Friday, 31 May 2013

There's a problem with the transmission....

In my last post, I pointed out that QE does not work when the transmission mechanism for monetary policy is impaired because of a damaged and risk-averse financial sector. This caused some confusion among those who think that throwing money at banks automatically makes them lend, so I attempted to explain it on twitter. Predictably, I ended up in an extended discussion first with David Beckworth and then with Andrew Lilico, in the course of which it became clear - to me, at any rate - that not only does QE fail when damaged banks aren't lending normally, but it actually impairs the transmission mechanism itself. This might explain why QE seems to become less effective the more of it you do. It's like hard water. It gradually clogs up its own pipes. 

To explain this, let me first go through the money creation process in our fiat money system and the ways in which QE influences that process.

The monetary base, M0, is created by the central bank. It consists of notes & coins, and bank reserves - the money that banks use to settle payments. M0 makes up maybe 10-15% of the total money in circulation. The rest - "broad money" - is created in the course of lending both by banks and by non-banks that do bank-like things. It should be remembered that non-banks are the customers of banks: cash held by non-banks always finds its way into banks. 

Bank reserves never leave the banking system. They are not "lent out", as is often claimed. When a bank lends, it creates a deposit "from nothing", which is placed in the customer's demand deposit account. When that loan is drawn down, the bank must obtain reserves to settle that payment - but the payment simply goes to another bank (or even the same one), either directly through an interbank settlement process, or indirectly via cash withdrawal and subsequent deposit. The total amount of reserves in the system DOES NOT CHANGE as a consequence of bank lending. Only the central bank can change the total amount of reserves in the system. This is usually done by means of "open market operations" - buying and selling securities in return for cash. 

Because banks create deposits from nothing when they lend, the availability of reserves at the time of loan creation is not a constraint on lending. When the financial system is functioning normally, banks borrow reserves from each other to settle payment requests, and if there is a shortage of reserves in the system the central bank will create more: alternatively if there are more reserves in the system than are needed to settle payments, the central bank would normally drain them by selling securities back into the market. Some central banks impose a "reserve requirement" of, say, 10% of eligible deposits: this is a liquidity buffer to ensure that banks can meet most payment requests without having to borrow from each other or from the central bank. If there is a positive reserve requirement, it is the central bank's responsibility to ensure that there are sufficient reserves in the system to enable all banks to meet the reserve requirement.

It should be apparent from this that the monetary base RESPONDS TO lending demand. It does not drive it. This is borne out by evidence that if anything, M0 creation lags broad money creation

That's the basic mechanics of the system. However, it is not quite that simple. Monetary policy may influence lending demand by means of reserve adjustments. If the central bank decides to reduce the total amount of reserves in the system, scarcity of reserves pushes up the interest rate at which banks will lend to each other: conversely, increasing the amount of reserves pushes down the lending rate. The increased cost of reserves is supposed to act as a brake on lending. Unfortunately, when banks are chasing market share instead of margin - as they were in the early to mid-2000s - increasing the cost of reserves is not a particularly effective brake on lending unless the increase is very large. Increasing market share can compensate for loss of margin to quite an extent (this is why low-margin retail lending is only really viable as a high-volume business). And in the end, no central bank is going to allow payments to fail because of scarcity of reserves. Indeed in Europe, reserve creation by the Eurosystem to facilitate payments is automated. 

QE can be regarded to an extent as large-scale open market operations. The central bank buys securities in return for newly-created cash. If the securities are bought directly from banks, then the banks simply replace riskier and less liquid assets with cash. If the securities are bought from institutional investors or individuals, the cash still ends up in banks in the form of deposits. Either way, though, the total amount of reserves in the system increases.   

The UK, US and Japan have all done extensive QE, and as a consequence the banking system is now awash with US dollar, sterling and yen reserves far in excess of the amount needed to settle payments. Increasing the amount of reserves in the system was supposed to encourage banks to lend. But the financial sector is badly damaged in all three countries: bank balance sheets are full of non-performing loans that tie up capital and are not easy to unwind. Additionally, there is regulatory pressure on banks to reduce their risks and shrink their balance sheets. Shrinking a bank balance sheet means selling or unwinding unwanted loan portfolios. If a lot of banks are doing this all at once, the effect must be a reduction in overall lending volume. Remember I said that money is created when banks lend? When loans are paid off - or written off - money is destroyed. So general deleveraging in the banking sector, as we have been seeing for the last five years in the US and UK and for the last fifteen years in Japan, means that broad money supply is likely to be stagnant or actually falling. Now, it may be that QE encourages some banks to maintain higher levels of lending than they would otherwise have done, because in theory it reduces their funding costs (though that may not actually be true in practice, as I shall discuss shortly). We simply don't know. But what is clear is that the size of the monetary base has nothing whatsoever to do with broad money supply. When banks are deleveraging, broad money may still fall even when the monetary base is increasing.

To be fair, the Bank of England and the Fed both noted that damaged banks were not likely to increase lending and QE should achieve its effects mainly in other ways. But what they both missed was the damaging effects of QE on the flow of money through the financial system and the consequences for monetary policy transmission.

QE increases the amount of reserves in the system and reduces the amount of other forms of safe security, particularly various forms of government debt. Since the financial crisis, borrowing and lending between banks and non-banks has become more-or-less completely collateralised, with the debt of highly-rated sovereigns being the preferred choice of collateral. There is also a scarcity of collateral due to collapse of US MBS issuance, increasing shortages of high-quality sovereign debt due to sovereign downgrades, and regulatory changes encouraging buildup of safe asset reserves and hoarding of collateral. One of QE's effects is to reduce even further availability of safe collateral and therefore increase its price. THIS IS DELIBERATE. The stated intention of QE is to depress government bond yields to make them less attractive to investors and therefore nudge those investors towards riskier assets. Unfortunately this also increases the cost of the collateral needed by banks and non-banks to obtain funding, including from central banks. It could be argued that whatever encouragement increased reserves give to banks to lend is offset by the increasing cost and scarcity of the collateral needed to obtain the funds to settle lending. It's a wash.

