Wednesday, 26 September 2012

Vince's Folly

From the Oxford Dictionary: 
 folly : noun (plural follies)
1 [mass noun] lack of good sense; foolishness:an act of sheer folly[count noun] a foolish act, idea, or practice:the follies of youtha costly ornamental building with no practical purpose, especially a tower or mock-Gothic ruin built in a large garden or park.
Middle English: from Old French folie 'madness', in modern French also 'delight, favourite dwelling' (compare with folly (sense 2)), from fol 'fool, foolish'
The Business Secretary, Vince Cable, has outlined plans for what he calls a Business Bank, with the aim of improving the flow of credit to small & medium-size businesses.
"We need a new British Business Bank with a clean balance sheet and an ability to expand lending rapidly to the manufacturers"
said Cable to his fellow party members at the Liberal Democrat conference.

Wow, I thought. The Government has done another U-turn. It's going to create a State Investment Bank which will lend directly to businesses - even though not so long ago it refused categorically to create such a bank from the ashes of RBS. Since the main reason why businesses can't get credit is that banks are charging exorbitant rates for lending to anything that looks even slightly risky, providing a means of financing businesses that bypasses sclerotic banks seems rather a good idea.

But two things puzzled me. Firstly, the amount of money proposed as capital for this bank was tiny - £1bn. It was suggested that the private sector (presumably pension funds and insurance companies) would match this, but that is still peanuts, frankly. Compare this with the Bank of England's Funding for Lending scheme, which is providing up to £80bn of cheap money to banks ostensibly for lending to businesses and homebuyers.

And that's the second puzzle. If the Bank of England is providing all this money to banks for lending to businesses, where does this new "business bank" fit in? What would be its role?

No-one seems very clear, to be honest. Some reports suggested that the bank would provide a "one-shop stop" for the various Government and private financing initiatives for businesses, ending the current confusion and providing essential advice to business owner/managers. This would indeed be a good thing - but it isn't banking. Many people believe that this bank would actually lend directly to businesses itself, leveraging its equity by up to £10bn - i.e. traditional fractional reserve banking. But that would be direct competition with commercial banks claiming funding through the Funding for Lending scheme, which is most of them. People really should read what the BIS website says (my emphasis):
"The new institution will operate through the wholesale markets, it will not have any retail presence and will not displace or subsidise banks." 
No, this is not going to be a fractional reserve lending bank.

So what is this bank going to be, then? The BIS website directs us to the recommendations of the Breedon report. I have previously written about this report, so I won't say much about it here, but suffice it to say that it does not recommend creating a bank, as such. What it does recommend is creation of a State agency to buy up business loans from lenders (i.e. commercial banks), pool them and repackage them into securities for sale to investors in the capital markets. To people in the UK this isn't any sort of traditional banking: it is seriously spooky and definitely belongs in the catalogue of "evil investment banking" activities. As someone commented on twitter the other day, "isn't securitisation of loans what got us into this mess?" But American readers would be familiar with this. It is what the US Government-Sponsored Enterprises (GSEs) do.

The GSEs Ginnie Mae and Fannie Mae were created originally to improve access to mortgages so that a higher proportion of Americans could own their own home. Freddie Mac was later created to give Fannie Mae some competition, and since then other GSEs have been created, notably Sallie Mae for student loans. As far as I know, though, there is no American GSE for small & medium-size business loans. And the UK does not have GSEs at all.  Various UK banks, most notoriously Northern Rock and HBOS, experimented with the American originate-to-distribute banking model, but they used their own SPVs - and it has to be said that their experiment was far from successful. Most loans still remain on the lenders' books. This agency would not only be the first GSE in the UK, it would also as far as I can see be the first GSE for small business loans in the world.

This is not necessarily a problem. The fact that the UK is not used to originate-to-distribute banking may add risk to the scheme, though I don't think the US understands its originate-to-distribute model very well either. But the US's fragmented banking system and smorgasbord of competing regulators made it all too easy for loan originators to mislead GSEs and investors as to the scale of the risks they were taking on. Perhaps the UK, with its tradition of universal banking and its simpler regulatory system, may cope better: in particular, perhaps the "regulatory black hole" between originators and GSEs, which Congress still has done nothing to eliminate, will be covered by the Bank of England's conduct supervision.

My bigger concerns about the scheme, though, are twofold: firstly, market access for the securities that the new agency (it is in my view misleading to call it a bank) would create; and secondly, the implications for commercial bank conduct of a Government agency buying risky loans from them.

The fact is that no market exists at present for securities backed with small business loans. The idea seems to be that pension funds and other investment funds would buy them, but it is unclear how they would achieve the credit ratings required to meet regulatory requirements for pension funds. Small business loans have high default rates: the securities would be tranched, of course, but with no market history even the senior tranches would struggle to achieve the high ratings that pension funds require. Unless, of course, the Government were to guarantee them - but it doesn't appear to have any plans to do so. Breedon has in my view created unrealistic expectations regarding the market for these securities, and unfortunately the Government seems to have believed him.

So what would happen if the securities failed to sell, or only sold at very high yields? It would, to say the least, be highly embarrassing for the Government. The agency would be left with unsold securities on its books, or would be forced to accept large losses. How long would it be before the Bank of England was pressured to accept these securities as collateral against bank funding, or - worse - buy them under its Quantitative Easing programme? Mervyn King said "absolutely not" when George Osborne suggested the BoE could buy corporate securities. But he is leaving office in 2013, and will his successor be quite so resistant? We shall see.

