Monday, 29 October 2012

Full reserve banking: the largest bank bailout in history

I've now read three different proposals for full reserve banking - respectively from the IMF, Lawrence Kotlikoff and Positive Money. Each is slightly different, but they all share the following essential characteristics:

  • 100% backing for deposits with cash and/or government debt. The IMF proposes cash backing for ALL deposits, including wholesale ones. Kotlikoff and Positive Money propose cash backing for sight deposits (current/checking accounts) only. 
  • Serious restriction on the nature and scope of bank lending
  • All money issued by the central bank only. The proposals differ as to whether the money supply should be directly managed for macroeconomic benefit or whether there should continue to be indirect control via interest rate policy. 
I've both written about and had extensive debates with Positive Money about their proposals, and I recently wrote about the IMF proposal. Kotlikoff's proposal is similar to both of these, in that it fundamentally changes the nature of banking, but structurally different in its extensive use of mutual funds and securitization of lending. It is also wider-ranging than the other two, covering not only shadow banking but insurance.  

The nature of banking is by no means a simple matter, and none of these proposals is easy to understand. Consequently much of the public commentary revolves around the economic problems and moral concerns in our present system. There is little discussion of the likely economic problems with a full reserve system, or of the moral concerns that it raises. In fact all three are, perhaps unsurprisingly, complacent about their proposals and apparently blind to their flaws. Here are a few gems:

- The IMF produced a DSGE model that painted a very rosy picture of an economy under full reserve banking. The model itself was lovely, but the calibration made a great many assumptions for which they produced little justification and some of which in my view were actually wrong: there were weird interest rate assumptions, and very optimistic ideas about inflation (since the proposal included writing off most private debt). I suppose the idea was to blind everyone with advanced maths. But I'm not that easily fooled.  DSGE models are only as good as the accuracy of their assumptions. As we used to say about computer systems, garbage in = garbage out.  

- Kotlikoff designed a system which includes its own version of what in the UK is known as the Tote. He claims that this is "perfectly safe betting". Crikey. Regarding betting as "safe" is the cause of much damaging addiction to gambling. And no-one who has ever bet on the outcome of a horse race would regard any form of betting as "safe". Quite apart from anything else, the opportunities to game the system are legendary. The use of a totalisator does make betting safer for the average numpty, but to describe it as "perfectly safe" is laughable. I suppose betting on horses is not quite so much of a tradition in America as it is in the UK, so Kotlikoff maybe doesn't know much about it. But in what way is replacing a casino with a betting shop an improvement?

- Positive Money propose that the Bank of England's Monetary Policy Committee (MPC) should control the money supply so that inflation remains stable. Quite apart from the political implications of this (MPC members are political appointees - why on earth does Positive Money think they would be incorruptible?), there is a serious information problem. The Office of Budget Responsibility's October evaluation report admitted that they got their growth forecasts wrong by a full 5 percentage points. Under Positive Money's proposals, the money supply for the economy would be directly determined by such forecasts. Had their system been in force, we would now be suffering serious monetary restriction, not because "banks aren't lending" but because the MPC had not produced enough money to support growth. In what way is this an improvement over the present system?

My greater concerns over full reserve banking, however, are its cost and its safety. Let me explain.

Both the IMF and Positive Money consider how the transition to a full reserve system might work - the IMF in some detail. But there is only one way full reserve can be introduced, and that is by means of the biggest bank bailout in history. 

At present, bank funding for payments works on a just-in-time basis, with banks running daylight overdrafts at the central bank and clearing them by the end of the day from a mixture of sources: banks do not have enough funds at any one time to allow all sight deposits to be drawn at once.  The possibility of banks simply not being able to obtain the funds to allow deposits to be drawn is covered to a limited extent by deposit insurance, but like all insurance schemes, deposit insurance is not intended to cover a situation in which all deposits were withdrawn from all banks at the same time. It is intended to deal with individual bank failures. 

Under full reserve banking, all banks would have to hold enough funds to allow all sight deposits to be drawn at once. To achieve this, central banks would have to produce a simply ginormous amount of new money: the IMF estimates that for the US, it would be 184% of GDP. 

Positive Money would no doubt say that as their proposal involves moving transaction accounts from private bank to central bank books, no new money needs to be created. I disagree. In order to move the transaction accounts, the central bank would have to create new reserves to the value of the total balances in those accounts. This is simply a consequence of double entry accounting: it is not possible simply to eliminate deposit balances from private bank balance sheets without also writing off the debt assets that currently back them. So either the central bank must produce new money, or there must be a debt jubilee. (The IMF noticed this and opted for the debt jubilee, but their accounting was wrong and they didn't consider the inflation consequences of such a massive debt write-off).

Some would argue that a one-off bank bailout on this scale is a small price to pay for safety in the future. Which brings me to my second issue. Would it really be safe?

Whether a full reserve banking system is "safe" for depositors depends on the trustworthiness of politicians and political appointees. The value of the currency is only as good as the willingness of government to support its value. Which is why inflation targeting is so crucial to economic management. I've said before that government debt and fiat currency are equivalent: assuming that under full reserve banking most money wouldn't be interest bearing as it is at the moment, the inflation rate is, domestically, the currency equivalent of the yield on government debt (externally, the exchange rate is the equivalent of the price). And just as economic and political difficulties can push up the yields on government debt, so they can push up the inflation rate, too, and/or debase the exchange value of the currency. We would be putting a great deal of faith in our politicians not to pursue policies that erode the value of the currency - especially as they, or their appointees, would be directly responsible for producing it. The UK and the US both have substantial trade deficits: debasing the currency is very, very tempting macroeconomic policy for politicians wanting to improve exports. And both the UK and the US have high public debt: inflation is very, very tempting as a way of reducing the debt burden without unpopular spending cuts. I suspect that before very long there would be political pressure to provide further protection to depositors by anchoring the currency to a physical asset such as gold, thus preventing too much money being produced. Welcome to the gold standard, 21st-century edition. 

Kotlikoff suggests that government debt would be an alternative "safe" backing for deposits. But government debt is as subject to variation in value as the currency. Safety for depositors would be dependent on the willingness of government to support the value of its debt - and that would mean not allowing the debt to grow. Even cyclical deficits would represent a risk to depositors. There would therefore be political pressure to run balanced budgets or surpluses AT ALL TIMES, even in economic downturns. Welcome to the UK of the 1920s 2020s.

So safety for depositors would depend on the willingness of government to give priority to the interests of depositors over everyone else. And this brings me to my fundamental moral issue with full reserve banking. Why should the interests of people who have money trump those of people who have not? Why should those who, through no fault of their own, have become dependent on state benefits in order to live, have their standard of living cut to the bone to protect people who have far more? To maintain a full reserve banking system, we would end up locking ourselves into an economic straitjacket which would seriously disadvantage the poorest in our society (both fiscal austerity and the gold standard are bad news for the poor in economic downturns). How on earth is this progress?

Even the transition to full reserve banking to my mind raises moral issues. If the US can afford to produce $4tn of new money (or debt) to protect depositors, why can't it afford to produce $4tn of new money (or debt) to relieve poverty and create a decent healthcare system?  If the UK can afford to produce enough new money to back all current accounts pound-for-pound, why can't it afford to produce enough new money to improve its creaking infrastructure? 

To me, full reserve banking looks like a very regressive idea. I suspect those who support it think that it would end economic downturns, and therefore the restrictions on economic policy that I note above wouldn't matter. That was certainly the implication of the IMF's analysis. But that sends a shiver down my spine. When did we last hear that we had "ended boom & bust"? We cannot say for sure that there would never be another economic crisis, never another recession that needed fiscal stimulus and extraordinary macroeconomic measures. Banks are not the only cause of economic problems. It would be madness to lock ourselves into an economic system that prevented us from responding appropriately to, say, a major oil price shock. But full reserve banking would force us to do that.

As far as I can see, full reserve banking is politically and morally disastrous. Either we would hurt the poor through harmful economic policies, or we would deceive depositors into believing their money is safe when it isn't. I don't know which is worse. 

