bank deposit accounts or suck it out of financial conduits? That money belongs to the people who sold the gilts back to the government, or to whomever has received that money in the course of normal financial transactions. Allowing the gilts to expire and recording the corresponding cash reduction in the Bank of England and consolidated Treasury accounts would create an imbalance with the wider economy. There would be more money in circulation than recorded on the Government's books. And since cash is a liability from the central bank's point of view, and there would be more cash actually in circulation than its assets, the Bank of England would be insolvent.

There is only one way a central bank can withdraw money from the wider economy - selling assets for cash in open market operations. But if its assets have expired, it has nothing to sell.  So the government would either have to replenish the Bank of England's capital from general taxation - which might involve tax rises, unless the economy was growing strongly enough to generate enough tax revenue - or it would have to issue more gilts to replace those that expired.

These new gilts cannot immediately be bought by the Bank of England, as it is not allowed to participate in a primary auction. So the immediate effect of gilt expiry would be a "spike" in government debt as new gilts were issued for the same amount, bought by the private sector and then purchased in the secondary market by the Bank of England - assuming that the private sector buyers want to sell, of course. Alternatively, of course, the government could raise taxes to recapitalise the Bank of England. Either way, the expiry of gilts held by the Bank of England requires real money to be contributed by government just as it does for gilts held by the private sector.

And no, the Bank of England can't just magic new capital into existence. Central banks create money for the wider economy, but they can't create money for themselves. The capital they need has to come from the wider economy via the government. It's a circular flow.

For that reason, the notion that government debt purchased by the Bank of England can be treated as "written off" is simply wrong. From an accounting point of view, yes, the debt is eliminated from both sides of the consolidated accounts. But out in the real world, the physical bits of paper still exist, and the real cash balances are still very much in circulation. Writing those off interferes with the flow of money from the real economy to government/central banks and back again.

Generally I find accounting concepts and practices very helpful when looking at the way in which our financial system works. But in this case, the accounting view does not conform with reality - and it is therefore very dangerous.

You see, the conclusion that Richard Murphy came to was that as the gilts purchased by the Bank of England can be regarded as written off since they are eliminated on consolidation, we can regard the UK's debt as much less than it appears to be. And therefore we can issue much more, can't we?

No, we can't. The real money is still there in circulation. The gilts are still locked in the Bank of England's vaults. And eventually they will expire - at which point government is either going to have to provide more money from taxation to maintain the Bank of England's capital and prevent an imbalance in the government accounts, or it is going to have to issue more gilts to replace them.

So the debt hasn't really disappeared at all. It is still out there in the real world. And it won't go away just because an accountant says it does.

Awful, awful.....

I've always said I won't comment on tax matters, as I am far from being an expert. But I really can't let this pass.

The Tax Justice Network today produced its first podcast.

It's a very jolly 15-minute broadcast, with jaunty music and a presenter who was obviously chosen for the fake cheeriness of her voice. I found it all rather patronising, rather like those awful radio adverts that the Child Tax Credits people produce from time to time - you know, the ones that make thinly-veiled threats to remove benefits if you don't tell them your circumstances have changed. But what bothers me far more is the dangerous inaccuracy of many of the statements made, and the unsupported allegations against companies, institutions (including the police) and individuals. If these allegations are true, they are dynamite. If they are false, they are also dynamite - for the Tax Justice Network.

There are four claims in the podcast:

1) that Barclays only pays around 1% corporation tax on its profits
2) that the City of London Police pursue high-profile tax evasion cases against private individuals that they have no hope of winning in order to distract attention from their failure to prosecute banks for tax evasion
3) that bankers' bonuses are a way of avoiding tax
4) that the sovereign states Ireland, Luxembourg and the Netherlands are "secrecy jurisdictions", which by concealing their tax affairs deliberately encourage companies to avoid tax legitimately due in other countries.

Let's unpick each of these in turn.

1. Barclays corporation tax payments

In 2010 there was a huge furore when the Guardian, in an muddled report, reported that Barclays had only paid tax of £113m on profits of £11.6bn, which represented 1% of its total profits. Presumably this is where Tax Justice got its figure from.

But this turns out to be not quite what it seems. Barclays' taxable profits in 2009 were actually £5.3 bn, the remainder being the AFTER TAX profit from Barclays' sale of Barclays Global Investors to Blackrock Inc. On page 103 of the 2009 report and accounts there is the following note:

"On 1st December 2009 the Group completed its sale of Barclays Global Investors to Blackrock, Inc. (Blackrock).  The consideration at completion was US$ 15.2bn (£ 9.5bn), including 37.567 new Blackrock shares. This gives the Group an economic interest of 19.9% of the enlarged Blackrock group, which is accounted for as an available for sale equity investment. The profit on disposal before tax was £ 6,331m, with a tax charge of £43m, reflecting the application of UK substantial shareholdings relief in accordance with UK tax law".

