Friday, 30 August 2013

The "ethical" Co-Op

The Co-Op Group is proud of its "ethical" values. From its website:

our ethical values

Openness  –  nobody’s perfect, and we won’t hide it when we’re not

Honesty  –  we are honest about what we do and the way we do it

Social responsibility  –  we encourage people to take responsibility for their own community, and work together to improve it

Caring for others  –  we regularly fund charities and local community groups from the profits of our businesses. 

But the Co-Op has a problem. It owns a dud bank. The Co-Op Bank acquired a load of toxic debt in its acquisition of the Britannia building society. The Co-Op Group deliberately concealed the true state of its bank's finances from customers and investors for over 2 years after that takeover. Even when it was forced to disclose in 2012, it attempted to distract attention by focusing on operating profit instead of total losses. It is hard to see this as consistent with the Co-Op Group's "ethical values" of "openness" and "honesty". But to my mind the current behaviour of the Co-Op Group is worse.

Yesterday, the Co-Op Group announced a loss of £559m in the first half of 2013 (versus a full-year profit of £18m in 2012). Although the performance of the supermarket arm was less than inspiring, the Group loss really had only one cause - the whopping pre-tax loss of £709m turned in by its banking subsidiary. The Co-Op Bank was forced to write off bad debts of £500m, accept costs (mainly IT-related) of £148m arising from the failure of the Verde deal earlier this year, and increase provisions for mis-selling of PPI, interest rate hedges and credit and identity fraud insurance.

The Co-Op Bank is seriously short of capital and, despite the writeoff, still has substantial bad debts. The Prudential Regulatory Authority (PRA) insists that the Co-Op Bank has to find £1.5bn of new equity capital, but the path to achieving this is fraught with difficulty. The Co-Op Group itself is only prepared to provide £1bn of new capital to its subsidiary: it wants the rest to come from a bail-in of subordinated debt holders, made up of institutional investors, hedge funds and about 15,000 ordinary people, many of them pensioners for whom these bonds form part of their pension savings. Coupon payments on subordinated debt have already been suspended, and it is anticipated that the principal haircut could be as much as 60%. Not surprisingly, the market value of these investments has collapsed.

Predictably, the subordinated debt holders are fighting back. And I think they have a case. Let me explain why.

The Co-Op Group, which is mutually owned (i.e. owned by its customers), is the 100% shareholder in the Co-Op Bank, which is a limited company.  Subordinated debt holders (Co-Op Bank preference shares and PIBS inherited from Britannia building society) are senior to equity shareholders. In insolvency (which is in effect the situation for the Co-Op Bank, since a regulatory capital shortfall means it does not have enough capital to continue trading), equity shareholdings are wiped before any type of debt holder, even a subordinated one, takes a hit. But it seems the Co-Op Group thinks normal insolvency rules shouldn't apply. It wants its liability limited and debt holders to share its pain so it doesn't have to take heavy losses.

Ripping off bond holders to protect the conglomerate's assets from forced sale is not in any way ethical behaviour. And nor is the rest of the Co-Op Group's strategy for ensuring that it doesn't have to bear full responsibility for rescuing its bank. It has tried to persuade the PRA to water down the capital requirements without success: the PRA is so far unmoved. But the Co-Op Group's management has other weapons.

From the Guardian today:
"Richard Pym, the bank chairman, said that without new capital the banking unit "will not be a going concern"."
Well, yes, we know that. If they can't raise enough capital the PRA will close the bank down. But it gets better. According to Philip Inman, 
"The Co-op group's new chief executive, Euan Sutherland, said there was no plan B." 
"The only alternative to meeting regulatory requirements to fill a £1.5bn shortfall in the bank's reserves would be a government takeover similar to the bailout of Northern Rock in 2008."
Sounds like a Plan B to me.  Actually it sounds like a gun to the Government's head. Or rather, a gun held to the heads of small subordinated debt holders in order to force the Government to act. Either the Government buys shares in the bank or the little people get hurt. My Ford namesake couldn't have put it better.   
Indeed, Inman expresses it similarly:
"Should the Co-op fail to secure a rescue of its banking division it will fall to the government to step in."
So it appears the Co-Op Group is using political pressure to attempt to coerce the Government into bailing out the Co-Op bank. It is absolutely essential that the Government resists, even if the price is little people getting hurt. Bailing out the Co-Op Bank would set an extremely dangerous precedent.
You see, the Government bailing out the subsidiary of a retailer is the same as bailing out the retailer itself. Suppose that the Co-Op Group's pharmacies subsidiary incurred such heavy losses that it threatened the solvency of the Co-Op Group itself. Would we expect the Government to buy shares in the pharmacies? I hope we would not. But if the subsidiary is a bank in trouble, apparently the Government should "step in" to protect the Group from insolvency. The Co-Op Group is not the only retailer with a banking subsidiary. Tesco, Sainsbury's, Marks & Spencer, Harrods - all have banking subsidiaries, wholly or partly owned. Should Government stand ready to bail out these, too? And doesn't this make retailers with banking subsidiaries "too big to fail"?
It is the Co-Op Group's sole responsibility to rescue its bank. Attempting to bail in subordinated debt holders is reprehensible and quite possibly illegal. Pressuring the PRA into watering down capital requirements - well, any bank can play that game: the PRA should not give in under any circumstances, and to its credit shows no signs of doing so at the moment. And using the plight of subordinated debt holders and the prospect of job losses as a political lever to get a Government bailout is frankly disgraceful. Especially as according to Philip Inman (op. cit) the Co-Op Group intends to pay bonuses to senior management.
Why, I want to know, does anyone think this outfit is in any way "ethical"? It is behaving no better than any other private sector retail bank and in some ways worse. Isn't it time we stopped believing the marketing "hype"?

Related links:
Under the radar - Coppola Comment
Is the Co-Op bank worth saving? - Harry Wilson, Telegraph
The Co-Op pays for past sins - Robert Peston, BBC
Job losses "inevitable", says Co-Op boss - Manchester Evening News

Tuesday, 27 August 2013

The Stalinist Bank of England

On BBC Radio 4 on Saturday 24th August, Simon Rose from Save Our Savers said this:
"You can actually see the real price of money in other places. Now they’ve decided that it should just be 0.5%, but if you look at the peer-to-peer market for instance, which matches off people who want to borrow against people who want to lend money, well there the rate’s sort of 5% roughly. That is people coming together saying “I’m going to lend some money, what will you pay me”, or “I need to borrow money, how much does it cost”. That is free market capitalism operating, not the sort of crony capitalism with the sort of Stalinist control of the price of money that we get from the Bank of England. People never seem to challenge the idea that the Bank of England should set the price of money, but I find it very bizarre that they do, particularly when we’re seeing the cost of their decisions." 
("How You Pay For The City", starting at 4min 20sec. I've transcribed it because BBC iplayer links are not available in all countries and are only up for a short time).  