Which brings me to the problems with monetary policy. The first thing to note is that as the increased availability of funds is balanced by increased cost and scarcity of collateral needed to obtain funds, QE makes no difference to liquidity in the financial system. This point has been brilliantly (and repeatedly) made by Peter Stella and the IMF's Manmohan Singh, but it seems no-one is listening. The extra reserves provided by QE are in no sense expansionary. If anything, QE is contractionary, because it reduces the velocity of money in the financial system. When collateral is scarce, funding flows are impeded. There may be more actual funds available, but if they aren't moving, they aren't any use. 

The second point concerns the means by which central banks influence the behaviour of banks. Because the fundamental driver of lending is the risk versus return profile for both lenders and borrowers, lending is intrinsically cyclical. Central banks attempt to dampen the cyclicality of lending by means of macroprudential regulation and monetary policy. Of these, the second is arguably more important: macroprudential regulation historically has had limited success. But large-scale QE fundamentally changes the way monetary policy is transmitted. When the system is awash with excess reserves, central banks cannot use reserve scarcity to drive up the cost of funding. The "funds" rate (Fed Funds in the US, "bank" rate in the UK) becomes useless as a policy measure. When reserves are excessive, therefore, policy must be transmitted via the deposit rate. 

Most central banks pay interest on excess reserves placed with them by banks: normally that rate is some distance below the interbank lending rate, to encourage banks to lend excess reserves to each other instead of parking them at the central bank. But as funding rates crash to zero, the deposit rate suddenly becomes far more important. Positive interest on excess reserves is currently used by both the US and the UK to prevent repo rates turning negative and prop up the short end of the Treasury yield curve. But this means that parking funds at the central bank becomes an increasingly attractive proposition for damaged banks that don't want to lend. To "nudge" banks towards productive lending, policy makers are now thinking about cutting central bank deposit rates to zero or even below. The consequences of negative rates are not fully understood, but even the brief look that I had a while ago suggested that they might not be quite what policy makers anticipate. And the problem with relying on deposit rates as the primary means of monetary policy transmission is that they are not underpinned by coherent macroeconomic modelling and their effects are not well understood. Some might argue that this is true of funds rates too, but it's far worse with deposit rates because they have never been used in this way before. Policymakers are making it up as they go along. And the economics profession is not exactly helping. The extent of disagreement among economists about how monetary policy works under these exceptional circumstances is eye-watering. It is telling that many of the most useful contributions to the debate about how best to conduct monetary policy at present have come from the financial blogosphere, not from the economics profession.

In short, monetary policy transmission is weirdly distorted by the effects of excess reserves and it has become extremely difficult for central banks to influence bank behaviour. Because monetary policy is hampered and there is reluctance to use fiscal policy as a complementary toolset, some politicians have been looking to macroprudential regulation to nudge banks towards more productive lending. This is madness. It is not the job of prudential regulators to repair damaged economies by, for example, watering down bank capital requirements intended to reduce the likelihood of catastrophic bank failures. I would rather see acceptance that, as Pozsar and McCulley (among others) have suggested, when interest rates are very low and monetary policy transmission is impeded there is a need for complementary fiscal policies.

There is much that I haven't covered in this post, and even what I have described here is controversial because it rests on an unconventional view of how the monetary system works (although perhaps not that unconventional now, since it is consistent with recent papers by both the Fed and BIS). You may disagree with much of what I have written, and I welcome constructive comments. A huge topic that I have not yet discussed is the whole question of expectations management, not only in relation to QE and its effects but in the transmission of monetary policy. I shall return to this in another post. In the meantime, Woodford is well worth reading on this matter. 

Related links:

Inflation, deflation and QE - Coppola Comment
Does the Federal Reserve fully control the money supply? - John Aziz (The Week) (with very cool charts!)

The whole question of collateral shortage, monetary policy transmission and (potentially) negative rates has been extensively covered in the financial blogosphere. Here are some of the best posts.

   When safe assets return - FT Alphaville 
   The decline of safe assets - FT Alphaville
   Pledged collateral in an IS/LM framework (part 1) - Manmohan Singh at FT Alphaville
   Pledged collateral in an IS/LM framework (part 2) - Manmohan Singh at FT Alphaville
   A confederacy of dorks - Interfluidity  
   (and all the links in this post, plus Interfluidity's previous posts on the "floor" system. A fascinating and important debate)
   The roving cavaliers of credit - Steve Keen
   When governments become banks - Coppola Comment
   The strange world of negative interest rates - Coppola Comment
   Central bank reserve creation in the era of negative money multipliers - Stella & Singh (Vox)

The recommendation of this post, as others I have written, is for fiscal & monetary coordination as suggested in this paper:

Helicopter money - Pozsar & McCulley

Implicit in this post is the idea (as spelled out in the Vox link above) that the traditional "money multiplier" does not exist. This was recently confirmed in these papers from the Fed and BIS:

Money, reserves and the transmission of monetary policy - Federal Reserve
The bank lending channel revisited - Disyatat, BIS

This paper from the Hungarian Central Bank documents the lack of connection between size of central bank balance sheet (i.e. reserve expansion) and broad money growth:

The effect of the monetary base on money supply - Andras Komaromi, MNB

For a good description of how endogenous money creation works in a fiat money system, read Cullen Roche's paper:

Understanding the modern monetary system - Roche

This paper has a US focus and it is likely that things work slightly differently in other countries: for example, the European banking model relies much less on disintermediated "shadow" banking. Perhaps we need more papers describing how money creation works in the UK, Europe and Japan. 