My other concern is about moral hazard. The failure of mortgage-backed securities in the 2007-8 financial crisis really arose because retail lenders took on unacceptable risks in mortgage lending, secure in the knowledge that they could unload those risks on to investment banks and Government agencies. The investment banks and Government agencies themselves were equally sure that they would be bailed out if it all went wrong, so did not exercise any sort of due diligence with regard to the investments they were taking on. No-one was managing risk, because in the end they all expected the Government to pick up the tab - which indeed is what happened. Now we have a proposal in the UK for a Government agency to buy up risky loans from commercial lenders. If the securities failed, would the Government bail out the agency? Yes, of course it would. So in that case, why would the lenders bother to assess and manage risk properly, if they knew they had a guaranteed buyer for the loans which itself would be implicitly guaranteed by Government? Why would they retain risky and non-performing loans on their balance sheets if they could unload them on to a Government-backed agency?

There is also a bit of a financial puzzle concerning the relationship of this scheme with Funding for Lending. Reports suggest that the total lending supported by this bank would be about £10bn. This apparently would be enough to meet the needs of business. But the Funding for Lending scheme is providing up to £80bn of cheap loans to banks. If business only needs £10bn of funding, what is the purpose of the rest of the money from the Funding for Lending scheme? There really can't be that many prospective home buyers in the UK. To me it looks very much like back-door recapitalisation of banks via the central bank.

The sheer complexity of this scheme makes me suspicious. If the primary purpose was to provide essential business finance, the simplest way would be via a State Investment Bank, capitalised by Government and lending directly to businesses as a fractional reserve bank in its own right. But that would bypass commercial banks - and once bypassed, what would be the justification for their continued existence? After all, a bank that won't lend except to people who don't need finance, and pays virtually nothing to savers, is an expensive waste of time - but that is how our banks are behaving at the moment.

I suspect that the primary purpose of both the "Business Bank" and the Funding for Lending scheme is not to provide finance for businesses. It is to recapitalise banks, clear out their balance sheets and get them working properly again. It is more Government money poured into an outdated and dysfunctional industry. It is yet another attempt to bring the dead back to life.

So this scheme is not what it may seem. A sensible solution to the shortage of business finance it is not. It is a folly, in the true sense of the word: a costly experiment in trying to control the uncontrollable: a monument to the foolishness of a Government that understands nothing of the machinations of the banking industry and the lengths to which they will go to preserve their hegemony.

Friday, 21 September 2012

The day after tomorrow

The title of this post is unashamedly plagiarised from the film, The Day after Tomorrow, in which extreme consequences follow from climate change. Three enormous storms develop - one each over the US, Europe and Asia - which together force the planet into a new Ice Age, killing millions and forcing the survivors to move south.

The science behind this film has I think been largely discredited from a climate change point of view. But I have been struck by the similarity with our economic situation. We have, indeed, three enormous storms - one each in America, Europe and Asia. And the consequences may be a fundamental realignment of the global economic landscape.

Storm 1 is already familiar to us. This financial storm is progressively destroying the Western system of finance. The "global" financial crisis of 2008 was centred over the US, the originator of the subprime debt collapse that underpinned the disaster, and the UK because of its primacy in global finance. But the dislocation it caused to the global financial system was the trigger for Storm 2 - the Eurozone crisis. And it is no means over yet. We still have a frozen and dysfunctional financial system, propped up by transfusions of money from central banks and governments. We are only just beginning to discover the extent of fraud in fundamental financial activities such as rate-setting and lending. We have trillions of dollars of derivatives backed by fictional assets waiting to unwind.

While I don't buy into the "US dollar will collapse in hyperinflation" theory, I do think there is far more turmoil to come. Zombie banks cannot be propped up indefinitely by depriving people of income, jobs and security: eventually the people will say "NO" and force politicians to switch off the life support, and we will see a banking collapse which will make Lehman look like a minor blip. It would be useful if financial authorities acted pre-emptively to reform the banking system, dismantling and discarding the dead wood and clearing the way for new growth, but I'm not hopeful. They seem to be spending all their time trying to bring the dead back to life.

Storm 2, the Eurozone crisis, has not yet reached full strength. This looks complex, but at its heart is a political storm. The Euro project is doomed. It was wrongly constructed from the start and there is in my view insufficient political will to correct its deep structural problems. There is a growing fracture between the North and South parts of the Eurozone - and, uncomfortably, this also coincides with old religious and cultural differences: the "hardworking" Protestant North versus the "profligate" Catholic South. Ireland, which has in the past suffered terribly from territorial conflict dressed up as religious differences, is currently aligned with the Catholic South because of its high public debt following its unwise decision to bail out its banks, but in many ways behaves more like the Protestant North.  France faces an uncomfortable choice between maintaining the Franco-German alliance that is crucial to the survival of the Eurozone and accepting that its natural allies are the Southern states, especially Spain and Italy with whom it shares many characteristics.

The problem is, as students of European history will know, that previous attempts to create a super-Europe have always ended in the same way - war. Already extreme nationalist parties are growing in popularity and old grievances are being dusted down and polished. I find it very sad that the project that was supposed to eliminate the risk of European war may end up causing it.

And the death throes of the Eurozone carry implications for the whole of Europe. If the Eurozone disintegrates into national conflicts and settling of old scores, how can the European Union survive even as a free trade area? What are the prospects for Eastern European countries caught between a collapsing EU and an increasingly acquisitive Russia? What would the impact of an EU collapse be on its key trading partners - particularly China, which is heavily invested in European countries?

Which brings me to Storm 3 - and the issue that underlies all three storms. China, India and Russia are all facing economic slowdowns. There has been much discussion of the Chinese construction bubble and subprime lending, its municipal debt problems, its dysfunctional regional banks incestuously related to its equally dysfunctional regional governments, and its reliance on the People's Bank of China to manipulate its currency and prop up its banks. All of this looks very, very familiar to students of the US and of the Eurozone. The same pressures that blew up in Storms 1 and 2 are building up in China. There is bound to be an explosion, isn't there?