I really can't let this pass. I don't think Rose has the slightest idea what he is talking about.......

The rest of this post can be read here.

Sunday, 25 August 2013

The law of rotten apples

Yichuan Wang has a lovely post in which he uses apples to explain how goods markets work in a money economy. It is of course a deliberate over-simplification of a general equilibrium, and I am perhaps being a trifle unfair to Yichuan in picking it to bits. But I couldn't resist.

Yichuan defines a recession as a "general glut of goods that aren't consumed", and goes on to suggest that this is because some people have apples but choose not to eat them. Indeed they do. Apples don't fall from the sky as Yichuan suggests, they grow on trees. Trees produce lots of fruit all at once, creating a glut, then none for the rest of the year, creating a shortage. So the market for apples is seasonal (for the purposes of this post I'm going to pretend that there is no international shipment of fruit to smooth out seasonal variation). Furthermore, in some years apple trees produce more fruit than usual, and in other years they produce less, largely due to weather conditions. So the production of apples is highly variable. The glut of apples in September is not because people are saving up to buy apples for Christmas, it is because there are more apples then than at any other time of year. It has nothing to do with people's intertemporal preferences, and everything to do with the desire of apple trees to reproduce.

Let's imagine an apple farm. The farmer's capital stock is his trees, which are a long-term investment since an apple tree doesn't produce fruit in its first few years. They require fertilizer in the Spring, they may need watering in the summer if the weather is dry and in the winter they need pruning. And in the autumn, of course, the apples produced by the mature trees in the orchard need harvesting. All of this creates year-round employment for the farmer and his staff. But the farmer's only income comes from the fruit produced by the trees, and as I've already noted, that is both seasonal and variable. He has something of a cash flow problem. I shall return to this shortly.

So let's imagine we have an amazingly good harvest of apples because of unusually favourable weather conditions. The apple farmer employs extra staff to pick apples, pack them (carefully) and take them to market. And to start with, it works well. Apples are popular: they come in different varieties, so there is something to suit everyone; they don't need to be put in the fridge; and they are handy for children's lunch boxes. So everyone buys apples. There is a boom in apple sales, our farmer makes lots of money, he pays all his staff and has money left over to buy a new Mercedes.

But the fruit just keeps on coming. By the end of September, everyone has had their fill of apples. No-one wants to eat an apple ever again. The price in the local market has crashed, but there are still piles of unsold apples. Traders start to refuse further supplies. But the apple trees are still laden.

So our farmer employs more people to take the apples to markets further away. He incurs transport costs, reducing his profits. But he manages to sell his apples - for a while. Then people further away become sick of apples too. Markets stop accepting his apples. So he sends his staff even further afield..... I'm sure you can see where this is going. Eventually the cost of transporting the apples to distant markets exceeds the returns from apple sales. There is a limit to how far you can afford to transport goods in saturated markets.

Now our farmer has a real problem. He can't sell his apples. In fact he can't even give them away. But he isn't beaten yet. He employs several local housewives to bake apple pies and apple cakes. Suddenly people start buying again: even people who now hate the very smell of fresh apples will eat apple pie. By creating new products that use apples as a raw material, he has found a solution to his over-production of apples. But he soon discovers that he has to keep on creating new products to keep people interested, or sales tail off. Fortunately the tendency of apple trees to over-produce is a well-known phenomenon, so the housewives' cookery books are full of recipes using apples.

But our farmer still has a problem. He still can't sell his entire apple production without causing the price to fall through the floor. To keep the price up, he needs to create an artificial shortage of apple products. So he starts to limit the number of apples he picks. The rest fall from the trees. The law of rotten apples is that when you can't sell apples in any form at a price that justifies the cost of picking them, you leave them to rot.

Yichuan says that people who don't want apples today will save their money so they can buy apples at some point in the future. But apples don't keep. Well, they do for a while - but they eventually shrivel. So when our consumers want apples, they may find that none are available. But you can preserve apples in the form of cider. So suppose our farmer buys a cider press and makes cider with his apples. Suddenly he has a year-round market for an apple product. He has not only solved the problem of seasonal over-production, he has solved the cash flow problem I mentioned earlier. He has enabled people to delay consumption of apples well into the future. Though even in this market, you can over-produce....there is only so much cider that people can drink before the local police start taking an interest.

So did our glut of apples cause a recession, with associated unemployment? Well, no. Actually it created additional employment, and it forced our farmer to innovate. The price of apples did fall, of course - we had deflation - but our farmer supported the price by creating new products, and as a last resort by restricting production. And if over-production became a yearly problem even with a cider press, he would diversify. Recessions happen when people cut consumption despite price falls and innovation. If people refused to buy apples in any form at any price, our farmer would go out of business and his staff would lose their jobs.

You will note that nowhere in this discourse has money been involved. This is not a pure barter economy - the farmer is paid in money - but people's decision not to eat apples has nothing to do with money. They simply cannot consume any more apples. Deflation is not necessarily a monetary phenomenon.

Now let's look at the other side of this - crop failure. Suppose our trees are attacked by a pest that causes most of the fruit to drop from the apple trees long before it is ripe. Now we have a problem. Instead of a glut of apples, we have a serious shortage. Let's assume for the purposes of this post that there is no substitute, so apples are an essential good. The farmer can charge whatever he likes for the few apples he manages to bring to market. And he does. Apples become more valuable than gold. Though of course people don't usually pay for apples in gold, they pay in money. So we have inflation - in fact we have hyperinflation. And note that creating more money does not solve the problem: all it does is enable prices to rise even more. No doubt money creation will be blamed for this, but the real cause is the failure of production. Inflation is not necessarily a monetary phenomenon.

Nor does our apple scarcity create employment. There are fewer apples to pick, fewer to transport, the farmer has no need to send apples to more distant markets since he can sell his entire production locally, he has no need to create apple products and his cider press remains idle. Because he can charge very high prices for apples he makes lots of money, so he still solves his cash flow problem even without making cider. Inflation benefits producers of essential goods at the expense of consumers - and also at the expense of producers of NON-essential goods as people are forced to devote more of their income to essentials. High inflation in essential goods can cause serious deflation and rising unemployment in the rest of the economy.

If you substitute "potato" or "corn" for apple, this situation should look more realistic. Failure of a staple crop is disastrous. In monetary terms, it causes very high inflation. But the real cost is people's lives. Hyperinflation in the price of essential goods causes starvation.