In other words, Barclays claimed perfectly legitimate UK tax relief on its profit from the disposal of Barclays Global Investors, because as part of the deal it took on new share ownership in the acquiring company.

However, £113m on profits of £5.3bn is still pretty low - until you realise that these were the 2009 results, which were carrying heavy losses borne by Barclays in the 2008 financial crisis. Under UK tax law, companies that make a loss in one year are allowed to "carry forward" that loss to offset against profits in future years. This is what Barclays did in its 2009 accounts, which is why it paid so little tax in 2010. All perfectly legal and above board.

So the Guardian report is misleading, suggesting as it does that Barclays had failed to pay tax due on that asset disposal and had failed to pay the right amount of corporation tax. In fact it had paid all the tax it was liable to pay under UK tax law, which was 1% of its total profits that year including the disposal.

But this is 2012, and the podcast has only just been released - yet Tax Justice is still claiming that Barclays only pays 1% tax. Is this true? Barclays' 2011 results were released a couple of weeks ago, so I had a look at its report and accounts. The short answer is, no, it isn't true. Barclays reported profits before tax of £ 5.879 bn and paid corporation tax of £1.928 bn. This is an effective tax rate of 32.8% - considerably higher than the UK's corporation tax rate. On page 6 the Group Finance Director notes that the high tax rate is partly because the Group was forced to "impair" its holding in Blackrock, but was unable to offset that loss against tax. You could argue that the Treasury has therefore clawed back some of the tax relief that Barclays claimed in 2009!

I wondered whether the high tax rate was exceptional, so I looked at the 2010 accounts as well. These give profits before tax of £ 6bn and tax paid £ 1.5bn, an effective tax rate of 25%.

Tax Justice in their podcast imply that the percentage tax paid in 2009, an exceptional year, is the percentage tax GENERALLY paid by Barclays. They have ignored the results from the two following years in order to perpetuate a poisonous myth of large-scale tax avoidance or evasion by this company. If I were Barclays I would be considering an action against them for libel.

2. City of London police

In the podcast, the presenter starts by pointing out that the City of London Police is partly funded by banks. If the presenter means that banks DIRECTLY fund the City of London Police, I beg leave to doubt it, frankly, and I want to hear her evidence. I suspect, though, that she is referring to the fact that they are funded by their local authority, the City of London Corporation, which derives a large part of its income from banks located in the Square Mile. But that's ridiculous. We could claim that all police forces are part funded by banks - after all, banks, like all businesses, pay business rates which are distributed to all local authorities under the block grant system. That doesn't mean that banks influence the conduct of the police.

She also ignores the fact that although the police investigate crimes and recommend cases for prosecution, it is the Crown Prosecution Service (CPS) that decides whether there is sufficient evidence to proceed and puts the case together. They do get it wrong - as the Harry Redknapp case shows. But does that mean they, and the police,  are corrupt? Well, according to Richard Murphy of Tax Research, it does.

When interviewed by the presenter, Richard Murphy remarked that "it strikes of, frankly, a police authority seeking to get headline news for itself to distract from the fact that it isn't prosecuting in the City of London. Harry Redknapp was found not guilty, but they didn't bring the right charge. And that has put back the whole process of tackling those who do use tax havens, because it's seen, bluntly, he got away with it."

And later on, Murphy goes on to suggest that the City of London Police is not prosecuting the right people, even though in his view there was more to the Redknapp case than came up in court. I find this a bit odd. If he thinks that Redknapp was actually doing something nefarious but was acquitted because the City of London Police didn't investigate it properly, how can he then claim that the City of London Police is not prosecuting the right people? Incompetent they may be, but a prosecution is still a prosecution.

Anyway, according to Murphy, Redknapp is actually guilty, even though the court has acquitted him. And that acquittal apparently is because the City of London Police only prosecuted him as a smokescreen, so to ensure he didn't end up in clink they brought a charge against him that they knew wouldn't stick. And the CPS are either complete dimwits or involved in the scam themselves. Blimey.

Actually, this is a very serious allegation. If true, it is corruption at the highest level in the City of London Police Force and possibly also in the Crown Prosecution Service. I hope, for their sake, that Tax Justice and Richard Murphy have evidence to support these claims. If they have, then they must - in the interests of rooting out corruption in our justice system - submit their evidence to the Justice Secretary and to the Police Independent Complaints Commission. If they have not, then they are once again in serious danger of legal action against them for libel and misrepresentation. Making unsupported allegations against the police and the legal system is unacceptable. They should either put up, or shut up.

3. Bankers' bonuses are a way of avoiding tax

I'm tempted to say "oh no, not this old chestnut again". But let's actually deal with the points made in the podcast.

