Sunday, 30 June 2013

May links

Posts and papers that I have read and used in my own blogposts in May.

Deposit insurance and lender of last resort

Lessons from the Northern Rock failure - Cass Business School

Bank runs, deposit insurance & liquidity - Diamond & Dyvbig


UK trade balance charts - Reuters

The truth about welfare - Ian Mulheirn

How Mervyn King lost the battle of Britain's banks - Simon Nixon trashes Mervyn King


ECB assessment of Eurosystem staff macro projections

ECB: Target balances and monetary policy operations (very good paper)

Pew Report: The new sick man of Europe

By the law of noncontradiction - Ashok Rao:


Sub-Saharan Africa winning the world easy money sweepstakes  - Simone Foxman (Quartz)

IMF report on sub-Saharan Africa

Debt sustainability in emerging markets

IMF's "we got it wrong" on sovereign debt restructuring. Painful!

Mismeasuring Poverty - ProSyn

Reuters on the FX effects of QE. Unwind risks repeat of Asian crisis.

IMF Fiscal Monitor: Fiscal adjustment in an uncertain world

Domestic demand US-Japan-Eurozone (chart) via Cardiff Garcia

Will Housing Save the US Economy? - Sufi, Chicago Booth university


 Uncertainty, Liquidity Hoarding and Financial Crisis - NY Fed

Co-op bank downgrade statement - Moody's

Bernanke speech: Monitoring the Financial System

Wall St's most worrying charts - Business Insider

FT Alphachat on negative rates (audio)

Balance sheet strength and bank lending during the financial crisis - IMF

Heterogeneous bank lending responses to monetary policy - IMF

Diamond & Rajan: Theory of Bank Capital - NBER (free to read)


Why are birthrates falling around the world? Television. - Brad Plumer at Wonkblog

The Great Grey Catastrophe - Reuters Insider (video)


Deflation in a world of abundance - An Abundant World

Savings is the smoking gun - An Abundant World

Hysteresis effects of financial crises - Delong (with ref to Oulton & Sebastia Barriel)

Wealth as insurance - Interfluidity

The case for inflation - Vox

For QE links see The QE Debate.


Free information, as great as it sounds, will enslave us all - Jaron Lanier (Quartz)

Mortgages are dangerous beasts

Barclays is complaining. The Prudential Regulation Authority (PRA) is proposing to test the bank's ability to comply with a proposed new regulatory target - the leverage ratio.

In corporate finance, the leverage ratio is the ratio of equity to total debt. But in the banking world, the leverage ratio is the ratio of equity to total assets. It is in theory a simple measure, although different accounting standards do make a difference to its calculation - for example, US GAAP and IFRS netting rules for derivative exposures are different, which leads Simon Johnson to make the mistake of claiming that Deutsche Bank's leverage ratio is too low relative to US banks, when actually under US GAAP it is rather good....However, I digress. The capital ratio, by contrast, is the ratio of equity to risk weighted assets. Risk weighting reduces the value of a particular asset or asset class in the capital ratio denominator: unsecured risky loans are weighted at 100% (i.e. the denominator includes the full value of the loan), but other loans are weighted at various percentages depending on the creditworthiness of the borrower, the value of any collateral and various other risk measures. Obviously, the lower the risk weighting, the lower the amount of capital needed to meet the capital ratio target set by regulators.

Barclays knew it couldn't meet the new leverage ratio target of 3% before 2015. So the bank's CEO, Antony Jenkins, warned that if the bank had to meet that target early, it might have to cut lending to UK households and businesses. This was dynamite. As the Sunday Times says (paywall), the PRA is incensed. A lovely spat is brewing between Jenkins and the PRA's head, Andrew Bailey, who has made it clear that cutting lending to the UK economy is unacceptable. But Barclays is by no means the only bank that is complaining about the new leverage ratio.

The biggest complaints have come from building societies and other lenders who specialise in mortgages. They argue that the leverage ratio penalises them because it fails to take into account the "lower risk" of mortgage lending. Nationwide, the UK's biggest building society and fifth largest lender, says it will have to find at least an additional £1bn of capital, which won't be easy because as a mutual it can't easily tap the financial markets for new equity.

Frankly I am amazed that anyone can seriously suggest that mortgage lending is "lower risk". Charles Goodhart recently commented that there have been four UK banking crises in his lifetime, of which three were caused by property market collapses. When house prices fall - which in the UK they do about every 20 years - even supposedly safe mortgages become risky, and risky ones become toxic.  And commercial property is even more vulnerable. Collapsing commercial property values was one of the biggest causes of UK bank insolvency in the financial crisis, and several of the UK banks still have significant amounts of impaired commercial property loans sitting on their balance sheets.

The idea that mortgage lending is "lower risk" comes from the fact that it is secured on property. Mortgages don't usually cover the entire cost of the property at the time of purchase. What is known as the "loan-to-value" (LTV) ratio is the ratio of the amount of the loan to the value of the property, and in a good quality mortgage it will be not more than 80%. The remainder is covered by the borrower from own funds and/or unsecured borrowings, often from family and friends. In financespeak, the property is the "collateral" against the loan, and the difference between the amount of the loan and the value of the property is the "haircut". In the event of the borrower defaulting on the loan, the bank can seize the property and sell it to recover the loan amount. Therefore the risk that the bank will lose money on the mortgage is regarded as low.

As I explained above, capital adequacy rules take into account lending risk. In the case of good quality mortgages, risk of default is negligible because of the value of the collateral. I should make it clear that collateral is not bank "capital" - it is the borrower's capital. The bank doesn't own the property, the borrower does, even though the borrower has bought it with the bank's money. But because the loan is secured on the borrower's capital, the bank doesn't need much capital of its own to support it. That's the traditional view and the justification for low risk weighting of mortgages in regulatory capital rules.

But mortgage risk rises spectacularly when there are housing bubbles - as there have been in the run-up to EVERY property price collapse in the last 50 years, not just 2007-8. Encouraged by the prospect of high returns and blinded by rising property prices, banks water down their lending standards. They lend larger proportions of the value of the property, even lending over 100%*. And they lend to poorer credit risks - people with no steady income, people who already have high debts, the recently self-employed, people who don't want to disclose anything about their financial circumstances. Capital adequacy rules do adjust to take account of increased credit risk, but in a rising property market this is still offset by the value of the property. Basically, as long as property prices are expected to rise, the view remains that the bank can't lose and therefore doesn't need much capital of its own to support even risky mortgages. In the run-up to the 2007-8 financial crisis, many banks' and building societies' capital margins were paper-thin.

When property prices fall, the "haircuts" on real estate collateral shrink. Obviously, for good quality mortgages this is annoying but not disastrous: a 75% LTV might rise to 90% but it isn't going to be wiped out. But for higher-risk mortgages, the effect on the bank's balance sheet can be terrible. If property values fall by 11%, all mortgages with LTVs of 90% or more are underwater (the loan amount is more than the value of the property). If a proportion of these borrowers then default on their loans, the bank takes losses. If the bank's own capital is insufficient to absorb those losses, then its creditors are at risk and it is insolvent. This is why apparently sound banks can suddenly become insolvent when asset prices are falling. I've shown this here with mortgages, but the same applies to other forms of lending and purchased securities, including the infamous CDOs whose value crashed to almost zero in the financial crisis.