So which is worse, inflation or deflation? From the point of view of the consumers of apples, inflation is terrible and deflation is desirable. But from the farmer's point of view, deflation is a nightmare and inflation is beneficial. Remember that Yichuan defined both apples and money as "wealth"? If the price of apples falls to the point where it is not worth the farmer's while to pick them, his "wealth" is worthless. But if apples become so scarce that the farmer can charge whatever he likes for them, consumers' "wealth" - which we assume is in the form of money - becomes worthless. In the end neither gains, because worthless money is of no use to anyone, and apples that no-one wants to eat will be left to rot. Mild inflation can encourage producers to produce more and consumers to buy more in the expectation of higher prices: mild deflation can encourage innovation and diversification. But at their extremes, both inflation and deflation destroy wealth. And at their very worst, they destroy lives.

UPDATE: Euronomist points out that consumers may suffer when there is deflation as their wages may be cut or they may lose their jobs. And producers of essential goods (as in this example) can also suffer when production is falling and inflation rising, because they have to choose between consuming and selling. Nothing is ever simple in economics.

Related links:

A primer on general equilibrium, or Why Money Matters - Synthenomics
There is no such thing as fiscal policy - Market Monetarist

If anyone really wants me to translate this into econo-speak, I will. But I hope that the real economists out there will appreciate my brand of everyday economics. 

Wednesday, 21 August 2013

Lender, beware

"It is time that people took responsibility for managing their own money, and stopped expecting banks to do it for them."

My new post at Pieria talks about the nature of the relationship between banks and depositors:
"I recently wrote a post with Euronomist in which we suggested that depositors should be explicitly charged for deposit insurance, rather than insurance being implictly provided by the state or covered by a levy on financial institutions.
"This did not go down too well in some quarters. There were a number of comments along the lines of "why should I pay for the risks that banks take?" and "banks should look after their customers' money". Underlying these remarks was a fundamentally wrong understanding of the nature of the relationship between modern banks and their depositors. And this wrong understanding is the main source of anger towards banks for putting depositors' money at risk, and anger towards banks for giving rubbish returns to savers. Most depositors believe that the job of banks is to keep their money safe. Many depositors also believe that they are entitled to a share in the returns that banks make from "lending their money out".  In short, depositors expect banks to invest their money responsibly to generate good returns, and absorb the risk of those investments so that depositors do not suffer losses. But that is not how banks see it. And the law is on the side of banks.......

Read more here.

Monday, 19 August 2013

The investment problem

Since the 2008 financial crisis, business investment has fallen considerably. This chart from ONS shows how gross fixed capital formation collapsed in 2007-8 and has remained flat ever since:

The associated commentary from ONS notes that the main falls have been in "dwellings", and in plant & machinery:
The revised data suggest that GFCF fell sharply following the onset of the economic downturn, as businesses revised priorities in the face of a reduction in domestic and international demand, and as conditions in credit markets tightened. The downturn in the housing market also had a substantial impact on investment in Dwellings, which fell from £15.8bn in Q1 2008 before the economic downturn, to just £10.9bn in Q3 2009. Investment in Plant & Machinery also fell, while investment in Other Buildings & Structures and Intangible Fixed Assets remained relatively static during this period.
 Basically, businesses just don't seem to be investing much. I'm particularly amused by the drop in "transport": it seems company cars are out of fashion.

But the sharp fall in business investment in 2008 is not quite what it seems. Here is ONS's chart of business investment since 1998:

ONS explain the 2005 spike as being due to the reclassification of British Nuclear Fuels Ltd. But they don't discuss the other evident spike - the one in 2007-8. The bubble-like nature of business investment at that time is painfully evident in this chart. We now know that some of that was the overblown housing market, and much of the rest was the even more overblown financial services industry. The financial services industry is now more than 13% smaller than it was in 2008 before the crash. 

But there's another interesting feature of this chart, and that's the long-term trend. I've recharted it from the ONS data and fitted a linear trend line to it:

Yes, that's right - a secular downwards trend in business investment for (at least) the last 15 years. ONS says the total fall over that period is about 10%. So the 33% fall since 2008 isn't quite what it seems. The 2008 peak was way above the long-term trend, and all that seems to have happened is that investment has fallen back to trend. In which case moaning about lack of private investment, and keeping interest rates on the floor in the hope that the private sector will spend some more money, just might be a bit futile (though that is not the only reason for keeping interest rates low, I hasten to add!).

I can think of several reasons why business investment might be in long-term decline. Falling cost of technology, for example. Availability of abundant cheap labour in developing countries making capital investment in (expensive) advanced technology uneconomic. Relative decline in manufacturing and growth of services. But if anyone has any more ideas, or objects to these, please do say so in the comments.

I wouldn't like to assume that falling business investment is necessarily a problem. Remember that the ONS's business investment chart records the amount of capital invested, but says nothing at all about the return on that capital. If the cost of capital is falling, then business investment could actually be increasing.The only part of "gross fixed capital formation" whose price we know was rising prior to 2008 then suffered a fall was property. The prices of plant and machinery could well be falling through the floor. And if they are, that might go some way towards explaining why ONS's figures for plant and machinery investment show falls since 2008. When prices are falling, companies defer spending decisions in the hope of further price falls. Deflation in plant and machinery prices, coupled with poor demand and an uncertain economic outlook, might act as a fairly serious deterrent to corporate capital investment.

But it is curious. I wonder how it relates to this:

Historical Data Chart

Maybe it's nothing, would appear that the 10-year gilt yield has also been in decline for the last 15 years. The 10-year gilt yield is used as a benchmark rate for all sorts of lending - and much corporate capital investment is debt-financed. Coincidence, much?

Oh, and just in passing, that gilt yield chart is another nail in the coffin of the idea that central banks control interest rates. The 10-year gilt yield was already in long-term decline when the financial crisis struck, and there's no evidence from that chart that either the base rate cut or QE had all that much effect. Fitting an imaginary trend line by eye, I would say that yields were above trend (i.e. too high) in 2007-8 and again (slightly) in 2010-11, then a bit too low in 2012 and are now about where they should be. In which case we perhaps also have about as much business investment as can reasonably be expected.

I may have read too much into the gilt chart - I admit its relationship with business investment is somewhat tenuous. But the trend on the business investment chart is striking. If business investment is actually at a level consistent with its long-term trend and with the path of long-term interest rates, then further incentives to invest are not likely to be effective. This does not bode well for an economy that still has unemployment at nearly 8%, falling real wages and substantial under-employment. I fear that if we want to deal with these, the necessary investment must come from the public sector, not the private sector.


Pedro Serodio sent me this on twitter:

Seems the UK's investment decline has been going on for 50 years, not 15. Any suggestions as to why this might be? Shire Blogger suggested that maybe too much investment is going into property. Diversion of investment overseas seems possible too, given the UK's status as a large financial centre. Suggestions welcome.

Related reading:

Economic Review, August 2013 - ONS

Thursday, 15 August 2013

A new approach to deposit insurance

Joint post with Euronomist.