Well, yes, I think there is. However, China's economics are different: unlike the US and much of Europe, it has a trade surplus and large foreign reserves, and has been industrialising at breakneck speed. It may weather its financial storm, although it is already losing its trade surplus as Western economies cut their imports. But it has another, bigger storm brewing - as do India, Japan and Russia. Both Sober Look and Also Sprach Analyst have discussed the Chinese demographic problem at some length, and others have discussed similar issues in relation to both India and Japan. No-one seems to know which one will blow up first, but there seems little doubt that eventually the ageing populations in China, Russia  and Japan, and male/female imbalance in China and India, will cause callousness towards those unable to provide for themselves, poverty among the working population, migration, civil unrest and perhaps regime change.

The same demographic problems face Western economies, too. The fact is that our populations are ageing: people are living longer and fertility rates have dropped. In the future we will not have enough people of working age to support our elderly. Governments are pinning their hopes on people working longer, but the problem is that although we have enabled people to live longer we have not yet enabled them to stay healthy for longer: an increasing number of people spend years living with levels of physical and mental disability that make it impossible for them to work. And people object to working for longer, too. There is a sense of entitlement around state pensions and elderly benefits: when these are reduced or changed people claim they have been "robbed", because they incorrectly believe they have paid for them during their working lives. And because the "grey vote" is politically powerful, it is a brave politician who tinkers with the entitlements of the elderly. Consequently younger people face the prospect of spending their entire lives in debt and paying high taxes to support their parents' generation. It is no surprise that many of them are looking to emigrate to younger, more vibrant economies.

So if I am right, that the economic storms we are seeing across the Northern hemisphere presage a fundamental realignment in the economic landscape driven ultimately by demographic changes, how will it pan out? The last sequence in the film shows the US president delivering a broadcast address from a hastily-established Presidential residence in Mexico. Why on earth Mexico would allow the president of a refugee nation to speak as if he ruled the world is never explained, but then that's Hollywood.  It seems more likely that the US would lose its global authority. We have assumed that the mantle of "world leader" will shift to China: but if China is caught up in the storm as well, then economic strength and authority may go elsewhere. Looking at the world, the nations that have youth and energy on their side are mostly southern ones. Latin America, Africa, Indonesia, Australia. I mentioned the growing fracture between North and South in the Eurozone. Will we see a much larger, global fracture between an elderly, economically stagnant Northern hemisphere and a young, vibrant, growing South? And will the vibrant Southern nations be willing to support the elderly North? What could the elderly North offer them in return? It is hard to see why a relatively poor, young Southern hemisphere would be willing to prop up an elderly Northern hemisphere that is considerably richer. Only if the Northern elderly are prepared to spend their wealth buying Southern goods would the Southerners play ball - but that is a recipe for slow economic death.

Mind you, China may not accept the inevitability of its population ageing. It has not hesitated in the past to use brutal methods to achieve demographic change. Faced with a working population unable to support its elderly, migration of young men (particularly) to countries where there are more young women, civil unrest and the possibility of revolution, what is it likely to do? Kill the unwanted (in this case the old, frail and disabled), or allow them to starve to death? Close its borders to prevent emigration? Use the armed forces to suppress protest? We will have to wait and see - but it has done all of these within living memory.

Western democracies have more of a problem, because of the power of the "grey vote". Successive governments have ducked the issue, fearing electoral unpopularity. It is highly unlikely that a democratic government would resort to the kind of brutality - forcible euthanasia, for example - that a dictatorship might. But will we see social pressure on the elderly, frail and disabled to "do the decent thing" - commit suicide so that they are not a burden on the younger generations? Will those who DON'T do this be ostracised, or worse, abandoned or forced to run? Will Logan's Run become reality?

All of this hangs on the availability of resources. Although the pace of growth of the world's population is reducing and the balance is shifting from north to south, it does seem likely that increasing global population will put further pressure on global resources and a fragile ecosystem. The Population Institute forecasts dire consequences for the world if political leaders do not address the question of fair distribution and sustainable use of resources. In their paper "The Perfect Storm", they raise important questions for world leaders to address in a summit planned for July 2030. Talk about forward planning!

But there are already struggles for control of resources. And those struggles are sufficient in themselves to cause a conflict that could wipe out the world as we know it long before 2030. The world is utterly dependent on the Middle Eastern oil-producing nations - and they know it. They pull the strings of our economies with their control of oil production. But they have a storm of their own, and this is what we REALLY should be worrying about. Important as the financial, political and demographic storms in the northern hemisphere are, they are as nothing compared to the possibility of Armageddon in the Middle East.

Thursday, 13 September 2012

The foolish Samaritan

Someone has just put this comment on my post "The Golden Calf":
Luke 10:30-37
Jesus replied, “A man was going down from Jerusalem to Jericho, and he fell among robbers, who stripped him and beat him and departed, leaving him half dead. Now by chance a priest was going down that road, and when he saw him he passed by on the other side. So likewise a Levite, when he came to the place and saw him, passed by on the other side. But a Samaritan, as he journeyed, came to where he was, and when he saw him, he had compassion. He went to him and bound up his wounds, pouring on oil and wine. Then he set him on his own animal and brought him to an inn and took care of him.  And the next day he took out two denarii and gave them to the innkeeper, saying, ‘Take care of him, and whatever more you spend, I will repay you when I come back.’ Which of these three, do you think, proved to be a neighbor to the man who fell among the robbers?” He said, “The one who showed him mercy.” And Jesus said to him, “You go, and do likewise.”
This is the story of the Good Samaritan, one of the best-known stories in the Bible. Usually it is used to promote helping others, but this commenter suggested that it justified saving - on the grounds that the Samaritan couldn't have helped the man if he hadn't had savings. This interpretation is not consistent with Jesus' teaching elsewhere, so I thought I would have a closer look at this story to see what I think Jesus is actually saying.