On expectations, a subject that I haven't addressed at all yet but discussed extensively with David Beckworth - here's Woodford's paper on the importance of forward guidance:

Methods of policy accomodation at the interest-rate lower bound - Woodford


Monday, 27 May 2013

Inflation, deflation and QE

Inflation is dead.

Well, in the US, anyway:

What is curious is that the US is doing QE. Lots of it. Which is supposed to raise inflation, isn't it?

Then there is Japan. Japan recently embarked on an extensive QE programme designed to raise inflation to 2%. Here's the path of Japanese inflation:

Historical Data Chart

It's very easy to see where QE started. It's when inflation fell off a cliff. Well, ok, it might have done that anyway, I suppose. Correlation doesn't equal causation, and all that. But it is curious.

Japan has, of course, done QE before. A look at the inflation path for the period 2001-2006, when Japan was doing QE, doesn't suggest a close relationship between QE and inflation. 

Historical Data Chart

The initial impact seems to have been deflation, though again we could do with a counterfactual. But for the rest of the period QE seems to have had little impact on inflation. In fact a researcher at the IMF concluded that QE's effect on inflation was small.

The UK does appear to buck the trend, since it experienced above-target inflation ever since commencing its QE programme, still the largest in the world relative to GDP although it is currently suspended. Though it is interesting that throughout 2012, when the Bank of England was doing QE, CPI was falling - it picked up in November 2012 when QE stopped:

Historical Data Chart

But this isn't quite what it appears. The UK's CPI was pushed up by tax rises, student tuition fee increases (what on EARTH are they doing in measures of CPI anyway?) and above-inflation rises in near-monopoly privatised utilities which are subject to government price controls. Yes, really. Government not only allowed those above-inflation rises, it encouraged them in the name of investment - though why it thinks utilities should invest for the future now when it isn't doing so itself is a mystery. And the other significant component of CPI in the UK is imports of essential items, notably oil. I suppose you could blame this on QE to some extent, because of its tendency to push up world commodity prices - but externally-driven cost-push inflation wasn't exactly what was wanted, was it? Anyway, the poisonous combination of external factors and government mismanagement pushed inflation up while real incomes have been falling. How to squash domestic demand in one easy lesson.....the effect on retail sales, for example, is horrible.

When you strip those effects away from the UK's CPI, it appears that inflation is dead there too. The Bank of England has been doing exactly this: it has "looked through" CPI to see the underlying deflationary trend. Not that it is planning any more QE at the moment. It is waiting to see how the Funding For Lending scheme works: this takes a different approach to reflating the economy involving new short-term government debt issuance rather than money - on the face of it a promising approach though to my mind it still relies far too much on damaged banks for its effects. But it seems the Bank is also thinking about negative rates.

Given the considerable evidence that QE does not raise core inflation in the countries doing it, it is a mystery to me why people are still talking as if it does. Bullard, for example, saying he thought the Fed's QE programme should continue until inflation hit 2%. And the Bank of Japan supposedly targeting 2% inflation, though no-one really believes it (or do they? it seems "inflation expectations" in Japan are up....). And all the talk of inflation being a serious risk from QE exit, as if QE exit is going to happen any time soon. Yes, Bernanke is talking about "tapering off". That isn't exiting QE. It's stopping it. Exiting QE (by which I mean returning the purchased assets to the private sector) is about as easy as ending capital controls and, like capital controls, will take years and years if it happens at all. And while inflation remains low there is no reason whatsoever to exit QE. If, in some future universe, inflation were to spike due to bank profligacy in the presence of enormous bank reserves, it is reasonable to suppose that inflation-targeting central banks would promptly drain those reserves by selling the purchased securities. Yes, I know the bond vigilantes dispute the existence of a market for such a large quantity of securities, but the private sector sold them in the first place, so why wouldn't they buy them back? Really the idea of a buyers' strike on central bank sales of securities makes no sense at all. The problem would be managing the pace of sales, taking into account impacts on inflation and on government finances.

So QE is NOT INFLATIONARY. Not now, and not ever. Let's put a stake through the heart of the idea that central bank "recklessness", as some people call it, will cause massive inflation.

The chart evidence above seems to show that if anything, QE has deflationary rather than inflationary effects. (yes, I know, correlation isn't causation, counterfactual....). But it has been difficult to come up with a convincing explanation for this. This post is my first attempt. I do not pretend to have a complete answer, and for that reason I am creating an open space on the Coppola Comment blogsite where the debate can continue and people can pool information and ideas on this subject.  We must find the answer....because if I am right, then QE is one of the biggest policy mistakes in history.

In my view the apparently deflationary impact of QE is due to what Stephen King calls its "unwanted redistributive effects", so is an indirect rather than direct effect. As the Bank of England noted in its review of QE's distributive effects, QE benefits the asset-rich at the expense of the income-dependent. To understand this, it is necessary to look at the context in which central banks do QE. The typical picture is of a stagnant economy with high unemployment, a high household savings rate (actual savings or debt deleveraging), risk-averse companies that are reluctant to invest, and - crucially - a damaged financial sector.

QE supports asset prices. Clearly, this most benefits those who own assets - who tend to be the rich and the old. In the aftermath of the 2008 financial crisis QE prevented catastrophic deleveraging and economic collapse: it was an emergency response to a desperate situation.  But since then, the debate has moved on, the benefits of supporting asset prices now are by no means clear and there appear to be all manner of unintended consequences.