Friday, 26 October 2012

The IMF proposes the death of banking

The IMF has produced a paper which purports to demonstrate the virtues of full reserve banking. More correctly, it dusts down an old idea from the 1930s (which was not implemented) known as the Chicago plan, applies some fancy maths to it because these days everything has to be proven to work through DSGE modelling, then presents it as the panacea to all our financial ills.

This paper conflates two quite different things, namely full reserve banking and debt jubilee, which causes a fair degree of confusion and I feel it would have been sensible to have separated them.  It was also very evident that the authors were far more comfortable with economic modelling than they were with accounting and financial flows, despite their claim that one of them had actually done loan accounting for a bank. The accounting models in particular are in my view seriously flawed, and insufficient consideration has been given to the impact of the suggested changes on financial flows and the role of banks. I don't propose to evaluate the authors' macroeconomic assessments in this post: I shall confine myself to an analysis of the accounting models and the effect on the financial system.

Pages 4-8 of the Introduction are concerned with the balance sheet impact of the move to full reserve banking and the debt jubilee, and they are supported by three accounting models (Figures 1, 2, and 3) at the end of the report. I'm reproducing the first two models here for convenience, and I have extracted the relevant bits of the paper here.

Model 1: changes to aggregate private bank balance sheets (click here for larger version)

Model 2: changes to government/central bank consolidated balance sheet (click here for larger version)

Even with the models it took me quite some time to understand how the accounting worked, basically because it doesn't. However, before I take a hatchet to the models, I need to note and briefly discuss some assumptions that the IMF writers have made but failed to document.

Firstly, they do not distinguish between central bank and government. This conflicts with the IMF's long-standing preference for central banks to be independent of government. Is the IMF about to change its views on this? The writers treat central bank accounts as consolidated with government accounts. This is reasonable accounting practice where the central bank is fully state-owned, as in the UK: indeed the UK Government produces "whole government accounts" (WGA) that include the central bank. But this paper is written from a US perspective. The Feds are currently privately-owned. They cannot be consolidated with government. So, undocumented assumption #1 is - all central banks that are not currently nationalised will be.

The effect of consolidating central bank and government accounts is to show government debt and money in circulation on the liabilities side of the same balance sheet. The IMF doesn't show this, but we know from the UK's WGA that government debt bought by the central bank is eliminated from the consolidated accounts, replacing it with the central bank money issued to purchase it. In effect that debt becomes money. As I've noted before, the problem is that although the accounting consolidation "eliminates" the debt, the debt instruments themselves still exist in reality. As government debt cancellation forms part of this proposal, this problem arises in the IMF's model. More seriously, it also arises with respect to money in relation to the cancellation of private debt (debt jubilee), as I shall discuss later.

The IMF writers regard fiat money as equity rather than debt. This is reasonable, since it is not redeemable and is backed by the productive assets of the country. Therefore their consolidated government accounts model shows a capital structure similar to that of a large corporation: equity and debt balancing a portfolio of assets. This in my view is realistic -but it doesn't mean that government can be treated like a corporation for accounting purposes. It is a very different animal.

Unfortunately the IMF's view of the capital structure of private banks is not so realistic. The IMF's model shows private banks' liabilities as consisting solely of deposits and equity. There is no mention of bonds or interbank borrowings: yet these days banks are financed to a considerable extent by bond issuance and interbank borrowing. Few large retail banks have a deposit base of a similar size to their total loans, but this is what the IMF's model shows. It is over-simplified and unrealistic.

This is serious, because the accounting for the proposed "debt jubilee" depends on loans being balanced by deposits. The writers seem to assume that "deposits" includes bonds. But what about interbank and repo balances? Are they "deposits" too? Whatever, it is clear that undocumented assumption #2 is - private banks' debt consists entirely of customer deposits. 

There is a similar problem on the other side of the balance sheet. The IMF writers assume that bank assets consist only of various forms of lending to domestic corporates and households, plus a small quantity of government bonds. Oh, if only that were true! The fact is that banks are major investors in non-government bonds, equities and derivative instruments, and they lend to each other and to non-bank financial institutions. And many of their assets are cross-border and denominated in foreign currency. Undocumented (and totally wrong) assumption #3 is - private banks lend only to domestic households and corporates. 

So, having made three assumptions that are both wrong and undocumented, the writers then go on to explain  the accounting for full reserve banking and the associated debt jubilee. The key components are as follows.

1. Banks must hold reserves in the form of government-issued money to an amount equal to the amount of customer deposits they hold.

As customer deposits are a moving target, I assume this means that the central bank will have to provide reserves on a daily basis as at present, though the paper doesn't say so. However, the central banking accounting for reserve creation is different in the IMF's model. There are no open market operations or collateralised lending. Instead the writers create a "financial asset" called "Treasury Credit" to balance the reserves created to back customer deposits. Effectively the CB will lend money to banks (unsecured) every time a customer deposits money, and the balancing asset will simply be a debt liability of the receiving bank. This is fractional reserve banking as we know and love it - a bank creating a deposit ex nihilo balanced by a loan account - but done by the central bank in relation to private banks on a simply massive scale. The result would be that banks would suddenly have enormous debt liabilities with regard to the Government/CB, and Government would have a balance sheet vastly expanded by the inclusion of the total of all domestic customer deposits (and possibly wholesale ones as well) in the form of equity. Figure 2 in the IMF paper shows this.

This is not so far removed from the "narrow banking" preferred by the Bank of England's Mervyn King. The difference is that reserve backing for deposits is provided by money, not by government debt. There are unresolved issues with the IMF writers' proposal because they have over-simplified private bank balance sheets. But otherwise, the accounting makes sense provided that assumption #1 holds.

If bank bonds were included in "deposits", then they would become risk-free assets equivalent to Government debt, or alternatively they might be redeemed. The paper doesn't say, but I assume that repo and interbank borrowings would be redeemed rather than backed, since banks would no longer be allowed to obtain funds from each other. This brings me to component two - the changes to bank funding.

2. Banks will not be able to use customer deposits (or any other sort of private borrowing) to fund lending.

All lending must be funded either from own equity or borrowing from government/CB. This last is particularly bizarre as it means the bank would have large amounts of money sitting around doing nothing, yet it must borrow EVEN MORE money in order to lend.

At this point I get irritated with the writers' unrelenting balance sheet focus. They seem to have completely forgotten about the profit & loss account and, indeed, the purpose of private banks. The sole aim of private banks is to make money, principally through lending. And the sole point of taking deposits is to fund lending. If deposits couldn't be used to fund lending, why on earth would banks want them? Deposits that couldn't be productively used, and that would moreover COST the bank money because of the 0.49% proposed interest charge on reserves required to back them, would not be commercially viable. Banks would inevitably look for some way of making money from depositors, probably in the form of safe deposit fees and management charges. The paper suggests that the real interest rate on deposits would be zero. I beg to differ. I think the real interest rate would be negative. Banks would have to be able to make money from them somehow, especially given the severe curtailment of lending and its low margin under this proposal.

Not only would banks not want to accept deposits, savers wouldn't want to make them. The model assumes a real interest rate of 1.07% on government bonds. Why on earth would savers (except very short-term ones) put money in a deposit account at 0% or less when they could buy government bonds at 1.07%? It seems likely that the effect of the rate inversion (deposit rate < reserve rate < government bond rate) would be to restrict bank deposits to safe deposits and checking accounts only. Time deposits and "at risk" sight deposits would become a thing of the past - banks would have no need to offer them since they would not need them for funding, and savers would have no reason to want them since there would be a plentiful supply of government bonds at a much better interest rate.

So this rule would be likely to end much bank deposit-taking. It would also end shadow banking, which is essentially a chain of deposits repeatedly on-lent against safe collateral.  But from a lending perspective, the picture is much less clear. This rule alone would not restrict commercial lending, but there is no explanation of how reserve interest would be paid, or how money supply inflation would be managed

Consider a bank making its first loan. The bank must obtain funds from the central bank in advance of the loan being agreed (since the money supply inflates when the book entries for the loan are made, and it is that inflation the writers are trying to eliminate). Those funds are loaned to the bank at the reserve rate. Because this is its first loan, the bank has no interest income, so it must either pay the interest from its own capital or it must also borrow from the central bank the money required to pay the interest. If the latter, then this funding model is a Ponzi scheme.