It is always dangerous taking Bible stories out of their historical context, so here's a bit of background. I am no Bible scholar, and there are plenty of people out there who know much more about this than I do, but the historical context for all of Jesus' ministry is the occupation of Palestine (including Israel) by the Romans - hence Jesus' reference to Roman coinage (denarii). Military occupation always causes breakdown in local forms of law enforcement, and Palestine was no exception. By the time Jesus told this story, the road from Jerusalem to Jericho was extremely dangerous: robberies were a daily occurrence and murder was common. Robbers set ambushes for people travelling the road. The man who was robbed, beaten and abandoned was ambushed - but his presence on the road was a clear indication to other travellers that robbers were around.

So the priest and the Levite passed by on the other side not because they didn't want to help the man, but  because they feared being attacked themselves. They thought the robbers were still around. They may even have thought the whole thing was a trap, set up by robbers to entice the unwary into assisting the wounded man.

Jesus' listeners would have known this. They would have known that the Jericho road was dangerous and it was unwise to travel it alone and unarmed, or to carry much in the way of valuables with you. So the whole story is quite remarkable. All of the travellers are alone - which would have been unusual. And the Samaritan is carrying valuables - oil, wine and money. Travelling alone with valuables would have made him a target, and he would for that reason have been unwilling to stop. So it is even more surprising that he stopped to assist a wounded man.

The payment made to the innkeeper is clearly made from money the Samaritan brought with him for his own expenses. He doesn't have enough money with him to pay for the wounded man's care, so he pays the innkeeper all the money he has with him and sets up a credit line for any additional cost.  Now why on earth would the innkeeper care for the wounded man simply on the basis of a small down-payment and a promise to pay up later? Most innkeepers would have expected the Samaritan to pay the whole cost up front. Perhaps the Samaritan was a regular visitor to that inn, so the innkeeper trusted him?

Anyway, the fact that the Samaritan actually didn't have enough money with him destroys the suggestion that he could only help the man because he had savings. It is often assumed that he was wealthy, but the story doesn't say this. What we know is that he was carrying oil and wine - perhaps to sell - and that he had a small amount of money with him, not enough to pay the whole cost of the man's care. And he promised to pay up on his return - which suggests he had to obtain the money. If he actually lived in Jericho, or had land or property there, he might have been able to sell some assets. But the fact that he intended to return suggests that he was only visiting Jericho, perhaps on business. In that case he would have had to obtain the money either by earning or by borrowing. Savings don't come into it.

So Jesus is not justifying saving. This story is, as Jesus indicates, about mercy. And there are two merciful people in this story, not one: the Samaritan, who risked his own life to save another, and the innkeeper, who took on the cost of caring for the injured man with no certainty of repayment.

The essence of this story is that in order to help others it is necessary to conquer fear for oneself. The priest and Levite were afraid to help the injured man, because they feared for their own lives: but the innkeeper and the Samaritan put aside their own fear in order to help another. At the heart of the selfishness that I criticise in my post The Golden Calf is fear - fear of scarcity, fear that no-one will help, fear that God will not provide, fear (above all) of death. That fear leads people to look after themselves at the expense of others, to hoard surplus goods and money instead of sharing it with others, to pass by on the other side instead of assisting an injured man. It is understandable, particularly when times are hard. But it is not what Jesus taught.

This is what Jesus taught:
Luke 12:13-21
Someone in the crowd said to him, “Teacher, tell my brother to divide the inheritance with me.”Jesus replied, “Man, who appointed me a judge or an arbiter between you?” Then he said to them, “Watch out! Be on your guard against all kinds of greed; life does not consist in an abundance of possessions.”And he told them this parable: “The ground of a certain rich man yielded an abundant harvest. He thought to himself, ‘What shall I do? I have no place to store my crops.’“Then he said, ‘This is what I’ll do. I will tear down my barns and build bigger ones, and there I will store my surplus grain. And I’ll say to myself, “You have plenty of grain laid up for many years. Take life easy; eat, drink and be merry.”’“But God said to him, ‘You fool! This very night your life will be demanded from you. Then who will get what you have prepared for yourself?’“This is how it will be with whoever stores up things for themselves but is not rich toward God.”
And Jesus sent out his followers with nothing (Mt 10: 5-15) : he told them not to worry about where food or clothing will come from, because God will provide (Mt 6: 25-34) : and in the Lord's Prayer (Mt 6: 9-13) he instructed his followers to pray for their DAILY bread - not their bread in forty years' time. Nowhere, that I can find, does Jesus promote saving goods or money to provide for oneself. What he promotes is giving without counting the cost and trusting in God's provision.

Now, for people who aren't Christians, this looks very, very foolish indeed. And I totally understand if people reject Christianity because of this foolishness. Foolishness is at the heart of Jesus' teaching. The Samaritan is foolish, the priest and Levite are sensible - but it is the Samaritan's behaviour that Jesus commends. The man who saves up for his old age is, by most people's standards, sensible: but Jesus describes him as "fool".  Saving your life by leaving others to die is contrary to Jesus' teaching: so is saving your surplus while others starve. Using Jesus' parables to justify saving yourself, either physically or materially, is simply unjustifiable.

Tuesday, 11 September 2012

The illogicality of the IMF

The IMF has just produced a new report on Ireland. It is not happy reading. But it is interesting- not least because it says as much about the beliefs of the IMF economists producing the report as it does about Ireland.

The report is structured in four parts:

1. Household consumption, wealth and saving

2. Access to credit, debt overhang and economic recovery: the Irish case

3. Medium-term fiscal consolidation in Ireland: growth-friendly, targeted, sustainable

4. Averting structural unemployment in Ireland

Each of these is in effect a separate report in its own right, and there is no attempt to draw over-arching conclusions from the findings of the four reports. Consequently the recommendations from one report are contra-indicated by recommendations from another report. Really the IMF should do better than this. But that's not my main issue with this report. It's the appalling logic.