What I describe above - property market collapse leading to widespread bank insolvency - has happened three times in the last 50 years in the UK: in 2007-8, 1990-92 and 1973-5. And it has now happened in the US for the first time in 70 years, with a much bigger correction than the UK experienced. Each time it was preceded by bubble lending and increasing risk in mortgage books. Each time, banks failed and were bailed out - in the first two crises (especially the 1973 crash) they were bailed out by the central bank, and in the most recent crisis they were bailed out by the Government. And each time, bank capital calculated using risk weighting rules failed to ensure that banks had enough capital to withstand losses on mortgages - including commercial property and construction loans.

This is why, in my view, the leverage ratio is essential. Risk weightings are not an adequate measure of risk when asset prices are falling, so reliance on risk weighted capital ratios can result in banks having insufficient capital to support losses. And furthermore, I think it is essential that capital rules are NOT watered down for supposedly "safe" specialist mortgage lenders. There is nothing "safe" about a specialist lender that is lending 95-125% LTV to poor credit risks - as Britannia Building Society and Northern Rock were both doing. Specialist lenders should have to comply with an unweighted leverage ratio just as universal banks will have to.

There is still a role for risk weighted measures, however. The problem with a leverage ratio is that it can encourage high-risk lending. After all, returns are better when risks are higher, and if regulatory capital rules ignore risks, banks might as well go for the really high-risk, high-return stuff. This can make their balance sheets more unstable and increase the risk that they will actually fail, which is not really what we want. So in my view we need both risk weighted capital ratio and leverage ratio. They do different jobs.

And there is one other matter too. Bank lending is fundamentally pro-cyclical: higher returns and (apparently) lower risks encourage excessive lending when times are good, but when times are bad low returns and high risks (especially if asset prices are or have been falling) discourage lending. Therefore macro-prudential regulation needs to be counter-cyclical. There has been some discussion of adjusting capital requirements according to the business cycle - relaxing capital adequacy rules in downturns to encourage lending, and tightening them in booms to discourage excessive lending. This is a start. But it is not enough. Lending standards are always watered down in the run-up to a crisis. Macroprudential regulation should be looking at asset quality, not just at capital levels.

And we also need to reconsider the effect of interest rate policy in booms and recessions. Standard macroeconomic interest rate policy cuts rates in recessions and raises them in booms. This affects demand for lending, because borrowers don't want to borrow at high rates but are often happy to borrow at low rates. But the converse is true for banks. Low interest rates discourage lending: high interest rates encourage lending. There is clearly a conflict of interest here which means that relying on interest rates alone to control bank lending is doomed to fail. I don't have a simple answer to this problem, but we need to look at ways of influencing bank behaviour that don't involve clobbering their margins when they are already damaged, or encouraging them to lend far too much at far too high a risk when times are good. And that involves building macroeconomic policy models that include banks as active participants rather than passive intermediaries, so that the effect of bank behaviour can be factored into forecast effects of macroeconomic policy. Unless we do that, we are going to continue to get macroeconomic policy horribly wrong, encouraging banks to behave badly and cause intermittent crises at terrible cost to our economy. As we have done persistently over the last 50 years.

Related links:

Bank lashes Barclays for loans threat - Sunday Times (paywall)
Risk insight: The Weakness in US GAAP Netting Assumptions - Nicholas Dunbar (Bloomberg Brief) (h/t Dan Davies)
British Banks' Comedy of Terrors - Simon Johnson (ProSyn)
Deutsche Bank's capital raising highlights leverage ratio bite - Euromoney

* High LTV mortgages are certainly not a recent phenomenon. My first mortgage in 1988 was 100% LTV. The property market crashed less than two years later and I was "underwater" (in negative equity, as we say in the UK) for the next five years.

Wednesday, 26 June 2013

Financial dislocation

My latest post at Pieria considers, among other things, the recent BIS report on the global economy and comments from the Archbishop of Canterbury on the future of banking:

"The conventional view of the financial system is that it acts as an intermediary function, converting the money created by central banks into a form that can be used in the wider economy and circulating it through lending and deposit-taking. The unconventional monetary policy instruments that have been used by central banks to reflate economies since the financial crisis (and in the case of Japan, for much longer) make use of this model. One way or another, the additional money created by central banks was supposed to find its way out into the wider economy, stimulating new investment, creating jobs and generally increasing economic activity.

But this isn't happening. Economies in the developed world remain flat, while the additional money created by QE has gone to inflate asset bubbles and increase inflation in emerging markets. Why has the additional money not gone where it was intended to go?"

The remainder of this post can be read here.

Sunday, 23 June 2013

QE myths and the Expectations Fairy

There are perhaps more myths about QE than almost any other monetary policy instrument. Here are five of the most pernicious QE myths:

Myth 1: QE raises inflation. Despite the considerable evidence that it does nothing of the kind, people still persistently believe that it does - that "eventually" inflation will come. This is because of the widespread misrepresentation of QE as "printing money". Numerous people have painstakingly explained what QE is and how it works, but inflationistas aren't listening. To them, QE is printing money, and everyone knows that printing money causes inflation. (That isn't necessarily true either, but as I said, they aren't listening). An alternative view proposes that because QE props asset prices, eventually the increase in asset values would feed through into an increase in the money supply as asset holders take profits and spend the proceeds, increasing inflation. This is perhaps more reasonable, but again there is little evidence to support this.

Myth 2: QE stimulates the economy by forcing banks to lend. This is based on the idea that if you throw money at banks they will lend. But banks only lend if the risk versus return profile is in their favour. At the moment banks don't want to lend, because their balance sheets are a mess. QE increases reserves, but it does little to repair bank balance sheets. No amount of excess reserves will force damaged banks with weak balance sheets to lend.

Myth 3: QE stimulates the economy by persuading corporates to invest. This is similar to Myth 2. It is based on the idea that if you make borrowing ridiculously cheap for corporates (i.e. throw money at them) they will invest. But corporates only borrow to invest if the risk versus return profile is in their favour. At the moment they don't want to invest, because the economic outlook is very uncertain and profitable investment opportunities look few. They are very happy to borrow to refinance debt or to buy back equity - but that doesn't help employment or incomes. I should make it clear, too, that this only applies to larger corporates that have access to the capital markets. Small and medium-size businesses are much more dependent on bank lending, and they are living in a financial desert - see Myth 2.

Myth 4: QE encourages households to increase spending. This is by means of the "wealth effect", whereby people who have assets that are increasing in value feel wealthier so spend more. Why the esteemed economists in charge of central banks seem incapable of understanding that having illiquid assets (such as houses) that are increasing in value doesn't make people who are income-dependent spend more is beyond me. Furthermore, NO amount of propping up asset prices will compensate for downward pressure on wages due to poor economic performance, or for benefit cuts and tax rises from austere fiscal policy. Nor will it compensate for reduction in the real incomes of people living on income from savings - which is certainly an effect of low interest rates and possibly also of QE. When ordinary people find their incomes being squeezed they cut spending, even if their houses are increasing in value. When ordinary people find their savings for their old age being eroded by low interest rates they save more, not less. Why these esteemed economists, not to mention the politicians designing fiscal policy, don't understand this is a mystery. Maybe they are all so wealthy that income-dependence is a foreign concept to them.

Myth 5: QE debases the currency. Whether this is seen as a positive effect depends on your viewpoint: devaluing the currency is supposed to help exports, but hard-money enthusiasts are appalled at the very idea of debasing the currency - they regard it as theft (I saw an article recently that described QE as the modern equivalent of coin-clipping). Actually there is very little evidence that QE has significant effects on the value of the currency - indeed as it doesn't raise inflation it is highly unlikely that it debases the currency. Though as a recent article at VOX pointed out, when a large part of a country's GDP is made up of global industry, devaluing the currency has little effect on exports, because exports are dependent on imports. The idea that devaluing the currency always helps exports is another of those economic myths, it seems.