Richard Murphy claims the following as evidence that bankers' bonuses avoid tax:

- Banks pay bonuses from untaxed income, which reduces their corporation tax bill. Murphy describes this variously as a "subsidy" and "tax relief". It is neither of these. It is simply an operating expense. All employee remuneration, including bonuses, is legitimate business expense and is therefore deducted from operating profits before tax. This is UK tax law as it applies to all companies, not just banks. I don't really see why there should be one tax law for banks and another law for all other companies.

- If bonuses are paid in shares, they suffer Capital Gains Tax instead of income tax, which is likely to be a lower rate (18-28% instead of 20-50%). This is true - when the shares are sold. But most bonuses paid in shares have restrictions that prevent share sale for a period time, or have embedded options which means they only "trigger" when the share price is high enough. In this way the employee takes a personal stake in the future success of the company: if the company goes bust, the employee gets nothing. And all dividends received on those shares are taxed at the employee's highest rate, probably 50%. I really can't see why this should be regarded even as tax avoidance, and it certainly isn't tax evasion.

What Murphy wants to do is distinguish bankers' bonuses (but not bonuses in other industries, including the public sector) from all other types of employee remuneration and disallow them as business expenses. This would mean that the effective tax rate on bank bonuses would be whatever tax rate the employee pays on the bonus plus corporation tax suffered. The lowest possible rate at the moment would be 25% corp tax + 18% CGT = 43% (assuming a low-paid employee and no dividend payment, which is unlikely). More likely would be 25% +28% (top rate CGT) = 53%, plus dividends at 50%. The highest effective tax rate would be on cash bonuses paid to high earners: 25% + 50% = 75%.  I've assumed personal allowances don't apply because wages are high enough to absorb them. I've also ignored employees' National Insurance payments on the assumption that the earnings would be above the upper limit - but if not, then NI needs to be added to the effective tax rate as well since it is in reality a tax. All of these effective tax rates will also be inflated further by employers' NI.

Well, I suppose charging those effective tax rates would be a disincentive to pay bonuses. But boy is that steep. And it's inconsistent, particularly when the bonus is paid in shares. Why on earth should banks (but not other companies) pay corporation tax on shares they issue to employees, when they don't pay tax on any other shares they issue?

4. Ireland, Luxembourg and the Netherlands are "secrecy jurisdictions"

What Tax Justice has done here is lump together Ireland, the Netherlands, Luxembourg and the Cayman Islands, ignoring the fact that the first three are sovereign states and the other is a dependency.  Sovereign states are at liberty to set their own tax rates and design their own tax regimes, and neither the UK, US nor any other country has the right to interfere with this. Ireland is under pressure from the EU to increase its tax rates because it is receiving assistance with its awful debts at the moment. But that certainly isn't true of the Netherlands or Luxembourg, both of which are models of fiscal rectitude.

In the podcast, Richard Murphy explains how Facebook uses Ireland, which charges a low tax rate of 12.5% anyway, as a conduit to channel funds out of the US into even lower tax jurisdictions such as Bermuda. Well, this may be true. BUT IT IS A SOVEREIGN STATE. If it wants to arrange its tax affairs in such a way that companies can do that, it has the right to do so. And to describe it as a "secrecy jurisdiction", implying that it is a naughty boy for failing to disclose its tax affairs for all the world to see, is nonsense. Sovereign states have the right to conceal their tax affairs from other countries. After all, tax is one of the ways in which they compete with each other to attract business. In fact the ability to charge very low corporation tax rates is virtually essential for small countries competing against much larger ones.

So the description "secrecy jurisdiction" may indeed be true - but that doesn't necessarily make the activities of either Ireland or Netherlands illegal or immoral. As both are members of the EU, if the EU were to agree on tax harmonisation they would then have to fall into line. But at the moment tax harmonisation is an AWFULLY long way off.  They can do as they please.


In fifteen minutes of podcast Tax Justice has managed to make two possibly libellous allegations and several claims that are demonstrably false. There are a number of smaller errors and inconsistencies as well, most of which are not worth repeating here. But I must finish with this one, which is an absolute howler.....

"Shadow banking". Oh dear. No, "shadow banking" ISN'T the network of tax havens. Shadow banks are unregulated "quasi-banks" that do much the same job as banks but are not subject to the same regulation and in theory don't get the same support either. We don't really have them in the UK, but the US has lots of them, although it is bringing the largest ones such as Goldman Sachs and JP Morgan under the regulatory supervision of the FED. Shadow banks unquestionably use tax havens, but it is incorrect and misleading to conflate shadow banking with tax havens.

Tax Justice's next podcast is in a month. I await with interest to see if it is as awful as this one.

Tuesday, 21 February 2012

False dawn

As dawn broke on 21st February 2012, the leaders of the European Union announced that they had agreed terms for additional financial support to Greece to enable it to meet scheduled debt repayments on 20th March. European Union officials pronounced that "the European debt crisis is ended".  Light has dawned, the sun is shining and everything is rosy.