Recent developments in the Eurozone, specifically Cyprus where the first EU-dictated bail-in of bank depositors took place, brought to light an important issue which had been hiding in the shadows: the flawed nature of current deposit insurance schemes.

Some advocate abolition of deposit insurance because it distorts incentives for banks and savers. But others believe that it is necessary to avert panic every time a bank nears its inevitable death. Yet although the two ends of the spectrum appear to disagree on the specifics of their proposals they both agree that the deposit insurance scheme needs to change if we want the future of both the financial sector and the wider economy be brighter than the present. In this article we present and develop a scheme which will address the need of depositors for safety without creating distorted incentives, while simultaneously helping to ensure the viability and stability of the banking sector in time of crisis.

A flawed scheme

The main purpose of the deposit insurance scheme is to safeguard depositors in the event of a financial institution’s bankruptcy. In addition, by guaranteeing the funds in a person’s account it prevents panic from spreading in the economy, with horrified citizens rushing to their banks so that they can withdraw their hard-earned money. Nevertheless, it has disadvantages. When banks do not have to fear for their customers’ funds they may indulge in risky speculative deals which destabilize both the bank itself and the economy in general. This is not pure speculation:  in one of the first deposit insurance schemes, bank failures actually increased due to increased liquidity and terrible choice of investments (notably real estate).

While the success of the deposit insurance scheme mainly depends on the good reputation and financial strength of the state backing it, bank failures can be costly to the economy. The cost to the state of large bank insolvency can be billions of currency. This amount has to be generated either by increasing taxation or by additional Government borrowing, which in turn will require increased taxation or reduced government spending which, depending on the state of the economy, may result in a severe recession. Governments that have currency-issuing capability may alternatively opt for printing money, which means that the taxpayer will essentially be paying for the bank’s failure through reduction of real buying power. In the financial crisis of 2008, taxpayers paid for the mistakes of bankers. The direction of discussion ever since has been around how to limit the consequences of bank failure for taxpayers by forcing bank creditors to bear more of the cost. The bail-in of Cyprus depositors and the haircut suffered by depositors in the UK’s Southsea Bank failure were such attempts, but the price that may be paid for this is greater likelihood of damaging large deposit bank runs and/or disintermediation of the banking system, introducing even more funding fragility for banks and increasing their reliance on the central bank.

Yet abolishing deposit insurance could have terrible consequences. In the event of a major bank failure, with thousands of people losing their money, a mass bank run with disastrous effects on liquidity and asset prices would be likely. In the absence of deposit insurance a single bank failure may escalate into a systemic crisis, followed by a major recession with money becoming a scarce resource. This has already happened before, in 1930, when, in the US, 744 banks failed in the first 10 months of the year, with more than 9,000 failures in the subsequent decade. Even though we have progressed in many respects since the 1930’s, convincing someone that his or her money is safe in the bank when a friend of theirs has lost everything in a bank failure would be difficult. Anyway, the depositor may be right: the repercussions of one bank’s failure may cause another to go bankrupt even if no withdrawal of funds is made.

Although the deposit insurance scheme bears the name “insurance”, it does not resemble normal insurance policies. When someone wants to insure a house or an automobile an amount of money – the premium - has to be paid in advance in order for the insurance company to assume the risk of compensating the owner if something goes wrong. This, however, is not the case with deposit insurance: the depositor does not have to pay any amount of money as a premium for having the deposited funds insured by the state. Instead, in European countries, the state imposes a levy on banks to cover the cost of anticipated deposit insurance claims. Bank depositors unwittingly pay for this through lower interest rates on their savings: but the burden is also shared by borrowers through higher interest rates, employees through lower wages and shareholders through smaller dividends. And in a systemic crisis, the insurance fund is never enough anyway. The UK’s FSCS was topped-up by state funding in 2008 and has had to repay that through additional levies on the financial institutions that did not fail – hardly an encouragement of sound financial management.

Nor is the state necessarily obliged to honour deposit insurance. Iceland refused to honour deposit insurance for foreign depositors in its banks. The UK and the Netherlands challenged this in the EFTA court and lost their case. At present, no European sovereign is obliged to honour deposit insurance in a systemic banking failure. Fortunately for the stability of the European banking system, this is not widely known: but the first Cyprus bail-in proposal, which would have partially bailed-in small depositors who were supposedly protected by deposit insurance, depended on it.

A new proposal

Our proposal is that depositors should explicitly pay a premium for the benefit of having the money insured. We limit this to interest-bearing accounts, because we consider non-interest-bearing (transaction) accounts to be a social good which should be protected by government without further cost to citizens. We propose therefore that transaction accounts would continue to be insured without explicit charge, but would no longer bear interest: insurance for transaction accounts would continue to be paid by bank levy.

Some might believe that insurance for interest-bearing accounts could be entirely provided by the private sector. But recent events suggest otherwise: when AIG became the largest underwriter for sub-prime mortgage CDS’s, nobody thought it would face trouble; the company was (and still is) one of the biggest insurers in the world. Yet, when the whole charade collapsed in 2008, AIG would have gone down with it if the US government had not bailed it out. Even insurance agencies which focus on extreme catastrophes like hurricanes, earthquakes, etc. would have trouble repaying the billions needed when it came to a systemic bank failure. In addition, private insurers would have an incentive to keep that money employed in projects so it could receive a high rate of return to make up for the costs of running the business: this runs the risk that in the event of a major bank failure the funds would be tied up in other investments with no immediate means of realising them, which would bring the insurer down with the bank and force the state either to repay the insured depositors itself or let them take the fall. Neither of these options is a good one, and we would thus prefer the state to assume the role of the insurer itself. 

When we talk about the state, we usually mean government. But in this case we think the role of the insurer should fall to the Central Bank. There are two reasons for this:
  •  The Central bank is (theoretically) independent of political agendas and has more access to classified banking data than any other agency. This would allow the Central Bank to perform a better analysis of the probability of an institution failing, thus making the insurance premiums commensurate with the realities of the banking industry.
  •  The ability of the Central Bank to create unlimited liquidity would enable depositors to access their money in a systemic crisis without causing fire sales of assets and price crashes setting off a rapid deflationary spiral as happened in 2008.
Since in many countries the Central Bank is also responsible for prudential regulation of the banking industry, care would be needed to ensure clear separation of function to avoid conflict of interest. This would be best achieved by maintaining the insurance fund as a separate legal entity with its own management under the Central Bank umbrella.

Transparency would also be important. The fund’s management should be obliged to make public every quarter the size of the fund, the amount of deposits it insures and provide an annual report signifying the events of the past year. In addition, the fund’s financial statements should be audited by independent auditors.