Part 1, the Household Consumption, Wealth and Saving section, notes that Irish households are highly indebted and their preference is for deleveraging (saving). This section claims that the main reason for their high indebtedness is the fact that incomes have fallen. Yet in Part 4, Averting Structural Unemployment in Ireland, the figures for reduction in hourly nominal wage rates in both the public and private sector do not indicate this as a primary cause of high indebtedness. Private sector average rates have fallen by 2.25% since 2009 and public sector by 3.25%. This is hardly a large reduction, and Part 4 suggests that employers have resorted to layoffs rather than wage cuts, leading to high unemployment.  Part 3 also notes that there have been large cuts to both in-work and out-of-work benefits. So the true story in Part 1 is not simply that "incomes have fallen". They have, but the main components of that fall are high unemployment (causing catastrophic loss of income), benefit cuts and increased taxes - not cuts in nominal wages. So household debt burdens (as a proportion of income) did increase as a consequence of the financial crash and ensuing recession, but they have been made much worse by the enormous fiscal adjustment carried out by the Irish government since 2008.

This is the trouble when you look at things only from a macro perspective. You can reach the wrong conclusion as to the causes of the problem you identify, and therefore suggest the wrong solution.

However, the writers of Part 1 are not only guilty of failing to observe that the wood is made of trees. They also produce one of the worst examples of bad economic logic I have ever seen. Even their citation does not support them. The relevant bit is this, in section 10 on p.7:
Disaggregating the contributions to the forecast highlights the significance of Ricardian effects whereby households relax savings when the government cuts the fiscal deficit (and vice versa); this effect is consistently found in the empirical literature.
Their citation is Huefner &Koske's 2010 paper "Explaining Household Savings Rates in G7 Countries: Implications for Germany" . But this paper does NOT consistently find Ricardian effects. It said only two countries in its sample - the US and France - demonstrated Ricardian effects: the other countries did not. The authors survey other research that does show such effects, but then specifically say that their findings do not agree with this. And note that this paper is about SAVING. Economically, paying off debt and saving is the same thing - but behaviourally they are very different, as I shall discuss later on.

Despite this, the IMF then go on to say:
Using the coefficient for the fiscal balance as proxy for this Ricardian offset, the ongoing fiscal consolidation in Ireland will contribute most to the estimated reduction in the household savings rate. The reduction in household liabilities or net wealth has a small yet significant contribution, likely a reflection of the common difficulty of estimating the balance sheet effect from empirical data.The decline in unemployment and the increase in the dependency rate play minor roles.
So, further fiscal tightening will force households to reduce the rate at which they pay off debt. It doesn't take a genius to work that out, but what has it got to do with Ricardian equivalence?

Ricardian equivalence essentially says that if government increases its deficit, households save more in expectation of higher taxes later on to pay that deficit. Therefore - the theory goes - government deficit spending is pointless as a demand stimulus, because households hang on to their money instead of spending it.

Here the IMF is using Ricardian equivalence in reverse. It is arguing that deficit reduction raises households expectations of future tax cuts and therefore encourages them to reduce saving. But the equivalence is asymmetric: households may indeed save more in anticipation of tax hikes, but as governments usually prefer to increase spending rather than reducing taxes when there is a surplus, and households know this perfectly well, it would be a foolish household that reduced saving before those cuts are announced (and even then they might wait until the cuts are actually made - governments can change their minds).

But there is a much simpler explanation for reduced savings rates when governments are tightening. And for that we need to look at how people actually behave - which the IMF economists have failed to do.

When taxes are raised and benefits cut, household real incomes fall unless real wages increase to compensate - which has not happened in Ireland and shows no signs of doing so. When household real incomes fall, in most cases this shows itself as pressure on discretionary spending. Saving is a discretionary spending activity: instead of spending surplus money (money I don't need for essential household expenses) immediately, say on a holiday, I put it away for spending in the future. So, if I have less real income because I have higher taxes and/or lower benefits, I have less money for discretionary spending or saving. I may choose to maintain my discretionary spending, in which case my savings rate will fall: or I may choose to maintain my savings rate, in which case my discretionary spending will fall. Or I may cut both. Which option I choose is determined by such things as the level of interest rates (poor returns on savings encourage spending), my expectations of future inflation (if I think my savings will be inflated away I may choose to spend the money instead - or I may save even more to compensate), and my worries about the future. In an uncertain economic environment where jobs are under pressure, I am more likely to maintain my savings rate while I can. But if my income falls to the point where my ESSENTIAL spending is under threat, I won't maintain either my discretionary spending or my savings rate.

In Ireland, households are maintaining high savings rates despite reduction in real incomes, and that is causing serious demand problems in the economy, as Part 2 notes in relation to the difficulties experienced by SMEs. The IMF thinks that if households are discouraged from saving, through fiscal deficit reduction by means of tax rises and benefits cuts, they will be encouraged to spend instead. This is bunkum, frankly. Fiscal deficit reduction can only be achieved by taking money from the private sector, which both discourages saving and dampens demand - hardly what is needed in a distressed economy.

But what is really worrying is the IMF's assumption that Irish households' preference for saving will tail off in the face of further fiscal consolidation. You see, Irish households by and large are not saving for future spending - they are paying for PAST spending. Debt repayments fall into the category of ESSENTIAL household spending (not discretionary) when they include things like mortgages and utility bill arrears, and many households also treat unsecured debt repayments as essential spending, because of fear of the consequences of default. Households will cut both discretionary spending and other forms of saving (such as pensions) to the bone to maintain these.Yes, if people are over-paying their debts - paying off debt faster than contractually required - cutting their incomes may discourage them. But so do very low interest rates, which we have now had in the Western world for a long time and yet people are still paying off debt. Clearly debt isn't something people want to have. If their desire to get rid of their debt is stronger than their desire for consumer goods and services, they will continue to pay off debt in preference to buying things. In which case, for debt payments actually to reduce, incomes would have to fall to the point where people are struggling to buy food - and we would then see increased defaults and foreclosures, not simply reduction in savings.