Except it isn't.  Not one commentor on the dawn deal thinks that it solves anything. As the BBC Breakfast reporter said, all it does is "buy time". Time for what? Time will solve nothing. Even with this deal and a VERY large amount of economic luck, Greece's debt is only forecast to reduce to 120% of GDP by 2020, which for a country as poor as Greece looks unsustainable. And that assumes that Greece is able to return to growth in 2013 despite the extra cuts imposed in this deal, which are almost certain to deepen recession further. And it also assumes that Greece somehow manages to maintain a primary surplus in excess of 4% from 2013 onwards. Neither assumption looks remotely believable. The IMF's worst case scenario (in its Debt Sustainability Report, leaked yesterday - timing impeccable, as always) is that Greece's debt in 2020 will be 160% of GDP, which is about the same as it is now and completely unsustainable. Zero Hedge, pessimistic as ever, commented that the IMF's "worst case" scenario looked decidedly upbeat and things could be much worse. Other commentors have joined in what is rapidly becoming a storm of criticism. This deal is yet another flavour of Eurofudge - and a particularly bitter one at that, because despite even more austerity and surrender of sovereignty being demanded of Greece, it does not appear remotely adequate.

Let's be clear what this deal is NOT.  It is not, in any sense, a rescue of Greece. Greece itself will receive very little of the additional lending provided under the terms of this bailout. The vast majority will go to foreign holders of Greek debt.  And the measures that Greece has had to agree to put in place to qualify for this "assistance" will push more people onto the breadline and drive the economy deeper into recession - if they can be imposed at all, which is looking increasingly unlikely. No, in no sense is this deal a bailout of Greece.

Contrary to popular belief, it isn't a bailout of private banks and financial institutions either. Private sector holders of Greek debt are being expected to take a reduction of 53% in the nominal value of their holdings and a total NPV loss (including interest payments) of 75%. By any standards that is a substantial loss. Yes, any prudent financial institution will have written down the value of its bond holdings to junk long since, so this haircut doesn't necessarily hurt their reported profits - in fact properly marked-to-market Greek bonds are probably worth even less than this haircut, so the debt restructuring might reduce their realised losses. But that is cold comfort. However you look at it, this deal leaves private sector investors taking heavy realised losses on their portfolios. And the "voluntary" description of this restructuring looks increasingly thin. The Institute of International Finance (IIF), which is the "private sector representative" that has agreed to this debt swap, actually only represents about 50% of private sector bondholders. The rest haven't been asked, but it is widely believed that hedge funds, at any rate, would prefer not to participate. Furthermore, even those bond holders represented by the IIF still have to agree to the deal. So the private sector could still scupper it. The Greek government is putting in place Collective Action Clauses (CACs) to force reluctant bond holders to participate in this deal.  I don't call that voluntary.  It remains to be seen whether the almost criminally useless ISDA agrees with me. Somehow I doubt it....even though it is hard to see that this is anything other than a structured default, so it should trigger a credit event.

It has been argued that the European Central Bank (ECB) and Eurozone National Central Banks are benefiting from this deal, because they are not taking a haircut. But since when has not losing your shirt been a "benefit"?  The ECB is taking steps to ensure that it doesn't get caught up in the debt swap and end up taking losses, and National Central Banks are expected to follow suit. So their investments are more-or-less secure. The private sector is understandably annoyed about the ECB's behaviour, since it means that their investments are effectively subordinated to the ECB and the ECB can rewrite the rules at any time to suit itself.  This may make it even more difficult to persuade private sector firms to participate in the haircut, which increases the likelihood of some form of coercion. I can't help wondering whether the ECB accepting some losses might have been a wiser course of action.

The only people who benefit from this deal are the politicians who have staked their careers on the survival of the Euro. That now includes the unelected "technocratic" Greek government, which now has a vested interest in preventing Euro breakup at any cost. But the benefit to politicians is starting to look doubtful as well.  National politicians in the Northern states of the Eurozone are finding Greek bailout hard to sell. The increasingly draconian measures demanded of Greece by politicians from Germany, the Netherlands and Finland are without doubt intended to sweeten the pill for their electorates. And in Greece, the population is tired of seemingly never-ending austerity and angry at both their own government and the Eurozone leadership. Memories of World War II are resurfacing in Greece and German leaders are being portrayed as Nazis. The benefits of the European Union - free trade, freedom of movement, support of certain industries and poorer areas, and above all peace - are quickly being forgotten, as the price paid by weaker and stronger countries alike for propping up the misbegotten Euro starts to look too high and old wounds are reopened.