As this fund would be literally a pool of money, the following questions arise:
  1.  How should this money be invested so that it remains safe and is available when required?
  2. What should happen if the accumulated amount of insurance premium became disproportionately large in relation to the value of deposits to be covered?
Regarding the first question, it would be extremely unwise for deposit insurance funds to be placed with the banks whose deposits it was intended to insure, or with other institutions that depend on those banks. Therefore it would probably be sensible for the fund to be restricted to investments in safe assets such as high-quality government debt. Central banks already have lists of acceptable collateral for funding and these would be a good start point for acceptable investments for the insurance fund, although the insurance fund’s list might need to be more restricted. In any event, there should be an explicit commitment from the Central Bank to top up the insurance fund should it suffer losses due to asset failure, including the failure of its own government’s debt. For Eurozone countries whose central banks are unable to create money, it might be wise to use the ESM to top up deposit insurance funds, with the ECB standing as insurer-of-last-resort in the event of the ESM being unable to cover the losses. Ensuring the safety of insured depositors and the stability of the banking system is more important than political arguments over whether or not this would constitute monetization of state debt.

Regarding the second question, it is of course necessary for an insurance fund to have a safety margin in excess of expected claims. This would be invested in safe assets in the same way as the rest of the fund. However, if the excess became too great it could be returned to depositors either as a reduction in future premium payments or as a tax credit. The premium is, after all, effectively an hypothecated tax on savings.

We are now reaching the most important part of the analysis: who should receive deposit insurance, how much that insurance should cost and what the insurance limits should be. The key points are:
  •  Transaction accounts would be fully insured for no charge, but would no longer bear interest.
  •  All interest-bearing deposit accounts would be subject to an insurance premium which would take the form of a marginal reduction in the interest rate.
  •  On interest-bearing accounts, customers will have the option of refusing deposit insurance, in which case they will receive a higher rate of interest but will not be protected in the event of bank failure.
  •  There would be no insurance limit on interest-bearing accounts. However, we would recommend a tiered insurance premium structure: deposit insurance premiums should be higher for larger amounts and higher interest rates, to reflect the increased risk they represent and discourage routine placing of large sums in insured deposit accounts as an alternative to other safe assets.
  • There would also be no insurance limit on non-interest-bearing transaction accounts. However, there would be a time limit on the account, beyond which funds in excess of a certain amount (possibly the current deposit insurance limit) would be automatically swept into an interest-bearing account.
To ensure transparency and avoid mis-selling, account opening procedures will need to be amended. On account opening, the bank should offer the depositor three options:
  •   A non-insured account with an interest rate of X
  • An insured account with an interest rate of say (1-0.075)*X
  • An account without an interest rate (transaction account)
The costs, benefits and risks of all three should be clearly explained. Additionally, it should not be possible to open a non-interest-bearing transaction account without also opening an interest-bearing account, either insured or uninsured.

Under the present deposit insurance scheme, the amounts insured are limited. There may be a view that insurance limits should continue under this scheme too. But we think the risk of destabilising runs on large deposits is sufficiently great for this not to be a wise decision. The imposition of capital controls in Cyprus to prevent large deposit runs has been economically damaging and we think it would be better to remove the incentive for large deposits to run. We suggest therefore that there should be no limit to the funds that can be insured in interest-bearing deposit accounts, but that higher insurance premiums should be charged for larger deposits to encourage investors to place funds elsewhere. Unlimited insurance on interest-bearing deposit accounts (for a price) would still give large investors an alternative to government debt as a safe asset, which in a market panic could help to ensure the stability of the banking system.

In the case of accounts with no interest rates (principally transaction accounts) we also propose that the amount insured should be unlimited. This is because the current EUR100,000 limit in the European deposit guarantee scheme is far too low for many corporate and some individual depositors. Corporate payrolls, for example, can be far in excess of the EUR100,000 limit and are in no sense “savings” – they are people’s wages. People buying and selling houses may also have funds far in excess of the limit going through transaction accounts, and would face homelessness if these funds were lost due to a bank failure while they were in transit. The US’s FDIC limit is $250,000, but even this is insufficient for some depositors. Loss of funds “in transit” can have terrible social and economic consequences, and we think therefore that deposit insurance should cover them regardless of the amount. We therefore propose, instead of an insurance limit, a time limit for funds in excess of the current deposit insurance limits. Funds in excess of this amount may remain in an insured non-interest-bearing account for e.g. 60 days, after which they would automatically be “swept” into an interest-bearing demand deposit account and insurance would be charged unless the depositor has opted out of insurance on that account.

Concern has been expressed that unlimited insurance would lead to abuse of transaction accounts by large investors seeking safety. However, we think this concern is unfounded. Under normal circumstances, a large investor would prefer interest-bearing safe assets over a non-interest-bearing insured account. Only under exceptional circumstances – say a debt crisis where safe assets were no longer “safe” – would an investor forego interest for safety. And under these exceptional circumstances, it would be sensible to allow them to do this in order to head off destabilising runs and ensure the stability of the financial system.

In conclusion....

We would like to remind the reader that the current state of the deposit insurance scheme is far from ideal. We have proposed an alternative which we believe would protect depositors from losses and prevent destabilizing bank runs without causing moral hazard for banks and the prospect of unsupportable losses for the state.

How we got here:
Sowing the wind – Coppola Comment
Sham guarantee – Coppola Comment
Anatomy of a bank run – Coppola Comment
Deposit insurance schemes: proposals and comments – Euronomist Blog 

This post can also be found at Pieria.

Wednesday, 14 August 2013

The illusory housing recovery

Apparently there is life in the UK housing market. According to ONS, UK house prices increased by 3.1% in the 12 months to June 2013, up from a 2.9% increase in the 12 months to May 2013.

Predictably, vested interests like estate agents, surveyors and developers are crowing. The director of the Royal Institute of Chartered Surveyors, Peter Bolton King, claims the housing market is "on the road to recovery".

I wish I could be so positive. But this "recovery" is not quite what it seems.

Here's a lovely chart from the ONS report:

No, you aren't seeing things. That is indeed an 8.1% increase in house prices in London. Even the rest of the South East doesn't run it close - though more on the South East's supposed recovery shortly. So what on earth is going on in London?

This might have something to do with it:

The Mayor of London's property report (from which this graph is taken) says that "average private sector rents in London are around twice the national average". But mortgage interest rates have fallen, at least partly due to Government intervention. Consequently, buy-to-let purchases are increasing at a rate of knots as existing and would-be landlords jump on what looks like a gravy train. Across the country, the Council for Mortgage Lenders says that buy-to-let mortgages have increased by 19% in volume and 31% in value in the last year. Much of that increase has happened in London. Although....BBC Newsnight, in its special report on buy-to-let as an alternative investment for disgruntled savers getting rubbish returns on their deposits, focused on Southend. The South East's 2.9% increase is also partly due to increasing buy-to-let lending, it seeems.