The IMF report highlights the fact that Irish households are highly indebted, with debts of over 200% of income - yet they recommend reducing household incomes still further, through more tax increases, benefit cuts and nominal wage cuts. They note that this will have the effect of reducing Irish households' debt repayments - but they attribute this to unproven economic effects rather than to the obvious cause, which is simply that people will have less money with which to pay off debt. They correctly identify lack of domestic consumer demand as the single biggest issue facing the Irish economy - but they think that if people are unable to pay off debt because their incomes have fallen even more, somehow they will increase consumer spending. And they also think that further fiscal consolidation will encourage people to spend, even though it will remove money from the private sector. Where is the logic in this?

I suspect that the recommendations of this report are actually driven by two unstated factors that have nothing to do with the realities of the Irish economy. Firstly, the fact that Ireland is currently in receipt of bailout funds, and return of this money is top of the IMF's priority list. And secondly, the almost religious belief among IMF staffers in fiscal consolidation as a cure-all for economic ills - rather as mediaeval medics believed in blood-letting. The IMF's recommendations for Ireland appear to be driven not by logic but by wishful thinking.

Thursday, 6 September 2012

Draghi's debt trap

After days and days of objections from the Bundesbank, threats to resign from its chairman, secret meetings, press leaks and shady deals, Draghi has got his way. The ECB will make "unlimited purchases" of certain Eurozone nations' government bonds with maturities of up to three years. It will use newly-issued euros to make these purchases. To address concerns about debt monetization, the ECB will sterilise these purchases (withdraw the newly-issued money from circulation) by some means yet to be defined.

Firstly, let's be completely clear about the justification for this. It is absolutely not to relieve the problems of debt-laden sovereigns. It is to protect the Euro. As I pointed out recently, the stability of the Euro is under threat because of a growing belief among investors that some countries will abandon the Euro and issue their own currencies. According to Draghi, interest rate policy is now ineffective in those countries that investors think might leave the Euro, because yields are instead driven by the risk of redenomination. This is serious. Redenomination risk makes it impossible for the ECB to control inflation (or, in the periphery, deflation) and increases the likelihood of speculative attack on the Euro. Therefore - in Draghi's view - the ECB must act to eliminate redenomination risk.

The ECB's weapon of choice is selective QE focused on rapidly-deflating parts of the periphery. I have previously argued for QE in the periphery - and reverse QE in Germany - as a means of managing the huge variation in the money supply across the Eurozone that is evident from the Target2 imbalance. Draghi has proposed QE in order to limit interest rate variation across the Eurozone. It amounts to the same thing. Despite the concerns of the Bundesbank and others, this is MONETARY policy. Bailing out distressed sovereigns is a side effect, but it is not the aim of the purchases.

The problem is that, side effect or not, sovereigns will receive relief, and that is likely to act as a disincentive for them to follow through with the fiscal reforms they have agreed to both as conditions for their debt relief programmes and in the Fiscal Compact. Draghi threatens to end purchases for sovereigns that fail to follow through with reforms: but as James Mackintosh at the FT points out, this threat is empty. If a sovereign failed to implement agreed reforms and the ECB pulled the plug on bond purchases, it would be likely to default - in which case the ECB would suffer huge losses on its holdings of that sovereign's debt, and the Euro would probably collapse. So how could fiscal discipline and structural reform possibly be enforced?

Leaving aside the headache for Merkel that such moral hazard will create, there is also the problem that QE amounts to direct funding of governments by the ECB, which is explicitly forbidden by EU treaty. Draghi originally argued that if QE is used as a monetary policy tool, the fact that it is also monetisation of government debt is merely a side effect and therefore not a treaty breach, but Jens Weidmann of the Bundesbank was not impressed. Today, to calm the fears of Weidmann (and others) about inflation arising from debt monetisation, Draghi agreed to "sterilise" the bond purchases. This means that the newly created money used to buy the distressed government bonds would be withdrawn from circulation after the purchase, returning the money supply to exactly as it was before the purchases were made.

Draghi has - perhaps wisely - not explained exactly how he plans to do this. He could offer banks term deposits at a slightly higher rate of interest than they currently get in the regular deposit facility - that wouldn't be difficult, since ECB deposit rates are currently zero. Or he could sell some of the junk on the ECB balance sheet in open market operations, assuming he can find buyers willing to pay him something near the amount he paid for the junk - we can't have the ECB making losses on its investments, now can we? Alternatively, the ECB could issue a short-dated debt instrument for the amount of money created: this would probably mop up what is possibly rather a lot of new money more effectively than term deposits, since it would be offered to a wider range of investors.

An ECB debt instrument might also go some way towards addressing the shortage of collateral that Cardiff Garcia notes. Mind you, the way that would work is simply priceless. Spanish bank sells Spanish government bonds to ECB for new Euros: ECB sells ECB bonds (bills?) to Spanish bank, thus "buying back" the new Euros: Spanish bank repos ECB bonds at the Spanish national bank or the ECB for new Euros......Complete circularity. You really couldn't make it up, could you?

But entertaining though that is, there is a much better variety of Euro fudge, or rather Vampire Squid ink, lurking at the heart of this proposal. From the very start of the Euro crisis, Germany has adamantly refused to countenance the prospect of Eurozone common debt issuance. Merkel has made it clear time and again that Euro bonds are not an option while peripheral government debt and deficits remain well above the Maastricht limits. But if the ECB buys peripheral government bonds, then sterilises the purchases by issuing an equivalent amount of its own debt, it has effectively replaced the national debt of distressed Eurozone countries with common Eurozone debt, guaranteed (via ECB capitalisation) by the Eurozone member states and in particular by Germany. Admittedly it would be short-term debt, but the precedent would be set.