The biggest losers from the failed Euro project are the people of Europe. The principles of democracy and self-determination are being sold down the river to maintain the illusion of unity and common purpose.  Across the board, measures are being put in place that undermine national democracy:

-  Greece must write into its own constitution a legal requirement to give higher priority to paying foreign creditors than to paying welfare and state pensions, and the money to pay these creditors must be placed in a so-called "escrow account" so that it can't be diverted to other purposes - in other words, Greece will no longer be able to default on its debts. Unless Greece manages to create a primary surplus within the next three months, which seems almost impossible, it will either have to default on its commitments to its own people or borrow yet more money to meet those obligations

- Hungary faces a funding freeze until it cuts its budget deficit - by means of austerity, of course.  The fact that its budget difficulties are at least partly caused by Eurozone banks reducing cross-border commitments in order to appease the Eurozone leaders, who insisted that they must not reduce Eurozone lending portfolios while they recapitalise, is apparently lost on the EU leadership

- Countries in "deficit reduction programmes" - currently Greece, Portugal and Ireland - are facing "surveillance" from Brussels to ensure they comply with the terms of these programmes. Under the terms of this deal Greece's surveillance is to be increased and Eurocrats are to take up residence in Athens, despite being deeply unpopular with the people

- Even countries that are not actually in "deficit reduction programmes" are now being monitored from Brussels to ensure they comply with the terms of the Stability and Growth Pact, and face sanctions and possibly fines if they fail to do so. That is most of the countries in the European Union, actually......

All of these are being imposed by unelected Brussels bureaucrats. Yes, in October 2011 EU national leaders agreed to the principle of these measures, but I wonder if they really appreciated the implications. No Europe-wide referendum has been held on any of this and the European Parliament has not been asked to approve these measures - in fact the European Parliament has been systematically sidelined and is so toothless now that Jack Straw today called for its abolition on the grounds of uselessness. The people of Europe have not agreed to any of this, and it is evident that many of them oppose the actions of the European leadership. Why should the governments of Germany and the Netherlands be able to dictate to national goverments in the rest of Europe how they should run their affairs? Why should unelected bureaucrats be tasked with "supervising" national governments? This is not democracy.

If the price of European union is abolition of democracy, then it is too high a price to pay. But I don't think  European union is being bought. On the contrary, the sacrifices demanded of ordinary people to preserve the single currency are a huge threat to European union. As externally-imposed austerity bites, not only in Greece but in other countries too, there is a real risk that Europe will fracture along historic lines and people will seek to settle old scores. The single currency is the biggest threat to European peace since the Second World War.

Like everyone else, I don't think this latest deal solves anything. I don't think it even buys much time. Even if private sector bondholders and national parliaments agree to the deal, and default on March 20th is avoided, it will only be a temporary respite. We will play this game all over again - for much higher stakes - in a few months' time. And waiting in the wings are other countries in debt distress. How long till Portugal needs bailing out? Its economy is already going into the same death spiral as Greece's, and for the same reason - harsh and inappropriate austerity measures. And then there is Spain.....at which point the wheels come off. Spain is much too big to bail out.

The dawn agreement is a false dawn, and the darkest hour is still to come. There is no solution to this crisis which can preserve the Euro in its present form. For the sake of all the people of Europe, Greece should default and leave the Euro now, before the "debt service primacy" requirement prevents it from doing so. And other countries should reassert their national sovereignty and their right to self-determination. Yes, there will be pain, and chaos, and huge cost. But surely it is worth it to preserve peace and democracy in Europe?

Monday, 13 February 2012

Thoughts on inflation

This extended post is prompted by numerous debates on whether or not Quantitative Easing (QE) is inflationary, whether or not creating new money to fund public spending is inflationary and whether inflation is really such a bad thing anyway.

Note to any real economists out there. In this post I will be describing some economic concepts, such as NAIRU, in layman's terms. If I get something wrong, please correct it (gently), but remember that I am not writing for an audience of economists so am trying to keep things simple!

I am old enough to remember the inflation of the 1970s. In 1975 wage-price inflation in the UK touched 25%.  This is nowhere near high enough to qualify as hyperinflation, which is defined as a monthlly inflation rate of 50% or more (Cagan 1956). The UK has never experienced hyperinflation. But the inflation of the 1970s was quite bad enough, since it destroyed people's savings and led to a vicious spiral of higher prices leading to  increased wage demands leading to increased production costs leading to higher prices..... The 1970s inflation was also coupled with economic stagnation - it was then that the term "stagflation" was coined. Those who suffered from the inflation of the 1970s tend to have a horror of price inflation that is perhaps out of proportion: they will put up with all manner of economic ills and injustices as long as price inflation is low.