But buy-to-let is not the only - or even the principal - cause of booming house prices in London. According to one estate agent surveyed by This is Money, 85% of prime property sales in London are to foreigners. And a report by the FT in July 2013 said that a record 82% of property sales were to overseas residents. Not immigrants - but people who live overseas and have no intention of moving to the UK. Many of these houses are bought simply as investments and remain empty once purchased.

So there is actually very little recovery in the London residential housing market. The 8.1% increase in house prices is due to inflows of hot money from overseas residents looking for safe investments (helped by the relative weakness of sterling), and a booming buy-to-let market due to high rents.

But what about the rest of the country? Well, there seems to be something of a North-South divide. Apart from London, house prices in the South East, West Midlands, Wales and the East are all growing at 2-3%. But elsewhere they are stagnant or falling.

As I noted above, it appears that buy-to-let has something to do with the rising prices in the South East. And it may also be influencing price rises in other regions too. However, it does appear that the Government's schemes to encourage first-time buyers are working. This chart shows the rate of increase of house prices by type of buyer. The evident spike at the beginning of April 2013 coincides with the extension of the Help to Buy mortgage deposit guarantee scheme to existing properties as well as new builds. There is little doubt that this enabled first-time buyers to borrow more and therefore buy more expensive property.

Would someone please explain to me why it is such a great idea for the Government to encourage first-time buyers to take on bigger mortgages at higher loan-to-value at a time when interest rates are at unprecedentedly low levels? The current low mortgage rates are by no means fixed in stone: Funding for Lending has reduced rates for borrowers, but there is no guarantee that they will remain low. Has no-one learned from the American housing crash of 2007, in which people with adjustable-rate mortgages suddenly found that the rate adjusted by far more than they could afford, and were forced into default? Where are the wage increases that support this increase in debt? This chart from the ONS shows that the rate of growth of wages is well below CPI, currently 2.8%, so real wages are actually falling:

I can't see how such expansion of lending, and the resulting rise in house prices, is remotely sustainable. The economy is not growing, real wages are falling and living costs are rising. I really don't buy the argument that rising house prices will somehow bootstrap the entire economy into sustainable growth. I'm in agreement with Moneyweek's editor-in-chief, Merryn Somerset Webb. Speaking to the BBC, she said:
"I tend to think rising house prices are terrible news. It's an entirely unproductive part of the economy," 
To my mind, unless economic activity increases and real wages start to rise, the housing market is bound to crash in due course, and the banks with it. Such rises in house prices are simply not sustainable in a flat economy with falling real wages. Encouraging house price rises under such circumstances is unbelievably stupid economic policy. But then this isn't about economics, really.

The supposed "housing recovery" is due to three things:
  • purchases of prime real estate in London by foreigners who have no intention of living in the UK but are attracted by the weakness of sterling 
  • expansion of the buy-to-let market by investors desperate to find some yield in a very low interest rate environment
  • Government schemes to encourage people to buy houses on the assumption that interest rates will remain low for a long time to come.
Really it is entirely illusory. It has been deliberately engineered by a Chancellor whose sole aim is to ensure outright victory for his party in the 2015 general election. By pushing up house prices, he ensures the support of his core vote: by encouraging people to buy and sell property, even at unsustainable prices, he hopes he can can claim to be the Chancellor who "got the economy moving". No wonder the loud complaints from savers (many of whom are Conservative voters) about low interest rates appear to be falling on deaf ears. No wonder Carney (with the tacit approval of the Chancellor) issued "forward guidance" that interest rates will remain on the floor until 2016. Markets were beginning to price in rate rises, but no way can rates be allowed to rise until after the 2015 election. The Conservative party's victory depends on it.

As my regular readers know, I am determinedly politically non-aligned, so what I am going to say now will probably shock a lot of people. Osborne's behaviour both angers and frightens me. He is playing brinkmanship with the UK economy to achieve political ends. Nothing he does makes much sense from an economic point of view - which is why the flagship Help to Buy scheme has been universally panned, even by his own department and by people from his own party. But if you view his actions as entirely determined by his desire to secure a Conservative victory in 2015, it all makes perfect sense. He is dangerous.

Related links:

House price inflation continues to rise, says ONS - BBC News
UK House Price Index, June 2013 - ONS (pdf)
UK Consumer Price Inflation, June 2013 - ONS
London Housing Market Report - Greater London Authority
Buy-to-let lending tops £5bn in second quarter - CML
London for Sale! - This Is Money
Foreign investors behind record 82% of London property activity - FT (paywall)
Funding for Lending Scheme - Bank of England
Help to Buy Scheme - HM Government
Help to Buy Scheme: how it works - Guardian
Funding for Lending scheme viewed as mixed success - FT (paywall)
BBC Newsnight Friday 09/08/13 (video)

And it seems Simon Wren-Lewis agrees with me. (h/t Tim Harford and Tim Coldwell)

Sunday, 11 August 2013

Should the UK be more like Germany?

My latest article at Pieria discusses the UK 's trade performance in relation to Germany's.

"The UK's trade performance is dismal. The UK imports too much, doesn't export enough and runs a massive trade deficit. We are told we should all tighten our belts, buy British and work harder for less pay so that the UK can become an export-led economy with a lovely trade surplus, just like Germany. After all, that's the way to economic success, isn't it?"

Read on.......

Thursday, 8 August 2013

Carney and the death of unreasonable expectations

Yesterday, Mark Carney, the new Governor of the Bank of England, announced that there would be no rise in the Bank of England's base rate until unemployment (currently about 8%) is below 7%. At its current rate of fall, this wouldn't be expected until the back end of 2016. So if there is no improvement in the UK economy, UK interest rates are expected to remain very low for the next three years.

Predictably, there was a storm of outrage from savers and their representatives. This tweet is typical:

The idea that very low interest rates is "stealing" from savers is based on savers' expectations that: their capital will be protected from inflation. UK CPI is indeed running above the interest rates on most forms of savings, so savers are losing money as the purchasing power of their capital is eroded. But is it reasonable for savers to expect that the purchasing power of their capital should be preserved, or even increased, over time?

I don't think it is. But to explain why, I need first to explain what inflation is.

In an economy where the money supply adjusts to economic needs*, the inflation rate is a measure of the excess of aggregate demand over aggregate supply. It is healthy for an economy to have a small excess of demand over supply, as it gives an incentive to producers to produce and consumers to consume: persistent disinflation is economically damaging, as the tendency of consumers to delay spending in the expectation that prices will fall reduces sales, depresses business income and can drive producers out of business, causing fire sales and layoffs, leading to more delayed consumption and further price falls - it is all too easy to see how this can become a deflationary spiral. But a positive inflation rate, even a small one, means that savers suffer erosion of their capital over time. The interest rate on savings is a compensation for that loss.