This is Draghi's debt trap. He set it up for the Bundesbank and, like the idiots they have so often shown themselves to be, they walked straight into it. In blindly pursuing their aim to prevent monetisation, with its attendant risk of inflation, they have unwittingly enabled Draghi to force their Chancellor into a position where she no longer has any power to prevent the issuance of common Eurozone debt.

You see, the ECB's sole mandate is to ensure price stability, which it can only do if the Euro is stable and monetary policy is effectively transmitted. So within its mandate it can do whatever it considers necessary to stabilise the Euro and maintain effective interest rate policy. Just as monetising peripheral government debt, if done solely for this purpose, would be MONETARY policy and therefore not illegal even though EU treaty specifically outlaws it, so converting peripheral government debt to common Eurozone debt would also be MONETARY policy. And the conduct of MONETARY policy by the ECB cannot, under EU treaty, be subject to political control. Unless Merkel can prove that in some way the ECB would be in breach of treaty by issuing its debt instrument, there is nothing whatsoever she can do to prevent it.  From now on, Magical Mario is running this show and all the other players are his puppets.

There are two morals to this story. The first is the one that Bob Diamond learned to his cost: never, ever pick a fight with a central banker. They have much bigger guns than you.

And the second is this: never, ever pick a fight with a central banker who learned his trade at Goldman Sachs. You will end up lovingly entangled in his tentacles while he bleeds you dry.

Tuesday, 4 September 2012

That shocking UK debt chart

I've been meaning to take this chart apart for ages.

It first appeared towards the end of 2011 and caused a considerable stir. Writers around the world castigated the UK for its profligacy. And from some Americans there was almost palpable glee that the smug UK was in a worse mess than the US. The French were facing a ratings downgrade at the time, and at least one writer used this chart to justify Sarkozy's argument that it was the UK that should be downgraded, not France. Review after review highlighted this "excellent" chart, and went on to blame the UK's dominant world position in financial services for its debt crisis. And it's still doing the rounds. It popped up on Twitter again last night. Which reminded me that it really, really needs debunking.

Not one of the many articles featuring this chart that I have read questioned its accuracy or pointed out that Morgan Stanley had provided neither an explanation of how the chart was constructed nor information on its data sources.  Nor did anyone except Steve Keen notice that there were several other charts around at the same time which showed total debt from all sources, and Morgan Stanley's figure for UK financial sector debt was more than twice anyone else's. This chart from the ONS has private sector debt at 450% of GDP, of which about half is financial sector debt:

There is something else odd about the Morgan Stanley chart too. What on earth is "Europe"?  In this chart, the UK and Sweden are shown separately from "Europe", even though both are members of the European Union, and Norway is also shown separately even though it is part of the continent of Europe. This is to say the least confusing for people who don't understand European geopolitics. Presumably by "Europe" Morgan Stanley mean the Euro area, though that is inaccurate and misleading: Europe is much more than just the Euro area - in fact it is more than the European Union, too.

Now the Euro area has a sovereign debt crisis, does it not? Er, not according to this chart. The public debt of "Europe" is considerably less than Japan's and only slightly more than the US*. So as Joe Wiesenthal points out, "Europe" actually doesn't have a debt problem. Now that would be true if "Europe" were a full monetary and fiscal union like the US. But it isn't. It's a collection of sovereign states which adopted a common currency because they thought it would benefit their own economies, not because they wanted to share with others. It's a collection of sovereign states which have agreed to some common laws and a certain amount of power-sharing, but who jealously guard their right to fiscal self-determination. It's a collection of sovereign states who DO NOT ISSUE COMMON DEBT. There is no equivalent of federal debt in Europe. This chart is effectively comparing the federal debt of the US, UK, Canada etc. with the MUNICIPAL debt of the Eurozone (not even the whole EU). If we included the municipal debts of the US in its total debt pile, the US wouldn't look nearly so good, would it - since we know that several of its states are virtually bankrupt?

Anyway, to return to the UK. According to this chart it is by far the most indebted nation on earth and is crippled by the debt of its bloated financial services sector. Is this justified?

"Partly", I think would have to be the answer. Other sources show that household debt/GDP is indeed very high, at around 100% of GDP. And non-financial corporate debt is also very high at around 110%. Public debt actually isn't as bad, at just under 60% in 2011 according to HM Treasury (Morgan Stanley marks the debt to market, giving a higher figure of about 80% due to rising gilt prices).  But overall, excluding the financial sector, the UK does indeed have something of a debt problem.

We should remember that a high proportion of household debt is mortgages, because the UK has a very high level of home ownership and property is relatively expensive. Mortgages on primary residences are generally regarded as reasonably safe forms of debt, because people will cut discretionary spending to the bone to protect their mortgages. But a lot of people are financially stretched in the UK because of high levels of unsecured debt, rising unemployment and, perhaps more importantly, UNDER-employment (people forced to take part-time work when they want full-time), and high cost of essentials such as fuel and heating. Mortgage interest rates for many are at all-time lows because of the very low interest rate policy and unconventional measures pursued by the Bank of England, and it is probably fair to say that mortgage defaults would be far higher than they are if interest rates were at historically normal levels. Also, the UK has not suffered the catastrophic property market collapses of the US, Ireland and Spain: this is mainly due to housing shortages, but it is also due to capital flight from the Eurozone (London property is a favourite safe haven for the Greek and Italian wealthy) and active support for the housing market from a Government worried about funding for elderly care (the over-50s own much of the higher-value housing stock).

Non-financial corporate debt, although very high, is not quite what it seems. Corporations also have unprecedentedly high cash balances. Exactly why they are carrying so much cash while also maintaining loan finance is a bit of a mystery (although it is sensible to have long-term loan finance coupled with a positive cash balance) but I would say has to do with worries about cash flow and access to working capital finance in the future, since banks are reducing unsecured lending. And that brings me to one of the major issues with this chart.