When the transmission mechanisms of bank lending and corporate investment are not working properly, QE does not reach the wider economy in any particularly helpful way, as I've explained elsewhere. But people - especially economists and politicians - believe that somehow it does, or it will, eventually. The Expectations Fairy will wave her magic wand and all these things will come to be.

When central banks do QE, inflation expectations rise: this is shown by higher bond yields at the start of QE programmes, usually coupled with a rise in the price of gold. As the programme continues and inflation fails to appear, expectations moderate, bond yields fall back and the price of gold collapses.  We have seen this effect most recently in Japan: high inflation expectations at the start of the Bank of Japan's current QE programme have now fallen back to where they were in early April, the currency has recovered its value and asset prices have fallen. Not one QE programme has ever generated significant inflation. Not one. In fact no central bank in history has ever succeeded in deliberately creating inflation. And yet every time there is QE, inflation expectations rise. It's magical thinking.

Those who believe that QE achieves its effects through raising inflation point to index-linked bond spreads (which are a measure of inflation EXPECTATIONS) as evidence that QE works. But expectations and reality are not the same thing. Just because markets EXPECT inflation doesn't mean it is going to happen. Frankly, since the reason markets expect inflation is based on a misunderstanding of QE and its effects, it would be amazing if expectations did turn into reality.

Inflation expectations from active QE are illogical enough. But now we are seeing even greater illogicality. The Fed starts to talk about tapering off QE. And immediately we get markets pricing in interest rate rises - which would normally be associated with rising inflation. So it seems that talking about NOT doing QE can also raise inflation expectations. There seems to be some kind of belief that when the Fed stops doing QE all the excess reserves will leak out into the economy and cause inflation. Why, for goodness' sake? The banks are in no better shape than they were before (and reserves aren't "lent out" anyway). Yes, there could be a huge credit bubble - but as we saw in the mid-2000s, that can happen just as easily when there aren't excess reserves. And as corporates are not much more positive than they were before, and household incomes are no higher than they were before, and unemployment is still uncomfortably high, where on earth is this credit bubble and inflation going to come from? It's more magical thinking.

There is zero chance of domestically-generated inflation while wages are falling, contractionary fiscal policy is depressing real incomes, banks are not lending and corporates are failing to invest. Externally-driven inflation is possible, and we are of course seeing inflation in asset prices as a consequence of QE. But the core trend is disinflation in developed countries - I hesitate to say "deflation", since inflation is still above zero, but core inflation is on a downwards trend in nearly all developed countries. Some people think that the UK is an exception, but I disagree with this: UK CPI is currently distorted by rises in student fees and by above-inflation price rises in privatised utilities that could and should have been prevented by government. Strip out those, and the UK's core inflation rate is heading for the floor like everyone else's.

Belief in inflation caused by QE is therefore irrational. So is belief in inflation caused by NOT doing QE. In fact belief in ANY of the myths I describe above is irrational. But markets are responding to central bank signalling on the basis of those myths. More importantly, governments are constructing fiscal policy on the basis of those myths. And this is poisonous.

When banks aren't lending and corporates aren't borrowing to invest, QE does not affect the wider economy in any very helpful way: its effects if anything are contractionary, because of the hit to aggregate demand for some groups caused by the depression of interest rates on savings. But politicians construct fiscal policy in the belief that it does. Therefore - in their view - fiscal policy can be directly contractionary, because it will be offset by expansionary monetary policy. The UK's Chancellor has pursued an austere fiscal programme for the last three years, cutting both out-of-work and in-work benefits, raising taxes and - most unhelpful of all - cutting capital investment to the bone. He has done so (and continues to do so, despite concerns expressed by a number of institutions including the IMF) in the expectation that the Bank of England's loose monetary policy, including its large QE programme and other initiatives such as extended-term repo and Funding for Lending, will protect the economy from the contractionary effects of fiscal austerity. The Expectations Fairy will wave her magic wand and Gideon will get the economic recovery he desires despite his considerable efforts to prevent it......

Sadly the reality is different. QE and its relatives do not protect the wider economy from the effects of fiscal austerity. There has been a considerable hit to aggregate demand in the UK, firstly due to recession (which as the Institute for Fiscal Studies (IFS) notes has caused significant falls in nominal wages), and secondly due to ill-considered fiscal policy. I have to ask whether, in the absence of supposedly supportive monetary policy, the Chancellor might have adopted a more relaxed approach to fiscal consolidation.

The political situation in the US is different: there, fiscal tightening has occurred more because of political gridlock than deliberate policy. But the effects are much the same. And it is a real pity. The US was doing well: it was the one country that appeared to be getting the balance of monetary and fiscal policy about right - helped by a disintermediated banking system, which improves monetary policy transmission - and it was starting to recover. But then the payroll tax cuts were allowed to expire...and now there is the sequester....It remains to be seen whether the US's nascent recovery will survive this idiocy. Given the downwards path of US inflation and its stubbornly high unemployment, I am not hopeful.

The most idiotic policies of all have to be in Europe. Though they aren't doing QE. They are relying on everyone else's QE to stimulate the Eurozone economy, while screwing down aggregate demand all over the place. I'm not about to advocate QE in the Eurozone - the banking system is severely damaged, so I strongly suspect it would be either ineffective or actually contractionary. But fiscal austerity is doing immense and possibly permanent damage to some Eurozone countries. A better way of revitalising the Eurozone periphery really has to be found.

And then there is Abenomics.....I don't pretend to understand Japan, but it seems to me that to have any chance of success, monetary and fiscal policy must complement each other. All monetary stimulus is likely to do in a moribund and savings-dominant economy is blow up asset bubbles, which then of course burst spectacularly..... Not that I am necessarily suggesting fiscal stimulus either. The Japanese problems run deeper. Structural fiscal and social reforms are needed - but whether there is the political will to make such changes remains to be seen.

Central bank heads around the world have expressed concern about over-reliance on monetary policy alone to fix economic ills. Mervyn King commented that "there's a limit to what monetary policy can hope to achieve", a view echoed by Shirakawa, the former head of the Bank of Japan, in a speech in 2012. Bernanke, in his testimony to Congress's Joint Economic Committee in October 2011, observed that "Monetary policy can be a powerful tool, but it is not a panacea for the problems currently faced by the U.S. economy." And the ECB's Draghi, in an interview with the Financial Times in December 2011, bluntly remarked that "Monetary policy cannot do everything".

But Shirakawa has already been replaced with Kuroda, who has embarked on a massive QE programme: the Bank of England's Mervyn King is about to be replaced by Mark Carney, who is known to favour forward guidance (which amounts to greater reliance on the Expectations Fairy): and Bernanke's term as Fed chief will be up soon, though his replacement has yet to be named. And meanwhile governments in the US, UK and Europe continue their catastrophic fiscal consolidations while praying every day to the Expectations Fairy, who seems to have replaced the Confidence Fairy as the principal policy goddess.