We see this effect more clearly internationally. Germany, which suffered appallingly from the hyperinflation of the Weimar republic in the early 1920s, has a horror of inflation which drives their economic policy - and recently not only their own economic policy, but because of their economic dominance in Europe, much of the EU's economic policy. The consequence of this, in European countries experiencing recession, is deflation (not inflation) and appallingly high levels of unemployment, especially among young people

Many people are now arguing that inflation is no worse an evil than unemployment, and that higher inflation may be a reasonable price to pay for economic policies that increase employment. I suspect that many of the people calling for higher inflation have never lived through an episode of high inflation. Because the fact is that there has not been high price inflation in any major Western economy since the 1980s.  Retail price inflation has substantially been contained.

We have become so used to retail price inflation being contained that we now don't notice the policy that contains it. People argue that government since 1979 has abdicated its responsibility for economic management to the whims of the market. They use as justification for this view the fact that unemployment has generally been higher since then than at any time in the post-war period. This is indeed true - because at the margin, higher unemployment is the trade-off for lower price inflation. Let me explain.

When there are more people chasing jobs than there are jobs to be had, wages tend to fall because employers can dictate the amount they are prepared to pay and generally speaking job-hunters will accept it. This is basic supply & demand logic. I don't intend to discuss here whether this is a good thing or a bad thing, and the merits or otherwise of government intervention to support wage levels (such as the minimum wage and unemployment benefits) or trade union muscle to force up wages. I'm simply describing the basic dynamic when there is unemployment.

When everyone who wants to work is fully employed, employers have to compete with each other to attract workers. So the supply-demand equation is reversed: job-hunters (who are, of course, simply seeking to change jobs, rather than being unemployed) can choose among employers and will tend to choose those that pay the most. This tends to push up wages. So far this is obvious, yes?

Labour costs are a significant factor in production costs for most goods and services. So rises in wages will affect one or more of three things: the price eventually charged to the customer, the profits made by the company, and the productivity demanded of labour. Companies don't like to earn less, and workers don't like to work harder for their pay, so unless there is limited demand for the product or service, the price to the end customer tends to rise.  If prices to end customers rise in aggregate across the economy as a whole, that is price inflation. 

In simple terms, therefore, if everyone who wants to work is fully employed, there can be price inflation arising from the fact that employers will prefer to agree to high wage demands rather than lose workers. And if price inflation is anticipated by workers, they will price that inflation into their wage demands, which will push prices up further. This is known as cost-push inflation - or, in 1970s jargon, a wage-price spiral. 

If the aim of the government is to control retail price inflation, therefore, it is necessary for there to be some degree of unemployment. Exactly how much is a matter of debate. The aim of economic policy is to have what is known as the "Non-Accelerating Inflation Rate of Unemployment", or NAIRU - which is the amount of unemployment that maintains equilibrium between workers' tendency to demand more pay and employers' desire to drive down pay. If it is achieved, the theory is that labour costs will not affect inflation. The trouble is no-one agrees on what the NAIRU is, and it has been used to justify very high levels of unemployment in some societies, especially where there are benefits systems and legislation that limit the downward pressure on wages that high unemployment causes. 

So inflation targeting in Western government economic strategy since 1980 has indeed contributed to higher unemployment. But that's not abdication - it is simply a different strategy from the strategy adopted by most Western governments from WWII until 1980, which targeted full employment and legislated wage and price repression (prices & incomes policies) to control inflation. It could be argued that the pendulum has moved too far, and unemployment has been allowed to rise freely when more interventionist policies to control it would have been appropriate even at the cost of higher inflation in the short term. But the move to inflation targeting happened because the traditional (Keynesian) assumption that it was not possible to have both rising inflation and rising unemployment was shown to be false. The 1970s was a decade of high inflation, economic decline and increasing unemployment - so-called "stagflation". To this day there is no agreement on the reasons for this: some economists say that the main problem was the external supply shocks caused by the oil price hikes of 1973 and 1979, while others argue that the problem was inefficiencies in the labour market (notably, excessive union power) coupled with loose monetary policy. Personally I suspect that both views have some validity. But the stagflation of the 1970s is in my opinion one of the reasons why Keynesian economics fell out of favour. It simply did not explain the phenomenon and could provide no solution for it.  

The other accusation that is levelled at governments since 1980 is that progressive deregulation has rendered them unable to prevent or control inflation in other areas of the economy - notably in asset prices (especially housing) and credit (the money supply). There is some merit in this view. It is painfully evident that while retail price inflation has indeed remained pretty stable since the late 1980s, asset prices have been anything but stable. There have been two house price bubbles during that time, the first of which burst in the recession of the early 1990s and the second in the recession of 2008/9. Both were preceded by progressive relaxation of lending standards, enabling people to obtain mortgages that in normal times would have been denied to them. Contrary to popular belief, subprime mortgages and negative equity are not new phenomena. I bought my first house in 1988 with a 100% endowment mortgage and consequently spent the first half of the 1990s trapped in a tiny house which was worth less than the mortgage. And other asset prices have not been stable either: there have been several stock market crashes, the most severe being the falls of 1987 and 2008. So with hindsight, it is evident that inflation targeting alone is not sufficient to prevent serious economic problems arising. It successfully addressed the dominant problem of the 1970s. But it doesn't address the problems that have arisen since. 