In an open economy, the inflation rate is not always a good indicator of domestic aggregate demand. It may indicate the extent to which demand for goods (especially commodities) in the international marketplace exceeds supply, and that affects the cost of domestic production, driving up prices to consumers especially for essential goods such as food and energy. It may also indicate fiscal tightening, as rises in indirect taxes such as VAT increase headline CPI. And it may indicate that the international purchasing power of the currency is reduced (devaluation): sterling has devalued by about 25% since 2008. The inflation rate for consumers can therefore be higher than the actual productive capability of the economy. This is what is happening in the UK at the moment. Inflation is running above target, at about 2.9%, mainly due to price rises in imported goods (notably fuel), which are partly due to the low pound (larger image here):

Historical Data Chart

But the economy is growing at much less than this. Estimates vary as to the GDP growth rate at the moment but the last figure from ONS was 0.6%, which is just above the Bank of England's base interest rate, and economic growth has been hovering around zero for the last three years (larger image here):

Historical Data Chart

This is dismal. It is stagnation, not growth.

So why shouldn't savers be protected from the capital erosion caused by inflation?

 There are three categories of savers:
  • those who are saving for something that they expect to buy in the future
  • those who are storing up funds as insurance against loss of income
  • those who have more money than they need for consumption at the moment.
The first of these is a short-term savings need which is not materially affected by inflation unless it is very high. Short-term savings like these never command high interest rates and there is no particular reason for this to change, as the whole point is to spend the money fairly soon: if consumption is deferred by too long the natural price rise of the desired good or service, or even obsolescence, is a bigger risk than erosion of capital. While "saving up" for something you want is a good discipline and one which perhaps our society needs to re-learn, there is still a role for debt in bringing forward consumption where saving up simply takes far too long.

The second of these involves the largest number of people, though perhaps not the largest amounts of money. These are people saving for retirement and for unexpected future expenses. The savings are long-term - often 30 years or more. Now, I've noted already that it is healthy for an economy to have a small positive inflation rate. Given that for savers to have a return on their savings AT ALL requires a healthy economy, I don't see any reason for savers to expect to be compensated for the natural erosion of purchasing power that exists in a healthy economy. It's a necessary cost of saving. They just need to save a bit more to allow for it, that's all. Alternatively, if people feel strongly that they should be compensated for inflation, index-linked investment products are available for longer-term savings. They will pay a bit more for them, but their capital will be protected.

But what if inflation is higher than the amount needed to keep the economy humming along? Shouldn't savers expect to be compensated for this? Not necessarily. We would normally expect that higher inflation would cause interest rates to rise, which compensates savers for the greater loss of purchasing power. Raising interest rates increases the cost of finance for businesses and households, which causes them to defer business investment and consumer spending. In an economy that is experiencing inflationary pressures due to fast growth, this is a good thing: but for an economy that is stagnating, businesses deferring investment and consumers deferring spending is disastrous. This is why "stagflation" - the combination of high inflation and a stagnating economy - is so poisonous. Raising interest rates to choke off inflation destroys desperately-needed economic activity, delaying recovery. And stagflation accurately describes the current state of the UK economy.

The desire of savers to be compensated for loss of purchasing power is understandable but wrong. The risk-free rate of return is related to the growth rate of the economy, not the inflation rate. Savers have no right whatsoever to expect to receive a higher rate of return than the ability of the economy to generate that return. If the economy is growing at 0.6%, the risk-free rate of return cannot be any higher than that. If savers want higher returns they have to put their money at risk.

At the moment savers have unreasonable expectations. They expect to have returns on their savings far above the current level of economic growth, and they also expect to have their savings protected from loss. But the only way savers can have risk-free returns above the growth rate of the economy is by others - most likely government - taking on debt. It's rent-seeking, frankly. I find it extremely odd that the same people who clamour for higher interest rates for savers are also those who shriek about the deficit and warn about the dangers of high levels of government debt. They clearly don't understand that higher interest rates for savers in the present climate means a larger government deficit because of increased cost of interest service on risk-free investments (government bonds). Or if they do understand, they don't care.

And while I'm at it, I shall criticise those who want higher interest rates on bank deposits, too. Bank funding costs have a direct bearing on the cost of finance to the wider economy. Interest rates for SMEs are already cripplingly high despite bank funding rates being low. If interest rates on deposits rise, what do you think will happen to interest rates for the small businesses that we so desperately need to encourage? Really there is a logic fail here. In calling for higher interest rates, savers are effectively demanding that there should be no recovery. And in killing off such unreasonable expectations, Carney is doing us all a favour.

What we need is for savers to take risks with their money. Now there is a bit of a problem here, I agree. The "reach for yield" in capital markets caused by low interest rates and excess liquidity is leading investors to switch into all manner of high-risk investments, such as sub-Saharan government debt. I regard this as excessively risky to the point of imprudence and it is NOT what I mean by savers "risking their money", any more than I would recommend that they blow it all at Aintree or on the casinos in Las Vegas. When I say I want savers to "risk their money", I mean productive investment in their own economy for a future return - for example, in the small businesses I mentioned above. I would like to see government, including local government, issuing bonds to savers to finance long-term infrastructure and energy projects. I would like to see expansion in local investment banks and credit unions providing finance to small businesses. And I'm very encouraged by the growth of internet providers such as Funding Circle and CrowdCube bringing together small investors and businesses who need finance, crowdsourcing both debt and equity.

Obviously there are some people who need their savings to be as close to risk-free as possible - "rainy day" savings for example. I think there is a role for government in providing genuinely risk-free savings opportunities for those who need them, and recycling the funds into the economy via a State Investment Bank. But these savings, and other protected savings such as insured bank deposit accounts, should only bear the risk-free interest rate.

I've heard it argued that interest rates on savings should actually be above inflation because savers expect to be compensated for their decision to defer consumption into the future. I'm afraid I think this is utterly bonkers.Whatever the reason for saving, it gives current benefits (in econospeak, "utility") as well as future ones. If your reason for saving is to avoid paying the interest on debt, then there is satisfaction from knowing that the interest cost is avoided - and there may also be a moral satisfaction from having "saved up" for something. If your reason for saving is to insure against future loss of income, you will derive comfort from knowing that your future is secure. And if your reason for saving is that you already have four yachts, sixteen cars and a house on every continent and you can't think of anything to buy, well frankly I don't see why you should be compensated for the fact that you have more money than you know what to do with. Do something useful with it. Invest it in a small business. Give it to someone who needs it. Spend it on desperately-needed medical supplies in a poverty-stricken country. Get some "utility" from using your money to help others. You don't need it, you can't take it with you, and you certainly don't need compensation for not spending it. Really.