Paul Johnson, Director of the IFS, complained in a recent presentation that the problem with recovery from the 2008 recession is that, unlike the deep recessions of the 1930s and 1980s, there is no clear vision. I disagree with this: I think there is a vision, but it is based upon mistaken economic ideas and is therefore doomed to fail. The 1930s recovery was led by massive housebuilding programmes, and the 1980s recovery by radical supply-side reforms. In contrast, the main feature of the years since 2008, after a brief period of fiscal stimulus early on, is fiscal consolidation coupled with what the UK's Chancellor terms "monetary activism". The last five years have seen what the FT describes as the "largest economic experiment in history". And the results are stagnant economies, falling real incomes, increasing insecurity and uncertainty for the majority of people (especially the young), and a catastrophic drop in both private and public sector investment in many developed countries. The "vision" is an illusion. That is why there is no lasting recovery.

The Expectations Fairy is no more real than the Confidence Fairy, the Inflation Monster or the Bond Vigilantes. It is time for all of them to be consigned to the realm of mythology, and for monetary and fiscal policy to be grounded firmly in reality and redirected towards achieving the best quality of life for ordinary people.

Related links:

Inflation, deflation and QE - Coppola Comment
There's a problem with the transmission - Coppola Comment
Why do large movements in exchange rates have small effects on international prices? - Amiti, Itskhoki & Konings (Vox)
The inflation predictions weren't just wrong, many of them are hurting people - PragCap
Stock markets and money creation - Euronomist Blog
Unwinding Quantitative Easing - Grenville (Vox)
Is the developed world going down Japan's Long and Winding Road? - Shirakawa
Bernanke kills Fed credibility and the Confidence Fairy in one shot - Naked Capitalism
Slaying the inflation monster - Coppola Comment
What can wages and unemployment tell us about the UK's productivity puzzle? - IFS
Britain has never been through a recession like this before - Paul Johnson, IFS

Wednesday, 19 June 2013

A broken model

My latest article at Pieria is on the contradiction at the heart of banking:

"In my article on the slow death of banks, I suggested that banks maintained on life support would eventually become redundant as new forms of financial intermediation took their place. This is the first of two posts in which I discuss what those new forms might look like.

The key change that we are seeing is what we might call "disintermediation" - flight of both lenders (depositors) and borrowers from traditional deposit-taking lenders to other types of financial intermediary, many of them specialists in particular aspects of financial management networked to other providers that do different things. This has already happened to a large extent in the US, but the UK and European models of banking are founded on universal banks and it is difficult for many people even to imagine what a banking system deconstructed into its component parts looks like. But when you break down the traditional banking model, it becomes apparent that there is a fundamental conflict at the heart of universal banking that makes it untenable as a business proposition in the current climate....."

The remainder of this article can be found here

Sunday, 16 June 2013

In the countries of the old

Germany is exporting people.

Well, Eurozone countries exporting people is hardly news. But Germany isn't exporting the same sort of people as other Eurozone countries. Other countries are exporting their young and their skilled. Germany is exporting its old.

Economically this makes complete sense. Germany has a lot of old people and a relative shortage of the young & skilled. So it imports young & skilled people and exports old ones. After all, exporting old people is surely better than killing them.

There's nothing new about this, of course. Britain has been exporting old people for years. Relatively well-off pensioners like to retire to the sun after years of tolerating British weather. The southern countries of Europe contain substantial populations of expatriate Brits, many of them retired and living on savings. The economic collapse of the southern European states has taken its toll on them, of course: many British retirees in Cyprus lost substantial amounts of money in the recent bank restructuring, and owners of Spanish properties have seen the value of their villas and apartments drop as property prices have collapsed. But most of the sun-seeking pensioners are still there and enjoying a comfortable - and increasingly cheap - retirement.

Christina Odone recently bewailed the end of her "dream" of a Mediterranean retirement. She was talking rubbish. Property prices around the Med have never been so low, and for British pensioners expecting to live on savings, moving to a country that is undergoing internal devaluation has to be a good bet. Savings go much further when prices are falling (though admittedly they haven't much, yet). And sunshine is still free and plentiful: the southern European economies might be depressed and miserable, but the weather is as cheerful as ever. A renewed inflow of well-off pensioners from Northern European countries could do wonders for the Southern European states. I foresee the growth of new industries dedicated to serving the needs of the elderly, and perhaps new retirement homes with sea views and golf courses could revitalise the construction industry. And as our expatriate pensioners get older, of course they will need care homes and personal care. The healthcare industry, too, could be revitalised - though expatriate pensioners would have to pay, of course. Health insurance would be essential.

Germany's pensioners don't seem to be quite so keen on sun as British ones, since they seem to be going to Eastern Europe more than Club Med. Perhaps that's because Eastern European countries are closer, or perhaps it's because of historic ties, or perhaps it's just that retirement homes and care workers are cheaper in Eastern European countries than in Greece. The way things are going, that will soon change.

Interestingly, some of the countries to which Britain and Germany export their old already have a demographic problem. They are exporting their young and skilled, leaving a residual population of old and sick - who are being joined by old and sick from elsewhere. They are becoming the countries of the old.

What will life be like in the countries of the old? I asked this question on twitter and was told "look at Devon". Or anywhere along the South Coast of England, really. Visit any English seaside town in  Kent or Sussex and the population looks distinctly grey. The landscape is peppered with bungalows (retired people like bungalows because there are no stairs) and retirement homes. There are lots of little shops, tea rooms and golf courses. There might even be the occasional art gallery. But not much in the way of industry. You see, elderly people don't want to start businesses, and they don't want to work long hours: if they work, they want it to be a little part-time job that is not too strenuous. And once the majority of your population is old, the motivation to create new industries, grow existing ones, create employment and revitalise the economy just isn't there any more. It is young people who have the urge to take over the world and reshape it to their liking. Most old people just want a quiet life.

So "quiet" is exactly what these places are like. Which is fine for a coastal town. And Devon has always been a pretty quiet place anyway apart from the occasional bout of smuggling.  But a whole country that is happy simply to potter along, providing a comfortable life for its elderly citizens but not aspiring to anything more vibrant? Whatever happened to "restoring competitiveness"? Surely a whole country should be looking for growth?

There seems to be no logical basis for this assumption. What is wrong with a country becoming a sleepy backwater, if its population is happy? And what is wrong with a country deciding that what it really does well is look after the old - and providing exactly the right calm, undemanding environment for people in their sunset years? Why shouldn't some countries simply opt to become enormous retirement homes?*

There is a snag, of course. Although there would, as I have mentioned already, be new industries popping up dedicated to serving the needs of the elderly, the elderly themselves wouldn't be working in those industries, generally. And these countries have a growing shortage of working-age people: after all, the reason why care homes are being built in these countries is that care workers are cheaper....if they can find better-paid work elsewhere they will of course migrate. And not just care workers. The bigger risk is to the more skilled services required by the elderly, particularly in healthcare. These countries might have to pay doctors and specialist nurses rather highly to get them to stay. Would the elderly population be wealthy enough to pay them?

Well, perhaps. The fact is that most wealth is held by the retired and those approaching retirement. The trouble is that the elderly have come to expect to hang on to their wealth and be supported by younger people through their taxes. But in countries where the majority of the population is elderly, clearly this is not possible. An alternative means of providing universal services such as healthcare would have to be found. I've mentioned health insurance already: but even the US, the world leader in insurance-dominated healthcare provision, recognises that geriatric services are the most expensive and difficult to insure. And not all elderly can afford health insurance anyway. So some form of taxation is going to be required to maintain universal healthcare and social support. As the majority of people would not be earning significantly, realistically this is going to involve taxing property and financial assets rather than earned income: indeed it might be necessary to give workers tax incentives to stop them leaving. So in the countries of the old, perhaps wealth taxation rather than income taxation will become the norm.