As at present, the book entries for the loan create a deposit, but this time it is 100% backed by new reserves already provided by the central bank. So the loan STILL inflates the money supply - it's just that the central bank creates the new money rather than the lending bank creating it. Is the decision whether or not to grant the loan going to rest with the central bank - or is the central bank just going to do what the lender wants without question? If the latter, in what way is this form of money creation an improvement on the present situation? If the former, in what way is the central bank better placed to decide on the merits of a loan application than the lender?

When a deposit is drawn, the person or business receiving the money deposits it in another bank. Will reserves automatically transfer from lending to receiving bank, even for smaller banks and shadow banks that don't currently use central bank settlement accounts? If so, then the deposit would remain 100% backed by reserves when it moves from one bank to another. If not, then reserve imbalances could quickly build up, leading to deposits becoming "at risk" in net lenders. I foresee quite a lot of systems enhancements to extend central bank settlement facilities to those players that don't currently have access to central bank settlement facilities.

3. Existing household and short-term corporate loans will be bought out by government/CB (debt jubilee). 

This is where it all goes very, very wrong. The IMF writers, gleefully looking at a Government/CB balance sheet vastly inflated with huge amounts of equity, wish to take the opportunity to get rid of most corporate and household debt. So they buy an asset - customer loans from private banks - and write it off against equity. But in so doing they have forgotten that the equity is not simply shareholders' funds and retained earnings, as it is in a corporation. It is real money that is used in the real economy to buy real goods and pay real wages. If the equity on the Government's balance sheet were reduced the real money in circulation wouldn't reduce, and the result would be an enormous imbalance between the book records of money issued and the money actually in circulation (nearly all of which would be recorded in the books of private banks, and on which they would be paying interest). Figures 1 and 2 (third column) show this clearly. In effect, the Government would have issued a very large amount of interest-bearing money that it had not accounted for. I think they call this accounting fraud.

If they actually tried to balance the public records with private bank reserves, the result could be even worse. They would have to instruct all private banks to write down reserves by the value of the loans written off. As reserves would be the backing for deposits, the value of deposits would also have to reduce by the same amount. That would be a MASSIVE hit to depositor value. Effectively they would have trashed the currency (since it is the value of money in circulation that is written down) and people would have lost virtually all their savings.

The alternative would be for the private debt to remain on the central bank's balance sheet, where it could be segregated and treated as non-performing. This would have no impact on reserves, but would reduce the Treasury Credit. In effect, the central bank would be accepting private debt assets as settlement of the Treasury Credit (loan) imposed on banks in the move to full reserve banking. However, it can't be assumed that the Treasury Credit would match the total value of household debt and short-term corporate debt. If there was a shortfall for a particular bank (this is quite likely in large retail banks reliant on wholesale funding), would the central bank force the private bank to accept more reserves than it needs? As the writers envisage the repayment of debt being done by the borrowers themselves using money paid by the central bank into segregated customer accounts that could only be used to repay debt, it seems the answer is yes, it would. But the bank would have to pay interest on those reserves. The only way it could make money to pay the interest on those excess reserves is to lend more. Which brings us to component number four - the future purpose of bank lending.

4. In future, banks will be allowed to lend only for investment projects. 

Presumably this means that there would be legislation to specify the types of borrower and lending purposes that would be allowed, and Government would review each lending decision for compliance with this legislation prior to providing funds. The administrative overhead is frankly mind-boggling, but perhaps more importantly, it means that lenders would no longer be in control of lending decisions. They would simply be passive money-shufflers.

This does of course raise the question of how future lending needs other than investment projects would be met. Mortgage lending, for example. No provision exists in the model for banks to lend to FUTURE households to enable them to buy homes. Are the authors assuming that ending domestic mortgage lending will force a house price crash of a sufficient size to enable the majority of future households to buy houses without borrowing? Or are they assuming that people in future will rent rather than buying - and if so, how will landlords finance the purchase of property for letting? Or are they assuming that Government agencies (Fannie & Freddie) will lend directly to households, rather than indirectly via mortgage originators as at present? They don't seem to have thought about this at all.

If banks were restricted to lending for investment projects only, lending volumes would of course be seriously reduced. And furthermore, banks would make far less money from their remaining lending, since spreads would be tiny because the corporate debt write-off is assumed to reduce risk. The model assumes that corporate borrowers could alternatively obtain finance for investment from the capital markets at close to the risk-free rate, and that therefore bank lending rates could not exceed that. If that is the case, then bank lending is likely to be unprofitable given the cost of reserves required to fund it.

So, to sum up this rather long and detailed analysis: as far as I can see, in this model it is virtually impossible for private banks to be profitable. In which case they would soon cease to exist, and government would be forced to create state banking facilities to replace them. The question is, why did the authors stop short of recommending full nationalisation of the banking system, since that is the only way the model could work in the longer term? The authors think that private banks funding long-term investment projects is a Good Thing, but they offer no explanation for this belief. Could it be that they have retained private banks in their model because recommending a move to a wholly state-owned system would not be taken seriously by most economists and politicians? After all, state ownership of banking has been a far-left wet dream for a very long time. I'm not a fan of a wholly state-owned banking system, but it would surely be better than a system in which supposedly private banks are prevented from making commercial lending decisions, forced to borrow (and pay interest on) money they don't need and unable to make profits.

This proposal is poorly thought through. Or maybe it isn't. Maybe the real purpose of this proposal is to force the death of commercial banking, and in particular, shadow banking. For that is what it would achieve if it were implemented.

Excerpt from "Chicago Plan revisited" - IMF Benes & Kumhof

Excerpt from Introduction to "Chicago Plan Revisited", a paper on full reserve banking by the IMF economists Benes & Kumhof.  Full paper is here

At this point in the paper it may not be straightforward for the average reader to comprehend the nature of the balance sheet changes implied by the Chicago Plan. A complete analysis requires a thorough prior discussion of both the model and of its calibration, and is therefore only possible much later in the paper. But we feel that at least a preliminary presentation of the main changes is essential to aid in the comprehension of what follows. In Figures 1 and 2 we therefore present the changes in bank and government balance sheets that occur in the single transition period of our simulated model. The figures ignore subsequent changes as the economy approaches a new steady state, but those are small compared to the initial changes. In both figures quantities reported are in percent of GDP. Compared to Figure 3, which shows the precise results, the numbers in Figure 1 are rounded, in part to avoid having to discuss unnecessary details.

As shown in the left column of Figure 1, the balance sheet of the consolidated financial system prior to the implementation of the Chicago Plan is equal to 200% of GDP, with equity and deposits equal to 16% and 184% of GDP. Banks’ assets consist of government bonds equal to 20% of GDP, investment loans equal to 80% of GDP, and other loans (mortgage loans, consumer loans, working capital loans) equal to 100% of GDP. The implementation of the plan is assumed to take place in one transition period, which can be broken into two separate stages. First, as shown in the middle column of Figure 1, banks have to borrow from the treasury to procure the reserves necessary to fully back their deposits. As a result both treasury credit and reserves increase by 184% of GDP. Second, as shown in the right column of Figure 1, the principal of all bank loans to the government (20% of GDP), and of all bank loans to the private sector except investment loans (100% of GDP), is cancelled against treasury credit. For government debt the cancellation is direct, while for private debt the government transfers treasury credit balances to restricted private accounts that can only be used for the purpose of repaying outstanding bank loans. Furthermore, banks pay out part of their equity to keep their net worth in line with now much reduced official capital adequacy requirements, with the government making up the difference of 7% of GDP by injecting additional treasury credit. The solid line in the balance sheet in the right column of Figure 1 represents the now strict separation between the monetary and credit functions of the banking system. Money remains nearly unchanged, but it is now fully backed by reserves. Credit consists only of investment loans, which are financed by a reduced level of equity equal to 9% of GDP, and by what is left of treasury credit, 71% of GDP, after the buy-backs of government and private debts and the injection of additional credit following the equity payout.