The challenge for governments is to develop an economic management strategy that addresses all areas of the economy, rather than focusing on one indicator and ignoring the rest. We really don't want to see a return to 1970s-style inflation, which destroyed savings and reduced real incomes for anyone who wasn't in a union. But the deflationary policies we are seeing in much of Europe at the moment are equally destructive, wiping out jobs by the million and wrecking the future of an entire generation. Greece is now in its fifth year of deep recession but is being expected to impose severely deflationary measures on its economy. And in the UK, the government is busy imposing a range of public spending cuts on an already depressed economy while the central bank is creating money at a rate of knots in order to ward off an anticipated deflationary spiral. Interest rates are at an all-time low, but people are saving like mad and businesses are hoarding cash. This is what Keynes called a "liquidity trap". In an odd reversal of the 1970s, this time Keynes both describes the situation and has an answer for it.  Monetarism does too, though - and at the moment it is monetarist, rather than Keynesian, solutions that are being adopted. 

The Keynesian solution to a liquidity trap would be to increase public spending to compensate for the deflationary effect of private saving. Conversely, the monetarist solution is to expand the money supply to compensate for the deflationary effect of private saving. Both agree on the problem, but the Keynesian solution is fiscal expansion whereas the monetarist solution is monetary expansion.

Worldwide, there is a fashion for austere fiscal policy and  public spending cuts, offset by the loosest monetary policy in history. We are in uncharted territory: never before has money been created at the rate that the Fed, the Bank of England and the Bank of Japan have created it in the last few years. Even the European Central Bank has now joined the party, providing cheap funding for European banks through the Long-Term Repo Operation (LTRO), which has already created nearly 5 billion new Euros and will create a whole lot more at the end of February.

All this money creation is renewing fears of inflation in some quarters. Despite what I have said above about cost-push inflation, to monetarists the only cause of inflation is excessively loose monetary policy. Interest rates are currently close to zero and various central banks are doing, or have done, QE or some variant of it.  This is, by definition, loose monetary policy, hence their worries. But is it loose enough to cause significant inflation? Well, by all reasonable measures, the money supply in the UK and indeed in much of Europe is falling despite QE. So on that basis, no, it isn't. It is simply compensating for the deflation caused by tight fiscal policy, private sector saving and general economic decline. And it doesn't do it very effectively, either. Although base money - money created by the central bank - is increasing, broad money - money created by commercial banks, which is most of the money that actually circulates in the economy - is still falling. This is because despite the increase in their reserves provided by QE, banks aren't lending enough to offset the amount of money being destroyed or removed from circulation by businesses and households paying off debt and/or saving. 

I am personally of the opinion that QE makes very little difference in the short run. I've explained elsewhere why QE is simply ineffective.  Yes, all that extra money will have to be withdrawn at some point in the future, whether by allowing purchased gilts to expire, doing reverse QE or simply by raising interest rates. But at the moment it is largely irrelevant. I believe we have reached the limits of monetarism. 

So if the monetarist solution is ineffective, what about Keynesian fiscal stimulus? The problem with this, of course, is that if done conventionally, that would increase public debt - which already stands at about 80% of GDP. Borrowing costs are, of course, very low at the moment, but there are still worries that massively increasing public debt would result in much higher interest costs. And, increasingly, people who favour fiscal expansion as a solution to the liquidity trap - or are simply suffering because of the depressed economy - are looking enviously at the QE programme and asking why, if money can be created for monetary expansion, it couldn't also be created for fiscal expansion. So there are calls for money created by the Bank of England to be spent directly into the economy rather than used to purchase financial assets. The so-called "helicopter drop" would give a free handout to everyone in the country, either to spend as they please or to pay off debt (this alternative is also known as a "debt jubilee"): saving could be prevented by time-limiting the handout. Other suggestions are for created money to be used to finance investment in public infrastructure, including green initiatives and housing. There have also been suggestions for new money to finance job guarantees and benefits increases, cut income and consuption taxes, and guarantee all retail bank deposits.  

Money-financed fiscal expansion would in my view be far more powerful than QE and far more effective at getting us out of the liquidity trap. But it is certainly not risk-free and if not carefully planned and managed it could have unfortunate effects.  This is a bit of a no-brainer, really - if it is a more powerful stimulus than QE, as I believe, then it is also much more dangerous if misused.

I think there are some essential rules for "safe" money-financed fiscal expansion:

-  The business case for every public infrastructure project should show how it will generate the future taxation required to pay for it. If projects can't generate the returns required to pay for themselves then higher taxes or spending cuts would be needed at some point in the future.  