But supposing that despite tax incentives, there still aren't enough working-age people to look after all those elderly? After all, these countries don't just have a migration problem. They aren't breeding enough people to maintain their working-age population anyway. And as their population ages, the birth rate is bound to fall even more. In the countries of the old there will be few children.....

There is a solution, of course. Technology. "Telecare" and "telehealth" schemes are already being promoted in Britain as a solution to the shortage of carers: if robots can replace human carers, and computers can constantly monitor health and provide early warning of problems, there could be far less need for real people to work in the elderly care business, and costs could be much lower. The usual response to such a suggestion is "But the elderly need human interaction!". For me this confuses two things. Personal care and health care currently involve human beings, and have therefore for some elderly people become a substitute for real human contact. But they are not fundamentally about real human interaction at all. For me it seems entirely reasonable that personal care, particularly for the frail elderly who need 24-hour support, could be better done by robots than by humans who can be tired, distracted, embarrassed or grumpy. I have seen how tired my 80-year-old father has become now he is my mother's full-time carer: it seems to me that a few robots monitoring her and helping her would be a very good thing, not only for her but for him. The same applies to a good many routine healthcare functions: we are used to nurses monitoring long-term health problems, but there is no particular reason why this could not also be done by robots, though I think some human intervention would still be sensible (since robots would lack the intuitive skills that the best healthcare professionals have, which pick up problems that otherwise might have gone unnoticed).

Of course, a world of elderly care done entirely by robots, with elderly leading isolated lives and lacking human interaction could be horrible. I have no desire to see Romanian orphanages re-created in retirement homes. Realistically, human nature being what it is, there will be some horror stories.....but I hope that the majority of technological elder care will be better than that. And in the countries of the old, of course, the elderly don't have to be alone. One of the things that retired people have in abundance, unlike younger working people, is time. Yes, they may be busy - but they are busy with things they want to do, rather than with things that they have to do in order to earn a living and care for children. I would hope that one of the things that retired people would want to do is meet each other and support each other.  In the countries of the old, perhaps elderly isolation could become a thing of the past.

There are losses, of course. Migration of the old to other countries breaks the ties with their families and prevents them spending time with their grandchildren. Many will regret this. But then the same happens when the young migrate in search of work....after all, many never return. The fact is that our family ties are becoming progressively more attenuated. Even in my own family, all four of my parents' children left the place where we grew up, and we are now scattered all over the UK. And our children may end up scattered all over the world.

Yet the attenuation of family ties is mitigated by technology. Worldwide web applications allow people in different countries to communicate with each other by video link, send each other messages and share photographs instantaneously. International voice communications are still expensive but becoming cheaper, while data communication is cheap and abundant. And technology is improving - and becoming cheaper - all the time. In the countries of the old, the desire to keep in contact with distant families may encourage the elderly to start using the communications technology that they fear. And of course, as time goes on the elderly will not fear that technology anyway....after all, the currently middle-aged invented much of it.....

Technology both expands and shrinks our world, enabling people to live and work at considerable distances from each other while still remaining in close contact. And technology both depersonalises   and personalises: things that are now done by humans may be better done by robots, freeing up humans to do what we do much better than robots - interact with each other at a personal level through conversation and shared activity.

The countries of the old could, of course, be terrible. But they could also be wonderful places. Places that the working people of the world love to visit....quiet havens, where humans, technology and nature are in balance.

And if it doesn't work....for example, if we decide we would rather keep our old people with us, in pods in the back garden.....well, there is always another future for countries that no-one wants to live in. For where humans no longer want to be, the wild things find homes. Kipling called it "letting in the jungle". It is no shame for us to abandon a place. Nature has plans for our ruins.

Related links:

Germany "exporting" old and sick to foreign care homes - Guardian
The movement of people (and its consequences) - Coppola Comment
The creeping desert - Coppola Comment
The zero-sum trade in people - Coppola Comment
Kill the old - FT Alphaville (and the other editions of Kill the Old, too)
And so the sun goes down on my villa by the Mediterranean - Cristina Odone (Telegraph) (paywall)
Can technology fill the elderly care gap? - Telegraph (paywall)
High-tech devices to meet housing and care needs of old people - FT (paywall)
The Second Jungle Book - Kipling

* Yes, I know this is the theory of comparative advantage. And yes, I know it supposedly doesn't work where capital and labour are fully mobile. But in this case, I think it might. Time for a fresh look at Ricardo, perhaps!

Friday, 14 June 2013

Under the radar

This is the interesting story of how the Co-Op Bank got itself into a terrible mess without anyone noticing.

The Co-Op Bank was originally created by the Co-Operative Group, a mutually-owned retailer, primarily but not exclusively to serve the needs of its members. It painstakingly created a brand image around ethical banking and customer service, and aimed to occupy a small unique niche in the UK's high street retail banking landscape. To describe it as a "mutual" in the same way as a building society is misleading. It is not. It is a wholly-owned subsidiary of a mutual, and it is a bank. That is in theory a significant difference.

But in the run-up to the financial crisis, the differences between banks and building societies had become increasingly blurred. Many building societies had converted to banks - floating themselves on the financial markets - and in turn been swallowed up by larger banks. And many of the remaining building societies were acting much more like banks, borrowing large amounts of wholesale funds and doing commercial lending and commercial real estate lending in addition to their traditional residential mortgage lending. Even their mortgage lending was becoming riskier as they lent to less creditworthy borrowers at ever-higher loan-to-value percentages. Short of capital because of their mutual status - and a widespread belief at the time that capital wasn't important anyway - some of them became as highly-leveraged as banks.

In the fallout from the Lehman failure in 2008, followed by the nationalisation of RBS and Lloyds/HBOS, these highly-leveraged building societies got into serious difficulty.  One (Dunfermline Building Society) failed and was nationalised. Another (Kent Reliance) was bought by the private equity firm J.C. Flowers. Some were forcibly merged with others - the Nationwide, the UK's largest building society and now its fifth largest lender, swallowed three smaller building societies. And one - the Britannia building society - was bought by the much smaller Co-Op Bank in a deal reminiscent of the RBS takeover of NatWest.

At the time there were no public indications that the Britannia was in trouble. Indeed some people questioned the merger because it didn't seem a particularly good deal for the Britannia's members and staff. Whether, behind the scenes, government did know that the Britannia was in trouble and forced through a merger as part of its strategy of avoiding building society sector meltdown, we may never know. What is clear is that the Co-Op's CEO, Peter Marks, and the Britannia's CEO Neville Richardson, were very happy with the deal. The Co-Op Bank's CEO lost his job in the merger and was replaced with Richardson, who ran the enlarged Co-Op Bank for the next two years. He eventually left in a management shakeout in 2011.

And it was in 2011 that the true state of the Britannia's finances started to emerge. In the 2011 accounts, the Co-Op put £1.45bn of the loans it had inherited from the Britannia on "watchlist". This meant that they were not actually in default but were considered likely to default at some time in the future. And sure enough, in 2012 the Co-Op was forced to account for £0.5bn of new impairments on its ex-Britannia loan portfolio as corporate loan defaults doubled. This, along with provisions for claims on mis-sold PPI insurance, wiped out the Co-Op Bank's entire profits.