Figure 2 illustrates the balance sheet of the government, which prior to the Chicago Plan consists of government debt equal to 80% of GDP, with unspecified other assets used as the balancing item. The issuance of treasury credit equal to 184% of GDP represents a large new financial asset of the government, while the issuance of an equal amount of reserves, in other words of money, represents new government equity. The cancellation of private debts reduces both treasury credit and government equity by 100% of GDP. The government is assumed to tax away the equity payout of banks to households before injecting those funds back into banks as treasury credit. This increases both treasury credit and government equity by 7% of GDP. Finally, the cancellation of bank-held government debt reduces both government debt and treasury credit by 20% of GDP.

To summarize, our analysis finds that the government is left with a much lower, in fact negative, net debt burden. It gains a large net equity position due to money issuance, despite the fact that it spends a large share of the one-off seigniorage gains from money issuance on the buy-back of private debts. These buy-backs in turn mean that the private sector is left with a much lower debt burden, while its deposits remain unchanged. Bank runs are obviously impossible in this world. These results, whose analytical foundations will be derived in the rest of the paper, support three out of Fisher’s (1936) four claims in favor of the Chicago Plan. The remaining claim, concerning the potential for smoother business cycles, will be verified towards the end of the paper, once the full model has been developed..........

Monday, 22 October 2012

Reflections on fear

I've been writing a lot about fear recently, because it seems to me that much of what is happening in the world at the moment is driven by fear.

There is nothing new about this. Fear has been a primary driver of human activity for a very, very long time. In fact I would say that humans are innately a fear-driven species.

I know this seems odd, because we think of ourselves as successful, the dominant species on Planet Earth with no natural predators left. And indeed we are - now. But we have not always been so.

We think of ourselves as predators. And indeed, humans in groups are the most dangerous predators ever to walk the face of the earth. But at an individual level, humans are not particularly good predators: we are small, weak, slow and poorly armed. Nor do individual humans need to be large-scale predators. We are omnivores, not true carnivores: we are capable of gaining sustenance from an extraordinarily large range of foods, including - but most definitely not limited to - meat. An individual human living off the land does not need to kill large prey: he or she can live quite satisfactorily off small kills and foraging. For much of human history, humans have not been predators, or at least not on a large scale. No, for much of human history, humans have been PREY. And it is our history as prey that gives us our fear driver - and, in my opinion, our tendency to herd together in groups.

Fear is an essential survival characteristic of animals that are naturally prey. It is fear that gives them sensitivity to danger, and fear that enables them to react quickly and appropriately to threats. The classic "fight or flight" response to fear is an automatic reaction to a perceived threat: it suspends ordinary thinking processes and replaces them with a conditioned response depending on the nature of the threat, namely to run away or counter-attack. There is also a third response, which is more common in humans than I think people realise: that is the "freeze" response, where the individual under threat keeps very still and silent, even stopping breathing, in the hope that the predator will not realise they are there. Given that humans are not fast runners compared to their natural predators, and are (in their natural state) poorly armed, it would not surprise me to find that "freeze" is the most common human response to threat.

All this of course harks back to a time before there was human society, before there were weapons, before humans became significant predators. It seems likely to me that human society formed in the first instance when people started banding together to defend themselves against predators: leaders of these protective  groups would naturally be the biggest and strongest individuals, or possibly the most cunning individuals (after all, intelligence is a survival characteristic....). When weapons were invented, I suspect they were used in the first instance for defence, not for hunting. Hunting perhaps started when groups of armed humans realised they could seek out, attack and kill predators, thereby securing a territory, instead of waiting for the predator to attack. It is only a short step from groups of armed humans hunting down and killing predators to groups of armed humans hunting down and killing large herbivores for food. In both cases, the animal hunted would be much larger and more dangerous than anything an individual human could take on. Forming into groups both provided protection from predators and provided access to a wider range of food. To this day, we regard the primary purpose of a government as being to "secure the borders" - i.e. protect the group from predators. But these days the predators are not wolves or bears. They are something else entirely.

Once humans had established dominance as a species through their group hunting activity, their range of natural predators declined catastrophically. Even other animals that hunt in groups, such as wolves, would not take on a human group. Humans became (and still are) the most feared predators on earth. But in their subconscious minds, humans are still prey. They are still driven by fear, still looking out for predators. And when a species that is expecting there to be predators finds there are none, it invents them. Humans have created two sorts of "imaginary" predator: hungry gods, who have to be placated with animal or human sacrifice (just as herd animals will relax once a predator has made a kill), and - most distressingly of all - other groups of humans. We are now our own predators.

Down the centuries, we have acted out our fear of predation through religious ritual. Christianity proclaims that predation is now ended because of the sacrifice of one very high-status individual. The hungry god has supposedly been satisfied for all time by being fed someone who was more than human. But that doesn't stop churches demanding offerings of money with threats of divine retribution if the faithful don't pay up. So perhaps the god isn't entirely satisfied after all. Sacrifice comes in many forms! Many other religions also rely on various forms of sacrifice or offering to keep the hungry predator at bay. This strikes me as a fairly harmless sublimation of the fear response (I know many atheists would disagree with me, but please bear with me while I follow this through) and even helpful if it prevents regression to the more dangerous form of predator-invention. Sadly, though, too often religions have actually encouraged the formation of other predator-substitutes - namely, groups of humans that have invented DIFFERENT hungry gods. And these groups have fought each other to the death over their conflicting beliefs.

The process of predator-invention leads humans to "dehumanize" other humans. Dehumanization of people who look different, behave differently or simply occupy land that we want allows us to justify all manner of barbaric treatment of them. But underneath it all is fear - fear that the other group will take our land, our food, our jobs, our children, our lives. In other words, we see the group that we dehumanize as a predator - and as humans have done for millenia, we attack it before it attacks us. Much of the rhetoric from extreme racists today contains fear-attack language.

When humans attack other humans that they see as potential or actual predators (and let's be completely clear here - a thief, or a rapist, or a murderer IS a predator), they often do so brutally. Our fear leads us not only to want to tear the other apart, but to disfigure, humiliate and demean them - to break their power over us, not only by killing them but by destroying the power of their image in our minds. The desire to humiliate and demean can even override the desire to destroy: slavery initially came about as a means of demeaning vanquished foes and breaking their power, though it later acquired a much more commercial objective.

Today, we see fear everywhere. And consequently we are seeing "dehumanization" of particular groups. "The rich" (unspecified) are castigated for greed and threatened with asset-stripping. "Bankers" are universally reviled as criminals who should be locked up or even (as I saw in a recent tweet) beheaded. And at the other end of the scale, sick & disabled people are demonized in the tabloid press as "scroungers". This last is particularly unpleasant, because strident calls for impoverishment of sick & disabled people have been heard by government, and it is therefore busy dismantling social provision for some of the most vulnerable in our society. I do not like the way this is going. One of the strengths of human society has been its willingness to care for those who can't care for themselves: it is an important part of the "glue" that holds human groups together. Once we start dehumanizing those whom we formerly loved and cared for, we lose much of our cohesiveness - and, I would argue, our humanity. The breakup of the former Yugoslavia was characterised by dehumanization of people from different races and religions; the result was brutalisation and murder of people who had previously been neighbours and friends.

But more insidiously, many of the fear-driven beliefs and practices of earlier ages are returning, dressed up in modern clothes. The government appears to be willing to sacrifice ordinary people and businesses on the altar of austerity to placate the hungry gods of the bond markets. But are the bond markets really predators - or are they just scared people terrified of losing their wealth? And the financial sector is very evidently looking after itself at the expense of the rest of the economy - and a scared government is openly helping it to do this. It is perhaps less like a predator than a parasite. But it, too, is made up of people - people who are losing their jobs by the thousand and are terrified of a complete meltdown of their industry. There are even more scared people in government, bond markets and banking than there are in the real economy. And that is the most terrifying thing of all.