QE is supposed to nudge investors towards riskier investments by raising the price of safer ones. And it is succeeding in this: bond prices are at an all-time high and the stock market is reaching for the moon. This is supposed to reduce the cost of investment for those firms that can raise funds on the capital markets - i.e. larger companies. It doesn't help small businesses who don't have access to capital markets. That assistance was supposed to come through bank lending - but banks don't want to lend to risky businesses at the moment. But it doesn't seem that the reduction in borrowing costs for larger companies has encouraged them to invest for the future either. On the contrary, it seems they have been buying other assets....notably their own shares. There has been a swathe of share buy-backs in the corporate world, partly paid for with their extensive cash hoards and partly funded with cheap borrowing from the capital markets. Debt for equity swaps are all the rage. This does nothing whatsoever to improve growth, employment or income.

So we have a broken transmission mechanism. We often hear about a broken money transmission mechanism due to damaged banks, but we don't often hear about a broken EMPLOYMENT transmission mechanism due to damaged corporates. Far from QE support of asset prices enabling companies to invest for the future and employ lots of people, it encourages them to indulge in financial jiggery-pokery to shore up their balance sheets and maintain directors' incomes, while using high unemployment and government wage support systems as an excuse to force down wages. The sheer amount of spin from corporates about lack of investment opportunities is exceeded only by their constant moaning about quality of labour. You would think that the developed countries offer no opportunities for future profits, despite their skilled and flexible workforces and supportive infrastructure. And governments pander to this: they fund skills development programmes to compensate for the training that companies aren't doing, they cut benefits to force people to take on more work - any work, however unsuited to their skill set and however badly paid - and they cut corporate taxes as yet more encouragement to invest and employ. Yet unemployment remains stubbornly high, productivity is poor and and hours of work are falling.

In the case of smaller businesses - and more generally in Europe, where businesses depend more on bank lending - the problem is the broken money transmission mechanism. The fact is that damaged banks won't lend to riskier prospects, especially when they are under regulatory pressure to de-risk their balance sheets: interest rates on lending to small businesses remain high despite the considerable support extended to banks by governments in the developed world.  QE has provided banks with huge amounts of excess reserves - but it hasn't given them a reason to lend productively. As with corporates, QE simply gives banks an opportunity to shore up their balance sheets and maintain directors' remuneration. Banks, too, tried to spin their lack of SME lending as due to a shortage of good quality opportunities - but NIESR's recent research gave the lie to that.

So the broken financial and corporate transmission mechanisms mean that QE does not reflate the real economy. That alone would make it pretty ineffective. But it doesn't make it actually deflationary. To understand why the fact that it encourages hoarding and risk-averse behaviour means deflation, we need to complete the loop from companies starved of investment to an economy starved of demand.*

It does not matter whether a company is starved of investment because banks won't lend to it, or whether it starves itself of investment through exploiting QE-induced distortions in the financial markets. The effect is reduced productivity, which pushes through to reduced wages. If the cost of capital is such that using low-cost labour is cheaper than investing in machines, unemployment may fall, but so will productivity as workers have to use less efficient tools. Similarly, if it is cheaper to use poorly-paid temporary, part-time, casual and self-employed workers than to recruit full-time staff, unemployment will also fall - but average hours worked will also fall. In both the UK and US we are seeing increasing under-employment and reducing productivity: unemployment is high in both countries, but not as high as it might be if average hours worked were higher. For me this indicates a pattern of low corporate investment in both capital and people.

Under-employment and falling productivity force down real incomes. Add to this the effects of fiscal tightening in both the UK and the US, which hit working people on middle to low incomes disproportionately, and to my mind you have a significant hit to aggregate demand which is sufficient to explain deflation in both countries. Both UK and US governments believe that monetary tools such as QE can offset the contractionary impact of fiscal tightening. But this is wrong. Fiscal tightening principally affects those who live on earned income. QE supports asset prices, but it does nothing to support incomes. So QE cannot possibly offset the effects of fiscal tightening in the lives of ordinary working people - the largest part of the population. In fact because it seems to discourage productive corporate investment, it may even reinforce downwards pressure on real incomes. And when the real incomes of most people fall, so does demand for goods and services, which puts downward pressure on prices, driving companies to reduce costs by cutting hours, wages and jobs. This form of deflation is a vicious feedback loop between incomes, sales and consumer prices, which in my view propping up asset prices can do little to prevent.

Ah, you say, but most people own assets, don't they - through their pensions and in the form of houses. This is true. And it is fair to say that QE props up the value of both pension investments and real estate. But it depresses returns on savings.** Depressing returns is supposed to encourage people to spend instead of save. But when people are saving for their old age, and they see their savings whittled away in the form of below-inflation returns, they are likely to save MORE, not less. They will cut discretionary spending to increase pension saving. This I think is partly the cause of the apparently deflationary effect of QE in Japan. Japan's households have high savings rates because they have to save for retirement as there is no state safety net. In the US and UK the effect may be less, because both these countries have substantial state pension & benefits provision for the elderly. But....those schemes are unfunded, and future taxation may be unable to support claims on those schemes. Therefore governments persistently "talk up" the need to save for old age. It seems likely, therefore, that the combination of increased pressure to save for retirement and depression of returns on savings is encouraging people in the US and UK to increase savings at the expense of discretionary spending too. Once again it seems that the combination of QE with other things is deflationary, though that doesn't necessarily mean QE itself is.