In November 2012 the Bank of England's Financial Policy Committee - flexing its newly-acquired regulatory muscle - announced that a number of UK banks were short of capital. And in February 2013 it emerged that the Co-Op bank was one of them. At that time the extent of the capital shortfall was unclear but it was thought to be of the order of £1bn. Since then the estimates have risen and the hole is now around £1.8bn. Because of the mutual status of the Co-Op Bank's parent, plugging this hole was never going to be easy. Mutuals are owned by their members, not by external shareholders, so raising new capital via the financial markets is nigh on impossible to do (though subordinated debt - convertible to equity - can be raised). Consequently, mutuals usually rely on organic growth, cost-cutting and/or divestments to improve their capital position.

Despite concerns about the Co-Op Bank's weak balance sheet, negotiations with Lloyds Banking Group for acquisition of the Verde branches continued. Once again, it seemed, the Co-Op Bank was intent on swallowing something much larger. Acquiring the Verde branches would have trebled its balance sheet size and placed it among the UK's largest lenders. The Verde branches were better capitalised than the Co-Op Bank and came with their own version of the LBG IT platform which the Co-Op Bank would have to adopt. Because of this the Co-Op Bank scrapped its own IT upgrade programme, writing off £1.5bn of sunk cost.

In April 2013, to everyone's consternation, the Co-Op Group decided to pull out of the Verde deal. The Co-Op's statement was terse:
The Co-operative Group announces that it has withdrawn from the process currently being run by Lloyds Banking Group for the disposal of branch assets (“Verde”) after The Co-operative Group and The Co-operative Bank plc Boards decided that it was not in the best interests of the Group’s members to proceed further at this time. This decision reflects the impact of the current economic environment, the worsened outlook for economic growth and the increasing regulatory requirements on the financial services sector in general.
The Co-Op's attempt to blame the failure of the deal on the weak economy and unhelpful regulatory stance impressed no-one. Most commentary at the time was along the lines of "wonder what's really behind this"? And the real reason quickly became apparent. On 10th May 2013 the ratings agency Moody's abruptly downgraded the Co-Op Bank's credit rating to junk, citing poor capitalisation and anticipated further losses on its ex-Britannia loan portfolio against which it had insufficient loan provisions.

The departure of the Co-Op Bank's CEO, Barry Tootell, immediately after the downgrade was no surprise to anyone. But it left the Co-Op Bank leaderless at a time when the Co-Op Group was also about to undergo a change of leadership, with Euan Sutherland from Kingfisher Group taking over from Peter Marks.

The Co-Op's difficulty raising capital was the subject of considerable debate. In its statement, Moody's observed that the Co-Op Group's subordinated debt holders might have to take losses. Predictably, the value of those bonds promptly crashed. But Moody's suggestion that the Co-Op Bank might get taxpayer support was promptly squashed by both the Co-Op Group and by the government. Divestment of parts of the business was the focus of most debate. Many people pointed out that the Group was unlikely to raise the needed capital by selling its insurance businesses and would have to look at other divestments. Robert Peston suggested that the Group might even consider selling its bank, because otherwise it might have to divest key parts of its retail business. Frankly this was ridiculous. The present climate is hardly a good one for selling a seriously damaged bank stuffed full of toxic loans: the Co-Op Group would have had to retain a considerable proportion of those loans in order to make the bank remotely attractive to a buyer. And the Co-Op Bank's unusual position in the UK's market made a sale problematic: customers were not likely to be happy with a private equity takeover like Kent Reliance, selling to a high street bank would probably fall foul of competition rules, and the larger mutuals were already suffering from a bad case of indigestion after the last round of takeovers and mergers.

Fortunately the new Co-Op Group's CEO moved swiftly to squash any ideas of a sale, appointing Niall Booker as CEO of the Bank and deputy CEO of the Group. Booker's entire career had been spent in retail and corporate banking, and his most recent job had been restructuring HSBC's North American division after the subprime crisis. Clearly he had experience of rescuing damaged banks. And this was followed up with the appointment of Richard Pym as part-time Chairman of Co-Op Bank in addition to his role as chairman of UKAR, the holding company that manages the run-down of the residual Bradford & Bingley and Northern Rock bad assets. To me these appointments could not make it clearer that the Co-Op intends to keep its bank. And this view is supported by Co-Op statements to date.

So where does this leave us? And how is it that the Co-Op Bank's dreadful situation slipped under the radar? I have a number of thoughts on this.
  • In the aftermath of the financial crisis there was a prevalent belief that the crisis was caused by, firstly, investment banks and secondly, big banks. Small banks and specialist lenders were widely  believed, both by customers and by people who should have known better, to be "safe". And the Government fostered this illusion, perhaps because admitting that the UK's entire high street banking sector was dangerously leveraged and could fail at any moment would have spooked customers and caused the very disaster they feared. The Co-Op was a small bank and the Britannia a building society. Both, therefore, fitted into the prevailing model that big banks = bad and small banks (and building societies) = good. We now know that this model is flawed: all banks, big and small, including those (like building societies) that aren't called banks but do bank-like things, were damaged in the financial crisis. Arguably, the public's belief that building societies were safer than banks saved that sector from total collapse, because many people moved their money from banks to building societies at that time.
  • The Co-Op Bank's "ethical" image created a mistaken belief among its customer base that it would act responsibly. But ethical banking and responsible banking are not the same thing. I was less than impressed by the Co-Op Group's 2012 review, where they presented the operating profit as the headline result for Co-Op Bank and downplayed the fact that the bank had made a loss of £674m due to impairments and provisioning. If RBS - a much bigger bank and one already known to be seriously damaged - had done the same with its 2012 accounts there would have been hell to pay. RBS correctly reported its loss of £5bn as its headline figure, and it took some digging through the accounts to discover a pretty healthy operating profit that had been wiped out by fair value revaluation of its own debt, provisioning against mis-selling claims, and restructuring costs. In contrast, the Co-Op Group headlined the bank's operating profit with - in my opinion - the clear intention of misleading members and investors into believing that it was in better shape than it actually was. This to me is not ethical behaviour. I hope that the new board adopts a more open, honest and transparent approach to financial reporting in future.
  • Moody's deserves censure for its failure to downgrade the Co-Op Bank earlier. A 6-notch downgrade at one go smacks of being asleep at the wheel. No institution falls apart as dramatically as that without warning: there should have been an interim downgrade in 2012 after production of the 2011 accounts, in which the watchlist loans were declared. Moody's did look at the Co-Op Bank in 2012 as part of its general review of UK banks at that time - but bizarrely it actually UPGRADED the Co-Op Bank's standalone rating. I can only conclude it did not examine the 2011 accounts properly.
  • There are to my mind serious questions over the conduct of both Peter Marks and Neville Richardson. We now know that the Britannia had a huge toxic loan portfolio that would have caused it to fail had the Co-Op merger not gone ahead. But that doesn't appear to have been disclosed at the time - or if it was, Peter Marks must have decided to go ahead with the merger anyway. There are questions that need to be answered about the nature and extent of due diligence prior to the merger going ahead. And why did the Co-Op make no attempt to integrate its Britannia acquisition until after Richardson's departure? In fact it didn't even seem to know what was in the loan book. Call me cynical, but I can't help wondering if Richardson knew perfectly well that the Britannia loan portfolio was a disaster and concealed it from the Co-Op Group management. If that is true, then his behaviour is worse: Marks' megalomania made him foolish, but Richardson's behaviour is verging on criminal. I would like to see a proper inquiry into the circumstances of the Britannia merger and Richardson's subsequent tenure as Co-Op CEO. Unfortunately, as it seems the Co-Op Bank will not be bailed out by taxpayers, I am unlikely to get my wish.
  • There are also questions about the conduct of regulators, politicians and Lloyds Banking Group itself in relation to the Verde deal. The true state of the Co-Op Bank's finances was a matter of public record. But the Chancellor was an ardent supporter of the deal, hailing the prospect of an enlarged Co-Op Bank as a challenge to the dominance of the big banks on the high street. And the FSA, though not a supporter, did not act to prevent it. Lloyds, too, appeared totally bemused by the Co-Op's decision to pull out. It does not seem as if much in the way of due diligence - or even basic financial analysis - was going on anywhere. The Treasury Select Committee has now decided to investigate the circumstances of the failure of the Verde deal, a decision I welcome.  