Frightened humans are very, very dangerous to other humans. As I noted above, fear overrides normal rational thinking, replacing it with automated responses from a much earlier age. Those responses now are likely to be highly inappropriate. Fear leads people to do stupid things. A government full of frightened people does not bode well for good management of the economy, let alone compassionate treatment of the poorer and weaker members of society. And a financial sector full of frightened people could cause serious damage to the economy: people with wealth desperately trying to protect it, rather than using it productively to benefit both themselves and society as a whole, which is how investment normally works. There is a deep divide and antagonism developing between the financial sector and the real economy: ordinary people see the financial sector as parasitic, and the financial sector increasingly sees ordinary people as thieves. This is incredibly dangerous.

Let us remember that we are human. We can think - we do not have to be driven by instinctive drivers from an earlier age. We can love - we do not have to discard those who can't provide for themselves. And we can choose - we do not have to placate hungry gods (or bond markets). And above all, we can remember that humans owe their success to their ability to co-operate for mutual benefit. Fear drives wedges between people and ultimately destroys society. It is imperative that we learn to override our fear drivers and act rationally, even when apparently faced with extreme danger. For if we do not, our fears will become reality.

Sunday, 21 October 2012

The OBR and dysfunctional banks

This is a fascinating chart from the Office of Budget Responsibility's Forecast Evaluation Report for October 2012: 

(click here for larger version)

Like all charts, it tells a story. And the story it tells raises serious questions about the conduct of monetary policy and the behaviour of banks.

Before the financial crisis, the weighted average interest rate across all lending and borrowing was slightly below the policy rate set by the Bank of England, and the credit spread was downwards into negative territory. In other words, commercial interest rates for both savers and borrowers were generally lower than the policy rate. The result, as we now know, was a credit bubble and inflation in asset prices, as people and businesses were tempted by low rates to take on debt for asset purchase, particularly property. 

This chart contradicts the suggestion that some have made that the bubble was caused by the Bank of England's policy rate being too low. In fact the rate was at the top of the credit spread and higher than the effective rate, so most commercial interest rates were already lower. Would raising it have forced up commercial interest rates? Probably, but the rise would have had to have been an awful lot to get lending rates off the floor. We have not seen a policy rate of 15% since the early 1990s, but that is I think the sort of level that would have been required to prick the lending bubble. But prior to the financial crisis the BoE was targeting CPI inflation, not asset price inflation. The CPI inflation rate at the time was 2-3%. Raising the policy rate to the amount required to prick the lending bubble would have pushed this right down and probably caused a technical recession. More worryingly, it would have precipitated the sort of housing market collapse and banking meltdown seen in the US. The UK only suffered from the backlash of the US's housing market collapse - it did not really experience one of its own making. But had the Bank of England pushed up rates to prick the asset bubble, I think things might have been very different: there would have been a large number of mortgage defaults, because our variable mortgage rates leave most people vulnerable to rate rises, and the Government would consequently have had to bail out a much larger number of banks. 

But look what has happened since. The policy rate has fallen to an all-time low - it has now been fixed at 0.5% since Q2 2009. But that is only just beginning to feed through into the effective interest rate, and the chart indicates that most commercial lending rates remain far above the policy rate. Now, the policy rate is not an absolute indication of the cost of funding for banks - most banks pay slightly above that - but it is certainly an indication that bank funding is pretty cheap at present. Yet commercial borrowers are still paying high rates. This is undoubtedly because of banks' desperate need to repair their balance sheets and build up capital, but it doesn't help the economy. 

And note also the effect of QE. This chart does suggest - very strongly - that QE is effective in bringing down real interest rates - but not for borrowers from commercial banks. They are paying as much or more than two years ago. The effective interest rate is depressed because of lower rates paid to savers, not lower rates charged to borrowers. Credit spreads are widening.  

This suggests that QE, far from being a stimulus, is actually contractionary for the real economy. If rates to both savers AND borrowers were falling, and bank lending volumes were normal, then QE could be said to be a stimulus, because it would encourage more borrowing, and falling returns to savers might encourage them to spend rather than save. But that's not the case. Lending volumes are reduced and interest rates to borrowers remain high, while interest rates to savers are depressed: people on fixed incomes are spending less, not more, because their income is reduced, and borrowers faced with high interest rates are choosing to cut spending in order to maintain debt repayments. The overall effect is to take money from the real economy and transfer it to banks, who use it to shore up their damaged balance sheets. This raises questions about exactly what QE is supposed to stimulate and who it is supposed to help. What it is doing is reducing banks' funding costs and increasing their spreads. How that helps the cash-strapped people and businesses on whom the UK's economic recovery actually depends is a complete mystery to me. 

I have argued before that QE is pretty useless as a demand stimulus in the real economy. I am now wondering whether the effect is more toxic than that, and QE may in fact be contributing to our economic stagnation. In which case we should stop it NOW, and if that means banks fail, let them fail. Draining money from the real economy to prop up zombie banks is the policy of stagnation and decline, not recovery. 

Saturday, 20 October 2012

Fear-driven economics

On Monday, I attended a fascinating debate on the Economics of Deficit Reduction at the House of Commons (audio link in this post). Essentially the debate was about the pros and cons of fiscal austerity versus stimulus. On the "stimulus" side were Prof. Paul Krugman and Jonathan Portes of NIESR: on the "austerity" side were Bridget Rosewell of Volterra Consulting and Stephen King, Chief Economist of HSBC.

The definitions of both "austerity" and "stimulus" were somewhat unclear. As far as I could tell none of the four were remotely in favour of the severe austerity measures being imposed on some members of the European Union. Furthermore, none of the four were in favour of extensive cuts to capital investment such as the current Coalition government and its Labour predecessor have already undertaken (and more are planned). In fact Rosewell, supposedly anti-stimulus, actually said she was in favour of increased government borrowing for capital investment projects. In her eyes, the debate was really about whether continued support for current consumption was an appropriate course of action at the present time, given the levels of public debt and the fact that the UK is running a significant fiscal deficit.

Except that it wasn't. The debate was about whether the government should continue its austerity programme (Rosewell and King) or change to a debt-financed stimulus programme to encourage growth (Krugman and Portes). Internally rebalancing the current austerity programme towards capital investment and away from supporting consumption wasn't discussed. Nor was the IMF's advice, which is to allow automatic stabilisers to operate freely but refrain from explicit debt-financed fiscal stimulus measures. There was also no discussion of the sort of balanced-budget stimulus measures suggested by Simon Wren-Lewis: this is something of a pity, because it means that the debate tended to become a discussion about whether or not the UK government could afford to borrow the extra money required, which isn't really the issue (as I shall explain later). It all made for great debate, but sadly no practical solutions to a difficult situation.

Krugman delivered a consistent and well-thought-through message, well-supported by Portes, who actually gave a figure (2-3% of GDP) for the amount of stimulus he thought the economy needed. But I was disappointed with Rosewell's presentation. My notes taken at the time comment on the inconsistency of her message, which appeared to be driven largely by her fear of a return to the financial markets' dislocation of 2008.

The trouble with fear is that it inhibits both thinking and action. As the Bene Gesserit in Frank Herbert's Dune have it, "Fear is the mind-killer". Fear is one of the biggest issues I deal with in my work. Once someone gives in to fear, they stop thinking, and something that they actually are perfectly capable of doing becomes an impossible task. (As an aside - perhaps my own difficulty with maths is because I fear it?) The Hitchhiker's Guide to the Galaxy famously had "Don't Panic" in large, friendly letters on its cover. I, too, have "Don't Panic" written in large (and I hope friendly) letters at the top of sight-reading exercises for my students.

Fear also inhibits appropriate action. People who are afraid may do nothing, like the rabbit caught in the headlights which stands and waits to be hit instead of legging it at top speed - or like a student who suddenly becomes incapable of singing a single note. Or they may do stupid things. My sight-reading students have a distressing tendency to invent the music instead of reading what is on the page. They are perfectly capable of reading the music when they aren't panicking, but when they are, they are incapable of reading the music at all, so they make it up.