Then there is real estate. Homeowners benefit from Government propping house prices with various forms of QE. This support is explicit in the US at the moment, since the Fed is buying agency MBS, though perhaps less obvious in the UK. But QE supports real estate prices even if only government debt is purchased. The rising price of safe assets pushes investors not just towards riskier investments, but also towards safer ones....most notably prime real estate, which has risen considerably in value. Supporting house prices through QE, coupled with low rate policies that (especially in the UK) have kept mortgage rates for existing borrowers very low, has prevented mortgage defaults and supported aggregate demand. But there is a cost. Rental values are high, which hurts people who don't own property - the young, and people on low incomes. There is little evidence now of wealth effects from property prices increasing spending, as used to be the case prior to the financial crisis: people simply aren't taking out second mortgages to release equity for consumer spending at the moment. Fingers have been well and truly burned, and uncertainty around jobs and income means that people are reluctant to take on more borrowing....after all, if your income is falling and/or uncertain, servicing debt is a constant worry, and taking on more (unless you have to) is madness.

Overall, therefore, QE looks deflationary to me. Or if not actually deflationary in itself, at least completely ineffective as an offset to contractionary fiscal policy and fear-driven hoarding by companies and households. And there is one particularly poisonous effect that I mentioned in passing earlier in this post. The excess liquidity caused by QE, and shortages of the safe assets being purchased, encourages investors not only into riskier assets, but also into alternative safe ones. There is a lot of cash hoarding going on.....and I've noted already that QE drives up the price of prime real estate. It also interferes with the pricing of metals, which has implications for production costs in manufacturing industries. And spikes in the prices of foodstuffs and oil have also been attributed to QE. If this is true, then QE is toxic, because it increases the price of the essential goods that people need in order to live. But as with all things QE-related, it's not that simple....after all, commodity prices are falling at the moment. What is clear, though, is that QE causes enormous distortions in financial markets which are not fully understood and which create fear, uncertainty and instability in the financial system. This could be justified if its effects were evidently beneficial. But it is by no means clear that they are.

From where I stand, QE looks like a very bad bet indeed. The benefits are uncertain and the downside risks huge. In my view it should be stopped. But you may not agree - and I know that many people are much more positive about QE. If you believe that overall its effects are beneficial to the economy, please do comment. Or even submit a post of your own arguing the opposite case.

And here is a final thought. It's all very well criticising QE, but what should we do instead? After all, we have stagnant economies, damaged banks, risk-averse corporates, highly-indebted households, high unemployment, under-employment, low productivity and falling real incomes. Doing nothing is not an option. If QE is a disaster, what is the alternative?

Please do join in the debate by clicking on "The QE Debate" at the top of the screen. This post can be read both here on Coppola Comment and on The QE Debate. 

Related links:

Inflation is falling everywhere - FT Alphaville
Measure it however you like, inflation has been low and falling - FT Alphaville
Estimates of inflation expectations - Cleveland Fed (h/t Izabella Kaminska)
Bank of Japan's quantitative and credit easing: are they now more effective? - Berkman (IMF)
UK retail sales commentary May 2013 - Markit
The fatally flawed FLS - Coppola Comment
UK Treasury Committee oral evidence on QE - Gavyn Davies, Stephen King and Roger Farmer
Electronic money and negative rates - Pieria
The distributional effects of asset purchases - Bank of England
Lessons at the zero bound: the Japanese and US experience - Bernanke (NY Fed)
Executives cash in as cheap debt funds staff buybacks - FT (paywall)
Evaluating changes in bank lending to SMEs 2001-12 - NIESR
Bifurcation in the labour market - Coppola Comment
The financialisation of labour - Pieria
Bank of England must halt QE gilt-buying - Saga

John Cochrane outlines a different argument for the contractionary effects of QE in The Fed and Shadow Banking.

John Aziz recently suggested an alternative to QE.

* We should remember of course that we do not live in a closed world, but the US and UK both have substantial trade deficits and Japan has slipped into trade deficit too. Since the entire world is attempting to increase exports and reduce imports at the moment, it seems highly unlikely that the export sector can make up for lack of domestic demand.....especially since Japan's economy has stagnated for 20 years DESPITE a significant trade surplus for much of that time. I don't think an export-led recovery is really possible for anyone. Domestic demand is the key to recovery.

** Campaigners for the elderly claim that people who are living on the returns from their savings are finding their incomes squeezed because of QE. Some are compensating for this by taking on part-time work, but others are simply cutting spending. This is an obvious hit to demand, although this is a relatively small group of people so the deflationary effect would be small. But I am not convinced that this is a major cause of QE's deflationary effects: I agree with the Bank of England that the main cause of the squeeze on fixed incomes is low rates. The distributional impact of QE is far more complex.

Monday, 20 May 2013

The housing conundrum

House prices in the UK are too high. How much too high they are depends on where you are: house prices have been rising in London because rich Asian businessmen and French aristocrats are buying up prime real estate as a safe haven investment for their filthy lucre, apparently. But outside London and the South East, house prices have actually fallen over the last few years, a bit. But not much. Certainly not enough to make them affordable for young people on median incomes.

The trouble is, there are a lot of people out there who already own houses. Many of them are relying on the value of their property to top-up their pensions. And all of them have votes. The total voting power of homeowners in the UK far exceeds that of the young people who are being priced out of the housing market. It would be electoral suicide at the moment for any political party to sign up to policies that would cause a significant fall in house prices. 

However, there is future electoral benefit in making it possible for young people to buy houses. At some point many of these elderly property-owners are going to want to sell their houses, and if young people can't afford them then they are in for a big shock. It is not in older homeowners' interests to sit on an appreciating asset whose value is not realisable in practice. Writing down the value to something more affordable is a far more sensible strategy for older homeowners who have paid off their mortgages. Young people and old people therefore have more in common than they think they do. The people who really stand to lose from a major fall in house prices are those with mortgages, particularly those who over-borrowed prior to the financial crisis and are only just managing to service their debts. A fall in house prices could force many of these into negative equity. Painful though that would be, it would enable the housing market to readjust to a more sustainable level, and provided interest rates remained low, borrowers would be able to continue to service their loans. Yes, a lot of young families would be trapped in houses too small for them because the amount of their mortgage exceeded the value of the house - as I was in the early 1990s, the last time there was a significant house price correction in the UK. But repayment mortgages are forgiving things: eventually the outstanding amount would drop below the house value and they would be able to move.