It is all too easy for customers, regulators and politicians to be lulled into a false sense of security by bank management that is determined to hide the real state of affairs. The Co-Op Bank to my mind has systematically deceived everybody. It is unfortunate that a bank which commands such loyalty among its customer base should now have such a tarnished image. I hope that the new team cleans up its act. Because if it does not, it does not deserve the support of its customers. And the UK's banking sector would be the poorer for the loss of such a distinctive brand.

But there is also a wider issue here. This is far from being the first time that a bank has been brought to its knees by acquisitions, smiled upon by regulators and encouraged by politicians, that have turned out to be toxic. Indeed the Co-Op is only the latest in a very sorry list that includes LBG's acquisition of HBOS, RBS's acquisition of ABN AMRO, Barclays' acquisition of part of Lehman and a whole swathe of unwise and toxic mergers among banks in other countries such as Spain. To my mind it is not acceptable that distressed financial firms are rescued at politicians' behest by other financial firms while regulators turn a blind eye and laws are changed or waived to enable deals to go ahead - but that is what happened both in the headline-grabbing bank meltdown of 2008 and in the subsequent building society collapse of 2009. And as RBS, LBG and now the Co-Op show us, we still end up paying. They may have been prevented from collapsing, but they aren't able to support the economy. RBS and LBG have been restricting new lending, particularly to businesses, for the last five years. And the Co-Op Bank has now closed its doors to new business customers. The damage done by the Britannia merger will reverberate for years to come as both the Co-Op Bank and its parent are forced to restructure and shrink in order to close the bank's capital hole. We really have to find a way of dealing with systemic failures that doesn't involve wrecking healthy banks.

UPDATE - 17th June 2013
It has now been announced that the Co-Op bank will bail in its subordinated debt holders in order to raise part of its capital requirement, now confirmed by the Prudential Regulation Authority as £1.5bn. This will mean that it will no longer be a wholly-owned subsidiary of a mutual. It does not, as some people have suggested, in any way change the mutual status of the Co-Op Group itself, and as the proportion of external shareholders will be small, the Co-Op Group will continue to have a controlling interest. It does mean that holders of the PIBS inherited from the Britannia and the Co-Ops own preference shares, some of whom are very small investors, will take big losses and - perhaps even more importantly for some of them - will lose certainty of income, since the Co-Op Bank is unlikely to issue much in the way of dividends to shareholders until its balance sheet is in better shape and both PIBS and pref shares provide guaranteed interest income.

The remainder of the capital requirement will be met by divestments, primarily of the insurance lines, and by an injection of capital from Co-Op Group itself if necessary. There are no proposals to bail in depositors Cyprus-style.

The Co-Op Bank has already been split internally into good bank and bad bank, like the other damaged banks RBS and Lloyds, and the bad bank will be progressively wound down over time. However, this does mean that the Co-Op Bank will continue to suffer losses on its loan book for some time to come. It is unlikely therefore to be able to do much in the way of risky lending (such as to SMEs) for quite a while, which is unfortunately not helpful to the economy.

The proposed bail-in of bondholders is likely to trigger a further downgrade of the Co-Op Bank's credit rating, since it amounts to a partial default.

Related links:

Moody's statement on Co-Op Bank downgrade
Co-Op woes embarrass regulators and Treasury - Robert Peston
What does Moody's downgrade of Co-Op Bank mean? - Robert Peston
Treasury Committee to inquire into "Project Verde" - HM Government
Co-Op Group 2012 Annual Review
Co-Op Bank 2012 Financial Statements
Co-Op capital hole threatens Lloyds deal - FT (paywall)
Feelings not mutual - Big Issue In The North

Co-Op Bank's stock market future - Peston

Sunday, 9 June 2013

The zero-sum trade in people

The problem that I identified for the Eurozone in my previous posts is already well-documented on a smaller scale within countries - migration from rural areas to cities. And as various people have pointed out, we are also seeing it in the US and UK, which are currency unions. It's also a particularly worrying feature of the Baltic states and other Eastern European members of the European Union. In short, it's not just a problem peculiar to the Eurozone.

The theory behind free movement of labour runs as follows. Consider countries within an economic union  where there are no legal barriers to the movement of people. When a country undergoes internal devaluation which causes wages to fall and increases unemployment, the result is migration of the young, able and skilled to other countries where there is more work and higher wages. We can regard this as export of labour, and the countries receiving the migrants can be said to be importing labour. 

We assume that importing countries are attracting labour that they need, and exporting countries are shedding labour that they don't need. Migration of labour from low-wage to high-wage areas is an essential part of the internal devaluation process. For any given job, a worker will wish to receive a high wage, while an employer will wish to pay a low wage. The market-clearing price is somewhere between the two depending on their relative power: where there is a shortage of labour the price will be nearer to the worker's demand, while a glut of labour will enable employers to control the price. (Yes, I know this is a bit simplistic!) Clearly, therefore, the low-wage country has more labour than it needs, and the high-wage country does't have enough. If workers can move from low-wage to high-wage countries, therefore, the supply of labour increases in the high-wage country, putting downwards pressure on labour costs, and decreases in the low-wage country, putting upwards pressure on labour costs. And concurrently, when the cost of moving is lower than the benefit to be gained by relocating in a low-wage country, firms will move into that country. As the demand for labour falls in the high-wage country due to firms relocating, wages fall, and conversely as more firms relocate in low-wage country, wages rise. Eventually the two countries reach equilibrium, wages stabilise, labour stops migrating and firms stop relocating. 

That's the theory. Like all theories, it assumes a lot of things. Firstly, it assumes that for both workers and firms, price is the only consideration. That isn't the case: for example, for firms, availability of natural resources may be a key consideration in deciding whether or not to relocate. And workers may be put off migrating by language barriers or family ties. Also, local regulations may discourage firms from relocating and/or workers from migrating: free movement of both capital and labour may exist in theory but not necessarily in practice. 

More importantly, it assumes that the labour supply is homogenous and that there are no GENERAL shortages of skills. But this is not the case. There are general shortages of some skills - and it is always the people with scarce skills who leave first. Migration of people with skills that are generally in short supply can continue until the supply in the exporting country is completely exhausted, regardless of whether local firms need those skills: local firms are simply not going to be able to pay the wages available in the receiving country. This is because high wages usually mean a richer economy: people spend more, which generates income and profits for firms. Firms that are located in a depressed economy simply cannot match the wages paid by firms in more prosperous areas. Eventually this either forces them out of business or encourages them to move TO higher-wage areas in search of skills - exactly the opposite of the effect that forcing down wages is supposed to have on firms's behaviour.  

The usual political response to the "brain drain" of people with scarce skills away from less prosperous countries is to demand that the education system delivers workers with skills that are in short supply. But this is impossible. If industry cannot recruit people with the skills it needs because of competition from richer countries, how on earth is the education system supposed to recruit teachers with those skills? In fact the drain of skilled workers away from low-wage areas affects the education system as much as industry. Teachers can migrate too.