I think fear is the cause of a large part of what is wrong with the world at the moment. People are either doing nothing, or they are doing stupid things - such as imposing severe austerity on fragile economies in the mistaken belief that sharply cutting public expenditure will somehow magically bring about economic recovery. And people who believe that it is only going to get worse are adjusting their behaviour in the expectation of future losses.  Ordinary people are paying off debt and saving like crazy because they fear cuts in their real income shortly. Businesses are not investing because they see no prospects for an improvement in customer demand. Investors are prepared to accept gradual erosion of capital through negative real interest rates because they are terrified that default and/or hyperinflation will wipe them out. So I am concerned that the thinking of an influential economist such as Rosewell is so influenced by fear.

Having said that, rather than dismissing her fears, we should consider whether they are justified. Like pain, fear is a warning: if we are afraid, we should examine that fear and consider whether it is rational, and if it is, what an appropriate rational response should be. Is there REALLY a risk that financial markets would seize up again? Rosewell correctly notes that we don't actually know what causes financial markets to freeze, and she appeals for the economics profession to develop models that better explain and predict the behaviour of the financial system. I absolutely endorse her remarks. Classical economic models have excluded the financial sector, effectively treating it as passively reactive to real economic forces. We now know that nothing could be further from the truth - it is clearly an active driver of economic change, and not always for the better. But we don't know enough about what does drive market behaviour. So further research is needed.

So yes, there is a risk that financial markets might freeze again. But Rosewell then goes on to make a priori judgements about what would cause that to happen. In effect she suggests that the UK government borrowing another 2-3% of GDP for capital investment and perhaps private debt relief or tax cuts might cause the sort of market panic we saw in 2008. I really can't follow her logic here. In what way would a responsible government borrowing a small percentage of its GDP to invest in the future of its economy equate to a catastrophe of the same order as the failure of Lehman Brothers? Krugman dismissed Rosewell's fears about the financial markets as "fantasy", and to be honest I am inclined to agree. I can't see that she is comparing like with like.

Having said that, the financial markets do seem to be behaving irrationally - if fear is irrational. It seems to me that fear is the principal driver behind most investment decisions at the moment: fear of default, fear of inflation, fear of collapse, fear of loss.......fear of the unknown. As Christopher Cole of Artemis Consulting puts it, we have a "bull market in fear". So I suppose that it is entirely possible that financial markets might respond very negatively indeed to an already-indebted government borrowing a bit more. The likely effect would be a significant increase in the yields on government debt and perhaps a cut in its credit rating (not that anyone takes much notice of credit ratings any more). But yields on government debt are currently well below inflation and being pushed down by QE. There is room for quite a considerable rise in yields without causing financial distress to the UK sovereign.

But even if the UK borrowing more did cause financial markets to reject its debt, the UK has other weapons up its sleeve, like forcing pension funds and banks to buy its debt - it has already done this to some extent - or even, as a last resort, monetizing the debt at the Bank of England. The UK is not going to suffer a debt crisis of the same order as Greece. It has a sovereign government and a central bank. Greece has neither.

What the UK could suffer as a consequence of increased borrowing, or rather monetization of increased borrowing, is currency collapse. I find it extraordinary that despite all her fears of financial market dislocation, Rosewell ignored this risk. Markets know that sovereign governments with central banks can always pay their debts. So if they don't like the behaviour of the government they reject the currency in which the debt would be paid, not the debt itself. The last time this happened in the UK was in 1976, when the government was forced to seek assistance from the IMF to choke off a run on sterling arising from loose fiscal and monetary policy.

But again, let's consider the risk. Is the UK government borrowing an additional 2% of GDP for investment in a stagnant economy really likely to cause a run on sterling? I doubt it. Financial markets may be irrational, but surely not that irrational. The inflation risk from that amount of borrowing in a stagnant economy is tiny. Implosion of the Eurozone and collapse of the Euro is a much bigger risk. Even if the UK Government borrowed more, I think investors would still see it as a safe haven from the Eurostorm.

So broadly, I don't think Rosewell's fear-driven analysis stacks up. And I am particularly concerned by the illogicality of her conclusion, which is that the Coalition government is "getting things about right". Even from her own analysis, it is getting things very wrong. She is in favour of borrowing for capital investment, whereas the Coalition government is cutting capital investment to the bone. Furthermore, she has not explained why she regards reducing public borrowing as more important than allowing the private sector to reduce its debt burden. Non-financial corporate and household debt of over 170% of GDP is surely a much larger brake on growth than public debt of under 80% of GDP. And as Krugman explained in his opening remarks, it isn't possible for both to deleverage at the same time without provoking what he calls "a depression, properly understood".

The trouble is, there are an awful lot of people who think like Rosewell. The world is on an austerity drive, with crippling effect on the real lives of ordinary people and businesses. And perhaps more importantly, in the UK (and I suspect other countries such as France) where there hasn't yet been much real austerity, the FEAR of austerity is driving people into self-protective behaviour that seriously reduces economic activity. We are frightening ourselves into a completely unnecessary depression.

Tuesday, 16 October 2012

Fix the bureaucracy, for heaven's sake!

The Trussell Trust says there has been a sizeable increase in applications for assistance from its foodbanks. This has been reported in both the Guardian and on the BBC's website. But they aren't saying quite the same thing.

According to the BBC, which appears to have interviewed someone from the Trussell Trust, the reasons for the increased use of foodbanks are rising food and utility bills, job loss and less disposable income, and greater awareness of foodbanks. Hmm. These last two look suspicious to me. Money required for essential food isn't "disposable income", really - but if you know that there is a foodbank that will provide you with food if you're so skint you can't feed your kids, you just might maintain or increase your spending on less important things, mightn't you? Or am I being too cynical?

But what is much more interesting is the Guardian's report. This identifies two main causes for the increased use of foodbanks:
  • the dire state of youth employment, coupled with high rent costs. 16% of those seeking emergency assistance from foodbanks are aged 16-24. Interestingly, the BBC failed to report these figures but did have an interview with a 23-year-old who was having to choose between rent and food. I suppose they went for the human angle rather than hard facts.
  • the abject failure of the DWP bureaucracy to make benefit payments on time or correctly. 
Now, I've been writing recently about youth unemployment. There is no doubt that we do have high levels of youth unemployment in the UK: the headline figures are bad enough, but they are "massaged downwards" by excluding young people who are doing short-term and/or part-time work, and all those who are working as volunteers or unpaid interns to gain experience as a gateway to a career. But there seems to be an assumption on the part of governments not only here but across the EU that parents will support their 18-25 year-old children. The UK government is proposing to withdraw housing benefit from under-25s, presumably in the belief that they can just stay with Mum and Dad. How they are supposed to do this while making themselves available for work anywhere in the UK is beyond me. And what about those youngsters whose parents have died, or separated, or moved abroad, or simply don't want them there? What about those who have been thrown out of the care system? Really the Government hasn't thought this through. If they go ahead with this measure far more young people will be using food banks (or sleeping in doorways).

But the best bit of this, without doubt, is the DWP incompetence angle. Now, I'm not blind to the Guardian's political sympathies, and it occurred to me that the reporters could be using this as an opportunity to bash the Government, so I checked the Trussell Trust's website. In the notes to their press release on the increased use of foodbanks, we find this:
The two main reasons that people were referred to foodbanks in 2011-12 were benefit delay and low income. 
So the Guardian is right, it seems - and the BBC is wrong. Benefit delay is a major issue. The DWP has some explaining to do. 

Actually DWP incompetence has been a running sore for a long time now. They simply don't seem to be able to cope with the instability of people's lives - an instability to which the Government is contributing by changing the eligibility criteria for benefits. Chris Mould of the Trussell Trust is in my view absolutely right to call them out on the dreadful effect that late payment of benefits can have on people's lives. People who are dependent on benefits for basic living expenses cannot tolerate bureacratic inefficiency or incompetence that leaves them without money for extended periods of time. They end up in arrears with essential bills, they may lose a place to live, they may even end up unable to feed or warm themselves. And we are not talking about the elderly here: the Trussell Trust make it clear that the elderly are not a large proportion of claimants at the moment. We are talking about working-age people who for whatever reason are unable to find enough work to support themselves and their families.