So engineering a fall in house prices looks like a good economic strategy for the medium-term, although possibly not a wise one for politicians hoping to get re-elected in 2015. But the Government is not even discussing it. On the contrary, it is doing everything in its power to prop up house prices. It is not liberalising planning laws to enable expansion of private sector building programmes, as some have suggested. Nor is it sponsoring public sector building programmes. And on the monetary side, it now has two schemes designed to make it easier for first-time buyers - the Funding for Lending Scheme, which provides cheap funding to banks on condition that they lend more to house-buyers and small businesses, and the Help to Buy scheme, which guarantees part of the purchase price of a house, thus making it possible for people to buy a house without much in the way of a deposit. Both of these schemes have been criticised for potentially increasing house prices. 

This apparent short-termism is not entirely due to electoral considerations, though those are clearly a factor. A fall in house prices is not the easy solution it appears to be. In fact at the moment it would have disastrous effects on the economy. The reason is, of course, banks. And building societies. And indeed any financial institution that lends against property.

House price falls are disastrous for mortgage lenders. Mortgages are secured loans: the house that is bought is the collateral for the loan, and the loan is granted on the basis of the value of that collateral. As with all forms of secured lending, the value of the collateral usually exceeds the amount of the loan: the difference is made up with the house-buyer's own funds. Since the financial crisis mortgage lenders have reduced their loan-to-value (LTV) ratios considerably, which has made it very hard for house-buyers with limited resources to find the money needed for deposits (this is the stated justification for the Government's Help to Buy scheme). Good quality loans typically have a LTV ratio of less than 80%: the risk associated with the loan increases as the LTV approaches 100%. Above 100%, part of the loan is effectively unsecured. Without going into details about how bank capital ratios work, the higher the LTV, the greater the amount of bank capital required to support it, more-or-less. When house prices fall, LTV values rise - exceeding 100% for borrowers in negative equity. Falling house prices therefore eat up banks' capital, not because they took on risky loans but because their supposedly safe low-LTV mortgages become much riskier. Banks and building societies are already damaged from the financial crisis of 2007-8. A large fall in house prices could bankrupt many of them. Particularly at risk would be building societies and small retail banks, who tend to have lower capital levels than large universal banks because most of their lending is in supposedly "safe" mortgages. There is nothing "safe" about mortgage lending in an overblown and fragile housing market.

Improving the supply of houses without causing a major fall in house prices seems to be almost impossible. An extensive private sector house building programme would help the recession-hit construction sector, but it would force down house prices. That would apply whether those houses were for sale or for rent. Landlords borrow to finance the purchase of homes for renting out, and they carry the value of their rental properties on their balance sheets: and as rents tend to be set in relation to house prices, falling house prices would be likely to force rental values down. A major fall in house prices would therefore potentially bankrupt many landlords. And construction companies who borrow on the basis of expected returns could also be bankrupted if those returns fail to materialise because of falling prices. This is what happened in Ireland.

A social house-building programme similar to that after World War II might improve the supply of homes for rent without causing house prices to fall. Or it might not, if the effect was that people who might otherwise have tried to buy substituted into new social housing. And what if those houses were then sold to their tenants under the Right to Buy scheme? This would also cause house prices to fall, though perhaps more slowly than large-scale private sector house-building. Of all the options for improving the supply of housing without wrecking the financial sector, this looks the best. But it would require government not only to spend money, thereby increasing the fiscal deficit, but to abandon its ideological commitment to private-sector solutions and admit that we need an increased role for publicly-owned housing at the moment. I suspect hell would freeze over first.

So forcing a house price correction would have horrible effects on the economy at the moment. But for many people, housing is at the limits of affordability. The rise in the price of houses in the last two decades has far outstripped incomes, which have actually stagnated in the last ten years. Low interest rates have encouraged people to take on mortgages that stretch them financially. A rise in interest rates would force many people into defaulting on mortgages or other loans, which would also have a serious impact on the financial sector. A sudden rise in unemployment would have similar effects. And as real incomes decline due to below-inflation pay rises, benefit cuts, tax rises and underemployment, more and more people are becoming financially overstretched. They don't default on their mortgages, but they cut spending in other areas. This depresses demand for goods and services in the economy, forcing companies to cut costs - which usually involves reducing jobs and/or wages - and even go out of business. It is a moot question whether the real problem here is low pay or high inflation: perhaps it is a bit of both. But the solution is not easy. Raising interest rates to counter inflationary pressures would cause financial distress to many households and businesses. Raising wages without an equivalent rise in GDP would be likely to create higher unemployment. And raising real incomes through higher benefits and/or cutting taxes would increase the fiscal deficit.

So we cannot force down house prices, we cannot force up real incomes and we cannot vastly increase the fiscal deficit. The housing conundrum resembles one of those games of the "there's a hole in my bucket" variety - a mind puzzle, if you like. Many people solve it by leaving out some of the pieces - which of course is not a solution at all. Others want to do something dramatic such as a large rise in interest rates or a massive state-funded construction programme to "shock" the system into correcting - the idea being that the short-term pain would be worth it to achieve a sustainable correction. I understand their frustration, but I am not sympathetic to their solution. This Gordian knot cannot be simply cut with a sword. It must be painstakingly unpicked - and I fear that will take a very long time.