The financial sector's debt is, to a considerable extent, the savings of the household and corporate sectors, both in the UK and overseas. The size of these figures suggest that they include all forms of debt including domestic deposits (for comparison, the McKinsey chart below excludes domestic deposits from financial sector debt). It therefore shows the assets of the domestic non-financial private sector as the financial sector's debt, and in so doing gives a misleading picture of the UK's domestic finances. On this chart, every personal and corporate current account and deposit account balance is (presumably) included in "financial sector debt". This is also true for the other countries, of course - which should really make one rather worried about New Zealand. It has high household debt but apparently almost no financial sector debt. Do New Zealand companies and households have no liquid assets? And we should also take Japan's figures with a pinch of salt. Japanese households save like crazy, and this is reflected in relatively high financial and public sector debt levels (most of the Japanese government debt pile is owned by its population). But the real issue in the Japanese financial sector is asset quality, not debt: their banks are still hampered by high levels of non-performing corporate loans. The lack of granularity in this chart, and the absence of supporting data (or even attribution of data sources) makes it seriously misleading.

So is the UK's financial sector really as much of a problem as this chart suggests? Is financial sector debt really 600% of GDP? As Morgan Stanley do not give their data sources and the chart is no longer on Haver Analytics' archive list (and their website does not have a search facility) it is impossible to check how they arrived at this figure, but it is way out of line with other sources.  McKinsey, in their paper on the progress of global deleveraging, (link at bottom of post) gave UK financial sector debt as 219% of GDP:


This is consistent with the ONS figures from the chart further up the post, which was quoted by HM Treasury in its 2011 Budget report. And interestingly, McKinsey and Morgan Stanley both say they obtain their data from Haver Analytics. So why is the Morgan Stanley figure so much higher? Including domestic deposits can't possibly be the sole cause.

Grossing-up of interbank balances might be one possible explanation. Financial institutions lend to each other through the interbank unsecured and repo markets, and they also place deposits with and borrow from the central bank. The borrowing and lending of funds on a daily basis is the lifeblood of the financial system, and ensures that at the end of each day the financial system is fully funded overall, even though individual institutions are temporarily in debt to each other. This chart only considers debt. Could it be that interbank borrowings are included in Morgan Stanley's UK financial sector debt figures? If so, it is a gross error. Interbank borrowings should be netted, and only the difference (if negative) shown in debt figures.

But grossing-up interbank balances does not explain why the UK's financial sector is apparently so inflated relative to the rest. My guess is that Morgan Stanley have included in the liabilities of the UK financial sector debts incurred by UK subsidiaries of overseas financial institutions. In particular, they may have included derivatives issued and traded in London.

McKinsey say they do not include asset-backed securities in figures for financial sector debt, because that would cause double counting of the underlying, which is mostly domestic loans of various kinds. But they claim that Morgan Stanley do include them. By far the largest issuers of ABS are US financial institutions. Global Finance say that if ABS were included in figures for US financial sector debt, it would be 350-360% of GDP. Yet on the Morgan Stanley chart, US financial sector debt is shown as about 100% of GDP (as against 40% on McKinsey's chart).

Including in UK financial sector liabilities the debts incurred by UK subsidiaries of overseas financial institutions is perhaps an understandable approach, since these subsidiaries are usually UK-incorporated legal entities, but it creates considerable distortions. Just one example should be sufficient to show the distortionary effect: using this approach, the losses incurred by JP Morgan's Chief Investment Office in London earlier this year would have been counted as losses of the UK financial sector, not the US. And it raises the question who would be responsible if a systemically-important US financial institution suffered sufficient losses on its London trading activities to cause its failure.

In the financial crisis, the US government bailed out AIG even though most of its losses were incurred in London. But Iceland, facing a similar problem, repudiated the debts incurred in London. There was considerable ill-feeling between the UK and Iceland over Iceland's behaviour towards its banks' overseas creditors, and at one point the UK prime minister used anti-terrorism legislation to prevent Icelandic assets being moved out of the UK: relations between the UK and Iceland are still strained, particularly as Iceland now appears to be experiencing economic recovery (unlike the UK). However, the UK did nationalise and dispose of the UK subsidiaries of both Kaupthing and Landesbanki, and compensated insured UK retail depositors with Icesave. So it could be that because of the Icelandic experience, Morgan Stanley have assumed that the UK would in future have to accept financial responsibility for debts incurred by UK subsidiaries of overseas financial institutions, and have therefore included those debts in the figures for the UK financial sector.

I don't think this is remotely reasonable. Iceland's behaviour is not generally considered by the international community to be a good blueprint for the handling of major banking failures. Economically, it was unquestionably the right decision for a small country whose banking sector incurred losses that would, if taken on to the public balance sheet, have overwhelmed it - as Ireland's did. But suppose the US did the same? Suppose it decided, in the event of collapse of the global derivatives bubble, to repudiate all debts incurred by overseas subsidiaries of US financial institutions? That's the kind of behaviour that starts wars.

The Icelandic "solution" should be recognised for what it was - sovereign default - and rejected outright as an acceptable approach to resolution of major financial crises. Instead, there needs to be acceptance by the international community that no one country should have to bear the entire cost of major systemic failure. And an international legal framework should be developed for assigning responsibility and distributing losses fairly. In the 2007/8 financial crisis, most of the losses were borne by the US. But if the US had behaved like Iceland, most of those losses would have been borne by the UK. That's what I think the Morgan Stanley chart is showing us - and it is a terrifying prospect. We must learn from it.

* Eurostat figures show the Euro area combined sovereign debt at 88.5% of Euro area GDP in July 2012.

Related links:

Debt and deleveraging: Uneven progress on the path to growth - McKinsey Global Institute (pdf download available)