The DWP's response to the Trussell Trust's criticsm is mealy-mouthed. No apology for their inefficiency. No promises to improve the timeliness and accuracy of their claim processing. The tone of their response suggests that they think 80% of claims being turned round within 16 days is good. No it isn't, it's awful. That is one in five claims taking more than three weeks to turn round - and during that time the claimants receive nothing. Not a bean. No wonder the food banks are busy.

The DWP then blame the previous Government for their CURRENT inefficiency. You know, the Government that was voted out of office in 2010? I am getting more than sick of the propensity of the current Government to blame the last one for anything and everything that is found to be wrong now. They've had over two years. Even if it was a mess when they took over, they should at least have started to fix it by now. That they clearly haven't - in fact they appear to be making things worse - is down to THEM, not the previous lot. 

But worst of all, the DWP try to change the argument. The issue raised by the Trussell Trust is the DWP's demonstrable inability to run a large and complex social benefits system effectively. But the DWP claim that the reforms the government is making to the benefits system will make it more effective. Words fail me. Bureaucratic inefficiency is bureaucratic inefficiency, whatever system you adopt. Changing what the system does won't necessarily make it work any better. 

I'm not questioning here whether the Government's reforms of the benefits system are a good idea, although I do have serious reservations about them. I'm questioning their statement that those reforms will make the system more effective. Because unless the Government addresses the DWP's sclerotic processes and procedures, the reforms will make matters worse, not better. We can expect to see many, many more cold and hungry people waiting weeks and weeks for legitimate benefit claims to be met. And that, in a supposedly civilised society, is a disgrace.

Monday, 15 October 2012

Seven economists and a surreal debate

Over the last few days, there has been a great debate in the economics blogosphere over whether public debt is or is not a burden on future generations. The idea that high public debt is a burden on the as-yet-unborn is a popular theme with right-wing politicians and is used to justify deficit-cutting measures that may be counterproductive. So this was a really important debate and I have been watching it with great interest.

But oh, what a debacle. They couldn't agree what they meant by "fiscal cohort", except that it wasn't quite the same as "generation". And each of them seemed to have a different idea about how debt transferred down the generations actually would be paid off. Roughly, they divided themselves into two groups plus fence-sitters:

- those (Baker, Krugman) who argue that as the debt transferred down the generations is owned by members of those generations, paying that debt off through higher taxation simply moves money around among people already alive: future generations inherit both the debt and its repayment, so the net effect in aggregate is zero and there is no overall burden on future generations

- those (Rowe, Williamson) who argue that debt-funding consumption by previous generations effectively withdraws funds from future generations, reducing their ability to consume. This group generally did concede that debt-funded investment should benefit future generations leaving them with no burden, but they were adamant that debt-funding consumption (e.g. pensions for the elderly) would effectively leave future generations poorer.

I am not going to debate any of this myself.  I'm firmly on the fence with Delong, Smith and Wren-Lewis. For what it's worth, I think whether or not public debt proves to be a burden on future generations depends on the actions of politicians, not economists.

However, the purpose of this post is to share my amusement at the surreal nature of this debate with my readers.

Enter the Seven Dwarfs Economists, each with their own ideas about what to do with Snow White The Debt Burden.

Here they are, with their respective straplines (well, my interpretation of them, anyway).

1. Dean "Doc" Baker                         "This is my show!"

2. Nick "Sneezy" Rowe                      "If I go on about this for long enough,
                                                          eventually you'll agree with me"

3. Brad "Happy" Delong                     "We all agree, really"            

4. Paul "Grumpy" Krugman                 "Sigh. It's all distributional, you idiots"

5. Noah "Dopey" Smith                       "I don't know. But I can do math"
("Dopey" may be a bit unfair to Noah. Nick says he's smart. And he can do math. Which I struggle with.)

6. Simon "Bashful" Wren-Lewis           "It doesn't matter, at the moment" (balanced budget stimulus edition)

7. Stephen "Sleepy"Williamson             "It doesn't matter. Er, wait, yes it does" (Ricardian Equivalence edition)
(late entry)   

I feel we could submit this debate to the public vote, X-factor style. Vote for your favourite by number in the comments!


Saturday, 13 October 2012

A question of reality

In my recent post on the difficulty I have with mathematics, some of the comments appeared to suggest that mathematical objects that could not possibly exist in nature - such as perfect circles - nevertheless had objective "reality". This to me raises a fundamental question: can things that have no physical existence, but exist only in the mind (or in a computer representation of the human mind), be "real"?

This is not wholly a metaphysical question. I think it lies at the heart of the ongoing debate about the relevance of finance and economics to the world economy.

To me, economics is fundamentally a means of describing and predicting the transactions between real people for the real goods and services that they produce using the real resources of the earth. It is not about mathematical proofs, though economists do seem to spend a lot of their time developing these (not always with much relevance to the physical world). Nor is it, really, about money. But it seems to me that many academic economists now spend much of their time describing and predicting the behaviour of money.

Money is not a real good or service. It is a representation - a symbol - of real goods and services, that is all. And yet we have financial markets in which money, in various forms, is traded as a good in itself. Why does a virtual market for a virtual good (which is all money can ever be) demand so much attention from economists - and these days not just from economists, but from politicians and the media too? Why has the value of money become the primary driver of our economy?

In 1995, I designed a financial system that could model and account for a vast range of financial instruments, including complex derivatives, using contract theory. At the time, credit derivatives were just beginning to appear on the scene, and part of the objective of the system was to be able to understand and control credit derivatives. Sadly, the five-dimensional data model I created was too complex for the IT department to be able to translate into reality using their preferred technology, so the system was never built - if ever there was a case of the tail wagging the dog, this was it. However, that is not my point here. One of the things I had to model was cash, and cash-like instruments. And as I did so, I became more and more concerned about the unreality of the entire financial system. I saw the house of cards forming - and I saw the abyss upon which it is built, the black hole from which it draws its energy.  At the time, I didn't know what was in the black hole. But now I do. That black hole, I know now, is the real economy.

You see, our entire financial system is built upon a promise, that is all - a promise that we, the people, will produce enough goods and services to support the amount of money needed by the financial system. That's what a fiat currency system is. This definition should of course be the other way round: the amount of money in circulation should be enough to support the exchanges of real goods and services by real people in the real economy. But I have defined it as the financial system sees it, which is a mirror image of the reality.

Finance is a looking-glass world. Assets are liabilities, liabilities are assets, impossible objects are real, real objects have no meaning......The trouble with working for a bank is that you lose contact with reality. You can start to see the real economy as a black hole, something about which you know nothing and care less. It is simply a source of money: the connection of that money with the productive work of ordinary people is lost.

This is how money becomes a "good" in its own right, traded by people who know nothing of the real economy. Financial traders (no, I was never one!) occupy an "ivory tower" as high as that of pure mathematicians, and their "products" are every bit as unreal as a perfect circle. But we don't trade perfect circles, do we? At least mathematicians KNOW their objects exist only in the mind!

Back in 1995, I think we still knew that financial markets weren't the real world. But we seem to have forgotten this now. Monetary economics dominates: models of the economy concentrate on the behaviour of money: economic management is increasingly the province of central banks. Tweak an interest rate, buy some bonds, create some more money - those are the tools of economic management these days. Fiscal policy, too, is more concerned with the behaviour of investors than it is with the wellbeing of working people. The house of cards is bigger and more fragile than it has ever been, and it draws more and more money from the black hole to keep it alive. But the black hole is shrinking.

The IMF warned this week that there is a serious risk of global recession. And in a recession, the amount of money available to the financial system must fall. Production of goods and services declines: people's wages fall: people don't spend money. The engine that drives the creation of money for the financial markets runs at a slower pace. The UK, Japan and much of Europe are in recession: the financial engine is already running slower in these countries. Other countries, including emerging markets, are also slowing. There are suggestions that this slowdown may be permanent, that the world cannot return to the sort of growth levels seen prior to the 2008 financial crash. Yet the financial system still needs money in ever-larger quantities. So we respond to this by draining more and more from the real economy: the financial system grows ever more dominant, while the real world shrinks. The 2008 crash has so scarred us that we are terrified of the consequences of another crash: we would rather reduce whole nations to penury than allow banks to fail and investors to lose their money.