-  Short-term expansionary measures targeted at particular groups such as people on low to middle incomes must not create expectations of longer-term support. 

-  All expansionary measures must be strictly limited to the purpose of fiscal expansion and not be capable of extension to meet political objectives or buy votes. Maybe I'm displaying my own political scepticism here, but I don't trust politicians not to take the opportunity to pursue pet projects and build white elephants. 

Failure to adhere to these rules could have very serious consequences. Money financing is just as much a form of debt as actual borrowing, but without the "brake" of interest costs and the possibility of investor flight. And historically, there is a strong association between money financing of public spending and inflation. Admittedly,  that is because as far as I know, money financing has always been a last resort of distressed sovereigns unable to raise finance elsewhere because their economies are in such poor state, so runaway inflation was a risk anyway. I'm not aware of any examples of money financing by sovereigns that weren't associated with an inflationary spiral - if anyone knows of any, please let me know. But because of that association with inflation, there is a worldwide fear of money issuance as a means of financing public spending. So great is the fear of inflation that direct financing of public spending by central banks is actually illegal under EU and IMF rules, although those rules could probably be circumvented by a determined government. And however well-managed these interventions are, some inflation is inevitable. Indeed "some" inflation is the whole point, really.   

You see, both monetarist and Keynesian solutions to a liquidity trap involve pursuing policies that lead to higher inflation. And therein lies the problem. Keeping inflation low has for so long been the main priority of government and central banks that pursuing policies that seem to undermine this priority are anathema. Hence the Bundesbank's continuing opposition to any form of monetary expansion by the ECB, and Germany's insistence on maintaining fiscal austerity even though it is running large trade and fiscal surpluses to the detriment of other members of the Eurozone. 

The UK's problem, though, is rather different. Here inflation is NOT low - it is currently running at 4-5%.*UPDATE - now down to 3.6%* The Monetary Policy Committee (MPC) forecasts that it will fall significantly this year. But the MPC's record on inflation forecasting is frankly terrible - it has persistently understated inflation by 1-2% for several years. Why should anyone believe it this time? And why on earth would we pursue expansionary policies - monetary or fiscal - when inflation is already above the MPC's target?

Actually, on this occasion I think the MPC is right. The other characteristics of a liquidity trap - excessive saving and restricted bank lending - are evident. We have inflation due to commodity price rises and sterling devaluation (and until recently, consumption tax rises), not because of domestic demand or cost pressures. So maybe it could be safe to indulge in a small amount of carefully-targeted fiscal expansion. In fact, because it is potentially far more powerful than QE, we should need much less of it. So this can't be an opportunity to open the floodgates and spend huge amounts of money on political hobbyhorses. There are always lots of ways of spending money. It doesn't grow on trees.

For me, the best use of created money for fiscal expansion would be a partial debt jubilee. Figures show that the private debt burden in the UK is enormous - it dwarfs public debt. Overall - even leaving out financial services - the UK is the most indebted nation in the western world.  About half of non-financial services private debt is owed by households, of which the greatest part is mortgages: the rest is unsecured debt of one sort or another. Servicing this debt takes up a large amount of many people's incomes, and voluntarily paying it off takes even more. I argued some time ago that worrying about public debt when the private debt level was so high was insane. I have not changed my mind about that. Freeing people of some of their debt burden would enable them to spend more, which would be quite an effective short-term stimulus. There should in parallel with this be measures to improve the availability of finance for SMEs, and perhaps other measures to encourage companies to expand and employ more people.  

Will this lead to inflation? Well, yes. It's supposed to, actually. But a bit of domestically-generated inflation would enable the MPC to get interest rates back to something approaching a normal level, which would benefit the savers who are currently getting terrible returns on their investments. And the impact on borrowers would be mitigated by the partial debt jubilee. I don't see any great danger of runaway inflation from such a limited use of created money for fiscal expansion, especially if the MPC is doing its job properly. But there would be other dangers: in the prevailing economic ideology across the world, such fiscal "profligacy" is anathema and the UK would undoubtedly be punished in the international bond markets if it attempted it.

I actually see a greater inflationary danger from the enormous amounts of base money being created by the QE programme: they aren't doing anything much at the moment, but when banks start lending again and people and businesses start spending again, what will they do with all that extra money? Milton Friedman said "Inflation is always and everywhere a monetary phenomenon". Too much money chasing too few goods and services....will production in our economy really expand fast enough to absorb all the extra cash? And if not, will the BoE reverse QE quickly enough to mop it up? If not, then we can expect high inflation to appear once more.

I don't ever want to see high inflation again. But the fear of inflation is preventing governments in the Western world from taking the fiscal steps necessary to restore their economies to health and growth.  And the millstone of private debt is weighing us down. The real risk we face at the moment is deflation and depression, not inflation. It's time to put fear aside and do something about it.