Related links:

Escaping liquidity traps: lessons from the UK's 1930s escape - Nicholas Crafts (VoxEU)
The fatally flawed FLS - Coppola Comment
Help to Buy mortgage guarantee outline - HMT
IEA's Shadow MPC votes 6-3 for half-point rate hike - Economics UK
A history of social housing - BBC

Wednesday, 8 May 2013

April links

Below is a list of the things I have been reading and using as background to the posts I have written this month. It's not exhaustive.


Financial Conduct Authority documents:

Risk outlook -
Business plan -

Prudential Regulatory Authority documents:

Noah Smith on equilibria:

QE is a joke - wonkmonk_'s charts showing worldwide govt bond yield convergence

Free e-book of Smith's The Wealth of Nations (via Paul Krugman)

Scott Fullwiler on endogenous money and monetary policy

Cyprus: memorandum of understanding
Cyprus: amendments to memo of understanding (govt statement)
IMF statement on Cyprus
El-Erian on Cyprus
Buiters' note on Citi

Malta - Seeking Alpha article:

Banking Union speech by Yves Mersch:

Banking union article - Munchau

Finpoint on funding for lending:

CIMA's Financial Management mag: (good articles)

John Grout on wholesale deposits becoming "hot money": (very important article on untoward effects of banks' flight to safety)

Salz review of Barclays:

Walker report on corporate governance of banks & other MFIs

Anat Admati - paper on bank equity finance:

Liikanen report:

IT in banking


Pew report on effects of recession in US (via Bloomberg)


Brave New World - Huxley (free to read)

Other stuff

A Grunch of Giants (ref. IK)

Mozart piano concerto 23 - Horowitz - via Strikelawyer.

Tuesday, 7 May 2013

The financialisation of labour

My latest post at Pieria:

"We are used to thinking of workers as free agents who sell their labour in a market place. They bid a price, companies offer a lower price and the market clearing rate is somewhere between the two. Market economics, pure and simple.

But actually that's not quite right. The financial motivations of workers and companies are entirely different. To a worker, the financial benefit from getting a job is an income stream, which can be ended by either side at any time. But to a company, a worker is a capital asset.

This is not entirely obvious in a free labour market. But in another sort of labour market it is much more obvious. I'm talking about slavery.

Yes, I know slavery raises all sorts of emotional and political hackles. But bear with me. I am ONLY going to look at this financially. From a financial point of view, there are more similarities than differences between the slave/slaver relationship and the worker/company relationship - and the differences are not necessarily in the free worker's favour......"

The remainder of this post can be found here.

Monday, 6 May 2013

The equivalence of debt and equity

Much is being made at the moment of the idea that banks should have more capital. Predictably, there is huge confusion about what this actually means, and the usual suspects are once again mixing up deposits and capital (deposits are debt) and claiming that QE recapitalises banks (no it doesn't, but it does provide them with liquidity). I don't want to explain the difference again here, but if anyone is still unclear about what "capital" consists of for a bank, read this.

Predictably, banks and other financial institutions are fighting back. Concerns are being expressed about the effect on competition of EU's proposal for money market funds (MMFs) to have capital and liquidity reserves. And banks worried about their return on equity (already shot to pieces) claim that raising more capital would be a) unacceptable to their shareholders b) hugely expensive c) impossible anyway. Meanwhile, Anat Admati and Martin Hellwig, in their book "The Bankers' New Clothes", claim that the banks' arguments are specious: banks in the past have been much more highly capitalised, the Modigliani-Miller model shows that (apart from tax considerations) equity is no more expensive than debt, capital can always be raised if the price is right. This is yet another argument that could run for years and become increasingly political. Personally, I'm not going to take sides. I think they're all missing the point.

You see, there is actually no significant difference between debt and equity. Both are claims on the bank's income (when it is a going concern) or its assets (when it is bust). Nor is debt in any way money that the bank is "looking after": as far as the bank is concerned, debt is funding for things it wants to do (lending, trading...). And debt includes customer deposits.

Customers believe that when they put money in a bank deposit or current (checking) accounts they are putting it in a safe place. But that's not true. Customers are actually lending that money to the bank, which can use that money in whatever way it wishes. And as Andrew Lilico points out, they have no automatic right to return of that money. All they have is a claim. In the event of insolvency, that claim will only be honoured if there are sufficient assets to meet it after settling more senior claims. When a bank fails, the only real difference between a depositor, a bondholder and a shareholder is the seniority of their claims.

Let me explain. A typical bank liability structure looks something like this*:

Here it is reversed, for reasons that will shortly become clear:

I've added some percentages to these to indicate proportions of each type of asset in the capital structure. These may or may not be remotely realistic - that's not the point. The point is to show how losses due to asset writedowns affect corporate liabilities. Let's imagine to start with that the bank has to write down 3% of its assets (to keep it simple I am using the nominal not risk weighted balance sheet):

You can see that, for a bank that meets current UK regulatory requirements for a leverage ratio of 3%, this wipes out the bank's shareholders. They lose their entire investment.

If losses increase, this is who gets hit next:

Junior bondholders (holders of various forms of subordinated debt, including the so-called "Co-Cos" about which there has been much discussion) are bailed in and wiped. Their bonds are converted to equity and they no longer receive interest payments. They become ordinary shareholders, waiting patiently for the bank to be restored to health so their shares can recover their lost value and they can start to receive dividends again. However, sometimes governments interfere with this. When the Dutch bank SNS Reaal was nationalised recently, junior bondholders were wiped along with ordinary shareholders. Shares and subordinated debt were cancelled completely via an expropriation order by the Dutch government. In effect, the Government took over the claims of shareholders and junior bondholders against the rescued bank. There was a fair degree of outrage among investors about this, but it is worth bearing in mind that had the bank been allowed to fail, shareholders and junior bondholders would have lost their entire investment anyway. The Dutch government chose to rescue depositors and protect the financial system. They were under no obligation to make good shareholders and subordinated debt holders.