Along with skills shortages, there may be skills gluts which can make it almost impossible for redundant workers to find jobs that use their skills. For example, when the reason for a particular area suffering a serious fall in employment is that a major industry has collapsed, there are likely to be a large number of people with skills that are no longer needed in that area. Their chances of getting equivalent work elsewhere are vanishingly small: often the only work they can hope for is unskilled, poorly-paid and highly insecure. If the costs of migrating are high, these workers may not be able to afford to move. This is what happened in the UK in the 1980s and 1990s: despite the advice from a Government minister at the time to "get on your bike", the reality was that there were few jobs anywhere within cycling distance. Skills gluts perversely increase demand for unskilled jobs, as those who are unable to find work appropriate to their skills take unskilled jobs: this forces out the genuinely unskilled, who can find it almost impossible to find ANY work. Skills gluts are largely responsible for the prevalence of unskilled people among the long-term unemployed in many countries. 

The third assumption is that the labour supply remains constant - in other words, that as fast as people migrate, other people replace them. Now, in countries with a birth rate at or above replacement level, this is true. But if the country that is losing its young and skilled ALSO has a falling birth rate, it is in serious trouble. As the young and skilled leave and are not replaced, the age profile of the population increases, the proportion of sick and disabled increases and the proportion of unskilled to skilled increases. This amounts to a form of hysteresis. The attractiveness of the remaining labour force to firms declines as both skills and productivity fall: consequently firms are less likely to relocate to the country, which removes the brake on migration that relocation of firms would be expected to create (assuming of course that if jobs are available and wages equivalent, people will prefer to stay put). Migration would therefore continue until the only people left are those who either can't or won't leave. This problem is more immediate in those countries like Portugal that have had a falling birth rate for some years: but even if a country doesn't have a falling birth rate at the time that the young start to leave, by the time the migration has continued for a few years it will have.

Someone suggested that the loss of the young & skilled would be offset by immigration, so the population profile wouldn't change that much and firms would still relocate. I find this bizarre. Why would skilled immigrants come to a country from which people with the same skills were leaving? Surely they, too, would go to the higher-wage countries?

The problem of internal devaluation where there are skills shortages, skills gluts, labour market rigidities and a falling birth rate looks insoluble. But I don't think it is. I'd turn this round and look at it another way. I recently wrote an article comparing free workers with slaves, in which I noted that slaves are capital assets - firms have to pay for them upfront - whereas cheap, unskilled and insecure labour incurs no capital cost so can be a much cheaper alternative to a slave, and this is not necessarily beneficial to the free Roman times, people used to sell themselves into slavery, if the alternative was starvation. The migration problem within economic unions is actually a variation of the same thing, but it is perhaps more immediately comprehensible to view it as a balance of trade problem. 

I noted above that the country from which people are migrating can be regarded as exporting labour, while the country receiving the migrants is importing labour. And the receiving country unquestionably benefits. Immigrants plug skills gaps, benefiting its industries: immigrants spend their wages, benefiting economic activity: immigrants pay tax, benefiting public finances. Now, if the migrants were unemployed in their country of origin, then in the short term their departure is also beneficial to the fiscal finances in the exporting country. But skilled migrants leaving in search of higher wages may not be unemployed in their country of origin, and the gaps they leave may be hard to fill: and over time, migration of the young - even unemployed ones - creates a demographic problem for the exporting country. On balance, I would say that the importing country generally does better out of the people trade than the exporting one does. Considerably better. In fact, if the export of people means that the exporting country goes into terminal decline due to loss of the young & skilled and hysteresis in the remaining population, then I would regard the trade in people as zero-sum. The importing country benefits at the expense of the exporting one.  

Which invites the question - why is this export free? After all, imports usually have to be paid for. Exporting countries receive inflows of money in payment for the goods and services they provide - unless the export is people. Well, not quite though - if we export footballers, we get paid for them. And in days gone by, the trade in people could be extremely lucrative (though it's fair to say it probably benefited the intermediaries most). But we've abolished slavery now.....
And I'm certainly not advocating bringing back slavery! But there is a strong argument to my mind that countries that export labour as part of an internal devaluation programme within an economic union should receive payment from the importing countries. The labour they export for nothing contributes to the GDP and the tax revenue of the importing countries. It seems only right and proper that they should share in that benefit. 

Now, before anyone suggests this is not a "real" trade imbalance, let me remind you that the cost of supporting an ageing and poorly skilled population when GDP is falling means increasing levels of public debt....just as would be the case if this were a real trade imbalance. The loss of productive labour is disastrous for the fiscal finances. 

To my mind the normal riposte to this - that migrant workers will of course send money back to their families - is inadequate. Migrants make those payments out of taxed income: the exporting country does not share in that tax payment.  And as I've noted previously, if migrants believe that the state will support the old and frail, they may not send much back at all. Voluntary remittance is no substitute for a system of payments to compensate exporting countries for the loss of productive labour. Or, if you like, to reverse the implicit fiscal transfers from low-wage countries to high-wage ones that are the inevitable consequence of economic migration.

Of course, our rich young migrants might send money back to their countries of origin - to buy themselves retirement homes for their old age. I suppose this would stimulate the construction industry and increase house prices. I'm not entirely clear in what way raising house prices for an impoverished population is supposed to stimulate the economy. It is more likely, surely. to make it even harder for these people to afford basic necessities such as a roof over their heads. Nor is it reasonable to assume, as some have, that the inexorable march of technology will somehow make an ageing and increasingly unproductive workforce more affordable for states that are already highly indebted and whose GDP is falling. On the contrary, it seems more likely that technological improvements - which require capital investment that these countries are unlikely to be able to afford - will simply pass them by.

So where does this leave us? Most currency unions have some kind of system of fiscal transfers, though these are usually flawed and inadequate, not least because the importing countries/states/cities resent sending money back to exporters. But the European Union is not a currency union. Yet it still needs somehow to staunch the flow of people from countries such as the Baltic states if they are to avoid going into a death spiral. 

There are, of course, real issues here concerning the rights of the individual. It would be very easy to suggest that where there is no fiscal union, states should be free to prevent people leaving if they so wish. But this could result in a Kafkaesque nightmare, where people that aren't needed in the workforce can leave but others can't.....Though I find myself asking why states should be free to prevent certain people coming IN if they so please, but not free to prevent certain people LEAVING? To its credit, the European Union - in theory at least - does not allow member states to prevent people coming in, either.  But this doesn't help the states that are slowly bleeding to death.

I am forced to the conclusion that free movement of people within any economic union requires a commitment from all members of that union to ensure economic prosperity for all the people within the union, even if that means giving up cherished ideas of fiscal independence. Fiscal transfers to countries that are suffering the consequences of large-scale emigration are not "aid" or "bailouts". They are simply a recognition by more prosperous states that their prosperity is not entirely due to their own efforts. It is simply not acceptable for some states within a union to obtain competitive advantage by bleeding other states of productive capital and labour. For what kind of "economic union" is it if the prosperity of some is bought at the expense of the impoverishment of others? 

Related links:

The creeping desert - Coppola Comment
Ubi solitudinem faciunt, pacem appellant - Jonathan Portes (NIESR)
The shortage of Bulgarians inside Bulgaria - Edward Hugh (Economonitor)
The financialisation of labour - Frances Coppola (Pieria)