It seems to me that we are confusing the virtual market with the real market, the movements of money for real transactions. And the more time and energy we spend analysing and explaining the movements of money, and trying to influence the behaviour of investors, the further removed from reality we become. Christopher Cole, in an extraordinary article for Artemis Consulting, describes how the financial world - the simulacrum - is becoming the real world. His thinking is oddly reminiscent of the film The Matrix - and indeed he alludes to this in his article. But we really can't sign up to his vision. To do so is to consign the world to ever-shrinking real economies, growth of poverty and inequality, and social unrest. The image cannot become reality. Even traders have to eat, and you can't eat money.

The real tragedy is that we have never been so capable of feeding ourselves and producing all the goods we need. But the financial system depends on there being scarcity, because scarcity causes high prices, and only through high prices can the amount of money required by the financial system be justified. Allow prices to fall to a point where the real economy simply does not need the amount of money in circulation - what then happens to the financial system that depends on that money? Our "unconventional monetary policies" are all designed to raise prices, one way or another - by increasing world commodity prices, by raising domestic inflation, by pushing up financial asset prices. The claims of central bankers that these policies stimulate the real economy are hollow. They do not - they maintain the image.

Not only is finance a looking-glass world, it is a world of impossible contradictions. At the same time as  unconventional monetary policies are raising prices to enable the black hole to continue to produce the amount of money the financial system needs, the fear of inflation drives fiscal actors to cut spending and raise taxes, reducing real incomes and seriously constraining activity in the real economy, resulting in price cuts in non-essential goods and a falling money supply. The arguments used by economists to justify such behaviour in a recessionary environment are among the most convoluted I have ever seen. It seems that the economics profession has an ivory tower all of its own, in which it develops theories such as "expansionary fiscal contraction" that have nothing to do with economic reality and everything to do with trying to resolve the distortions in our financial image of the economy.

You see, although like mathematical objects, financial objects exist only in the mind, they are far from  perfect. They are illogical, contradictory and illusory. The real value of money is determined only by the value of the goods and services we produce. It has no intrinsic value of its own, and no meaning aside from that which we ascribe to it in the course of our real economic activity. We are paying a terrible price for our confusion of real with imaginary. All our productive energy now goes into feeding zombies.

The debate about "what is real" in economics - what the focus of the academic profession should really be - may run for quite some time yet. But to me, it is obvious. In 1995 I decided that I would eventually leave banking, because I could not spend the rest of my life propping up something that wasn't real. I wanted to live in the real world, even if I was materially poorer as a consequence. It took me another seven years, but I did leave, and I don't regret my decision. We can all make that choice. The financial world is not the real world. We do not have to live in it.

Image by John Vernon Lord.

Youth unemployment and abuse of statistics

Recent reports have highlighted the plight of young people in Greece and Spain, where youth unemployment is over 50%. 

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Or not. According to Jacob Funk Kirkegaard, writing in VOX, these figures aren't right. Oh dear no, not at all. In fact youth unemployment in Greece and Spain is not much worse than in the US, and when you look at the Eurozone as a whole, the US is actually worse. So it's not Greece and Spain that have problems with youth unemployment, is it? It's the good ol' US of A.

How has Kirkegaard achieved this remarkable redefinition?

Firstly, he has changed the definition of "unemployed" to mean only those who are unemployed and not in education or training - so-called "NEETs":

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Exclusion of young people in education or training makes a considerable difference to the figures, doesn't it? The question is whether it is a justified exclusion. As Kirkegaard notes, Stephen Hill of the FT first suggested that using NEET figures gave a better picture of European youth unemployment, but others have since expressed concern that these figures, too, do not give a true picture. In particular, the emphasis on skills development in measures to address youth unemployment fail to deal with structural problems in the labour market that can make the transition from education to work extremely difficult and mean that young people remain in education, training or various forms of unsuitable or unpaid work for far too long. These are all disguised forms of unemployment.

The proportion of young people staying on in education is currently at an all-time high, having risen steadily throughout the 2000s. Over the EU as a whole, more than 60% of young people stay on in some form of education after the end of compulsory schooling, though this does vary across the countries in the EU: a far smaller proportion stay on in Germany and the UK than in Scandinavian countries, for example. So if you exclude these people from the figures you end up with a much lower  number of unemployed. But these days the majority of undergraduates work their way through college, so excluding undergraduates from the figures does not accurately reflect the numbers of young people actually seeking work. Anecdotally, too, there is some indication that young people are staying on into postgraduate education because jobs opportunities are so poor, and because debasing of bachelor's degrees forces people to do masters degrees and PhDs in order to have a career.

Excluding from the figures young people who are not in tertiary education but in some form of "training" is far more contentious. Historically, governments have used training programmes as a way of removing young people from embarrassing unemployment statistics. The value of these training programmes has not always been clearly established, and it is all too common for young people to end their training no more employable than they were at the start. Some young people simply move from one training programme to another, interspersed with short periods of actual unemployment. If training programmes do not provide realistic opportunity for employment, they are no more than a means of massaging the figures.

Even the definition of "unemployment" does not reflect the reality of young people's experience of the jobs market. Many graduates take work that is not commensurate with their training or education level, thus depriving those with lower educational attainment of work that is suitable for them. Others are on short-term and/or part-time contracts. Still others go into forms of "work", such as volunteering or unpaid internships, that are not paid employment but do remove them from the statistics. Youth unemployment statistics are, frankly, unbelieveable.

Kirkegaard's focus on NEETs amounts to a statistical sleight of hand which I don't think reflects the true position, though it does expose some interesting cultural effects. But to be fair, he has done the same to the US figures as well, so at his massaging of statistics is at least consistent.  However, NEET figures still show that workforce participation by young people is actually higher in the US than it is in Southern Europe: interestingly, by far the highest figure for NEETS in the OECD is for Turkey, which I suspect is to do with cultural factors making it difficult for young women to work.

So having failed to make his point by replacing unemployment statistics for all young people with figures for NEETs only, Kirkegaard does another conjuring trick. Instead of looking at figures for individual European countries, he aggregates them as the Eurozone (E17) and European Union (E27). And lo and behold, both are lower than NEETs figures for the US. This is hardly a surprise. After all, the E17 figures include about half the countries coming in lower than the US on the NEETs chart, including the mighty Germany whose unemployment figures alone are sufficient to overwhelm Spain and Greece, simply because it is so much larger than either of them. And Kirkegaard points out that the Eurozone's unemployment figures are lower than both the US and the wider EU - so there isn't really a problem, is there?

To be fair to Kirkegaard, the EU itself says something similar. As I have noted before, the EU's own statistics show youth unemployment in the wider EU (E27) as slightly higher than youth unemployment in the Eurozone (E17). I lambasted them in that post for failing to take any notice of distributional problems across the Eurozone: the reason why the Eurozone's figures were lower was because of the distortionary effect of Germany's low youth unemployment rate. But the EU's solution to the problem is simple. There is free movement of people in the EU, after all. All young people in Greece and Spain really need to do is up sticks and move to Germany, and the problem is solved, innit? I'm not entirely sure how Germany would feel about this, mind. They may have a low youth unemployment rate, but it's not zero.....

But both the EU and Kirkegaard are abusing statistics for political purposes. In the case of the EU, it is to give the impression that Eurozone youth unemployment is not really a problem. And in Kirkegaard's case, it is to give the impression that US youth unemployment IS a problem. Now, I have a lot more time for Kirkegaard in this respect than I do for the EU. The EU's statistical abuse is blatantly intended to disguise the severe inequalities between different states particularly in the Eurozone. Kirkegaard isn't trying to disguise anything - he's trying to draw attention to a genuine problem in the US. US youth unemployment definitely is an issue, and it definitely should feature on the agendas of both presidential candidates - which it doesn't at the moment. But Kirkegaard should not have to bring this to US politicians' attention by manipulating European figures to make the US look worse. The US figures speak for themselves.