But if losses rise further, there is a much more complex situation:

Depositors, senior bondholders and wholesale lenders are currently ranked equally ("pari passu") in their claim for settlement.  However, debt that is secured directly on assets effectively ranks senior to unsecured debt, because it has a prior claim on certain assets.  So if the bank has issued asset-backed securities, or borrowed money via the repo market using its assets as collateral, those creditors effectively rank senior to depositors: the assets backing their debt are not available to settle other claims (they are "encumbered"). If those assets turn out to be worthless, the debt is effectively unsecured and its holders have an equal claim to a share of unencumbered assets.

The UK's Independent Commission on Banking recommended that depositors should rank senior to bondholders ("depositor preference"), and the EU is considering legislation to enforce this from 2018. But currently, once junior bondholders have been bailed in, both unsecured senior bond holders and depositors are fair game. This means ALL depositors - not just large ones. There is no intrinsic difference in claim seniority between large and small depositors.  Once depositor preference is established, though, senior bondholders would take losses before depositors.

The most senior of all claims are the official sector - central bank funding and other public sector loans. Only if a bank was so deeply in trouble that all deposits were wiped would the official sector take losses. I suspect that government would step in long before that point was reached.

The Brown-Vitter proposed legislation in the US would force banks to increase their Tier1 capital ratio (unweighted) to 15%. Anat Admati wants it to be 25%. That would mean that bank asset writedowns would have to be far greater before depositors were at risk. But it wouldn't eliminate the risk completely. And it would place other people - or potentially the same people, in a different way - at risk.

Capital is not simply "money that absorbs losses". It is people's savings. The principal shareholders in banks are pension funds - which invest the money that people save for their retirements. Losses for these people are just as serious as losses for depositors: although the consequences may not be felt immediately, money lost through investment failure may mean a materially lower standard of living in retirement, as Equitable Life pensioners could tell you. If we force banks - and potentially corporations too, since highly-geared corporations are a risk to their stakeholders - to finance themselves much more with equity than debt, losses will still fall on ordinary people. It's the same money, just in a different form. We should not forget this.

My walk through capital structure above I hope showed that when a company is failing, it does not matter whether you call your investment equity or debt - what matters is the seniority of your claim. Losses are the same whether it has 15% equity or 3% equity. Increasing the proportion of equity does not make it less likely to fail. All it does is increase the likelihood that creditors will get their money back.

The distinction between debt and equity made by, among others, Anat Admati is misleading. In insolvency, debt and equity are fungible. It does not matter whether the debt is called "subordinated", or secured on assets: if losses due to asset writedowns are sufficiently large and widespread, all debt is effectively converted to equity. Creditors have no more intrinsic right to return of their money than shareholders. They get paid first, but they don't necessarily get paid completely. Nor should they be. Lending money to anyone is risky. Banks are no exception. As long as it is clearly understood that creditors can, and should, lose money in insolvency, there is no reason for vast increases in equity in bank capital structures, because debt is effectively equity anyway.

I know that everyone is now going to shout - "BUT WHAT ABOUT DEPOSIT INSURANCE"?  The reason for protecting small depositors with deposit insurance is a social one. It has nothing to do with preventing bank runs, really - the best way of preventing a bank run is to ensure people know that banks can't run out of money (liquidity), which means a central bank doing a good job as Lender of Last Resort. Bank depositors are assumed to be naive people who don't understand finance, so need protection from risky banks. I don't think this is acceptable, really. These people are only too happy to put their money in banks when they could put it elsewhere. It needs to be made clear to them that their money is no safer in a bank than it would be in an investment fund - and then let them make an INFORMED choice about what to do with their money. There are advantages to bank deposits even if they aren't fully safe. There is in my view a case for protecting transaction accounts from losses, because we have become so dependent on banks for payments that allowing current accounts to take losses would cause real hardship to many people. But these are political considerations, and I am only expressing a personal view. They have nothing to do with the nature of deposits. All bank deposits are investments. "The value of investments can fall as well as rise, and the return of the investment is not guaranteed." Why isn't this statement on every bank deposit account agreement?

I am certainly not suggesting that banks increasing the proportion of equity in their capital structure is a bad thing. On the contrary, there is plenty of evidence that heavy reliance on debt finance can be destabilising not just for banks but for corporations, too, because of the cost of debt service and the risk that creditors will foreclose. Personally I would eliminate the preferential tax treatment of debt, which encourages debt financing at the expense of equity. But we should not buy into the idea that increasing the proportion of equity in the capital structure makes banks "safer". It doesn't. The only thing that really makes banks safer is limiting the risks they can take and ensuring they are well managed. When, please, are we going to regulate lending properly?

Related links:

Liquidity matters - Coppola Comment
Cyprus and the financing of banks - Coppola Comment
Tarullo's speech on capital and regulation - FT Alphaville
Brussels to clamp down on shadow banking - Financial Times (paywall)
Equity capital requirements - The Economist
Rant at me about property rights - Andrew Lilico
The Bankers' New Clothes - Anat Admati & Martin Hellwig
Independent Commission on Banking Final Recommendations (summary)- KPMG
EU Assembly seeks depositor preference in bail-in law - Bloomberg
Brown-Vitter bill analysis & commentary - Davis Polk
State of the Netherlands nationalises SNS Reaal - NL Government
Theory & practice of corporate capital structure - Deutsche Bank

* Yes, you are right, this does look very much like a CDO tranche structure. That's because it is. A CDO is a financial company and its tranche structure is a corporate capital structure.