And finally. I really don't hate savers, but I do think they need to be more reasonable. And I do have some sympathy for those who expected to use the income from their savings to top up their state pensions, and are feeling the pinch because that income is much reduced. However, the idea that these are "poor pensioners" is wide of the mark. The majority of pensioners live on the basic state pension and additional benefits, and they are not affected by this. The pensioners who are feeling the pinch are the better-off ones, the ones who have corporate and/or personal pensions and maybe other savings too in addition to the state pension. So I'm not impressed with the "poor pensioners" argument. The poor pensioners are those getting by on the basic state pension. This lot are poorer than they expected to be, but compared with the majority of pensioners they are not poor.  And I have to ask why people who are living on unearned income from savings should have their incomes protected when people who are living on earned income - many of whom are too poor to save for retirement - do not. The people who have seen the largest falls in their real incomes in the last five years are not people living on unearned income (savings or benefits), but people who are working for their living. When will I see some concern from savers - or more accurately, their representatives - for the people whose incomes are being squeezed by unemployment, under-employment, falling wages, inflation, tax rises and benefit cuts?

Related reading:
(heavens, all of it Scripture-based!)
The golden calf - Coppola Comment
The foolish Samaritan - Coppola Comment
The parable of the rich fool - Luke 12:13-21, NIV

Added 10th August 2013:
The symbolic importance of NOT raising interest rates - Tomas Hirst (Pieria)

* In an economy where the nominal amount of money in circulation is fixed - such as a strict bullion gold standard - it is normal for prices to fall over time (disinflation) if the economy is healthy, since economic growth coupled with a fixed money supply causes the purchasing power of money to increase.

Tuesday, 6 August 2013

One swallow

The ONS has some good news about UK industrial production. Here are the summary points from its statement:
  • Production output rose by 0.6% between Q1 2013 and Q2 2013. Manufacturing rose by 0.7% over the same period.
  • By far the largest contribution to the quarterly growth in production came from manufacturing, which increased by 0.7% following a decline of 0.2% in Q1 2013.
  • Looking at the broader picture, production output was 1.2% higher in June 2013 compared with June 2012, reflecting a 2.0% rise in manufacturing; 7.8% rise in water supply, sewerage & waste management; 4.4% fall in mining & quarrying; and 3.3% fall in electricity, gas steam & air conditioning.
  • Production rose by 1.1% between May 2013 and June 2013. Manufacturing rose by 1.9% with reported rises in all of its sectors. The highest contributor to the rise was the manufacturing of transport equipment, which rose by 5.3% and contributed 0.7 percentage points to the rise in manufacturing.
  • The preliminary estimate of GDP, published on 25 June 2013, contained a forecasted rise of 0.6% for production in Q2 2013. This release of data also estimates production rose by 0.6% between Q1 2013 and Q2 2013 and therefore has no impact on the previously published Q2 2013 GDP estimate.
Looks great, doesn't it? I must admit, I was impressed:

Fortunately someone was sharper than me:

It seems things aren't quite as rosy as ONS implies. Production is actually significantly below where it was in the same quarter a year ago. The "good news" is only an improvement in one month's figures.

But in fact it's much worse than that. This chart from the ONS's release shows how far UK industrial production has fallen since the financial crisis (larger version here):

What appals me about this chart is not the collapse of production in 2007/8, awful though is, but the fall in production since 2010. Even with the upturn, total production is now below the level that it was in the 2009 recession, and manufacturing has also fallen significantly since 2011. There must have been some kind of serious negative shock to production in 2010/11 to cause such significant falls. 

I have previously argued that double-digit inflation in domestic and industrial energy prices delivered a significant supply-side shock to the economy in the last quarter of 2010 and thereafter. I suggest that this chart supports my case, although others have alternative explanations.

However, whatever the cause of the evident shock to production in 2010/11, the fact remains that UK production is way below even its 2010 level, let alone its level prior to the financial crisis. The slight upturn this month, while encouraging, is certainly not the "UK recovery" that is being trumpeted. There must be a much more substantial and sustained rise in both manufacturing and production indices before we can really claim that that the UK economy is on the mend. There is still an awfully long way to go. 

One swallow does not make a summer. And one month's good production figures do not make a recovery.

Related links:
Index of production, June 2013 - ONS
What derailed the UK recovery? - Coppola Comment
How Mervyn King lost the battle of Britain's banks - Simon Nixon, WSJ
Austerity pushes UK economy towards triple-dip recession - Think Progress (Jan 2013)

Monday, 5 August 2013

Can labour markets be too flexible?

My latest at Pieria:

"Krugman has an interesting article in the New York Times. In it he suggests that when interest rates are at the zero lower bound and therefore (in an economy where physical cash is still important) unable to fall further, there is effectively no floor to aggregate demand. Here are his charts showing the difference between an economy where interest rates can fall and one where they can't.

Classical AS/AD model.

LRAS = long-run aggregate supply
SRAS = short-run aggregate supply
AD = Aggregate demand

The classic short-run/long-run picture.
Krugman explains this chart as follows:
"Suppose aggregate demand falls for some reason, say a global financial crisis. Then what the textbook says happens is illustrated by the red arrows. First the economy contracts, then, over time, it expands again as prices fall. And this leads to the notion that demand-side stories are all bound up with the assumption of price stickiness......... you should think though the mechanism by which flexible prices supposedly restore full employment. In the picture I just drew, the answer is that you slide down the AD curve. But why is the AD curve downward-sloping? Any plausible story runs through interest rates: either you have a fixed nominal money supply, so a rise in the real money supply drives rates down; or you have in mind some kind of stabilizing policy by the central bank."
So either you have an automatically-stabilizing currency system*, or you have an activist central bank.

Classical AS-AD model with interest rates at the zero lower bound.

AS-AD with the ZLB.

Krugman again:
 "Falling prices can’t reduce interest rates, so it’s hard to see why the AD curve should slope down....and in fact, because falling prices worsen the real burden of debt, it’s a good bet that the AD curve slopes the “wrong” way. "
For non-wonks, that means if real interest rates are too high and are unable to fall, falling prices and wages drive the economy into depression. Let me explain what that means in relation to the Eurozone periphery.

In most advanced economies, central banks have been using unconventional monetary tools such as QE to depress real interest rates. The jury is out on how effective these tools are at achieving that, but it is fair to say that countries such as the US and UK have not experienced the disastrous economic collapse that the Eurozone periphery countries are currently going through.

In contrast, the ECB has not eased monetary conditions for the distressed periphery countries. In fact it is currently tightening them as LTROs are repaid. The difference in real interest rates between core and periphery is substantial, and this has a direct bearing on the cost of finance for businesses, individuals and governments alike in periphery countries. Put bluntly, the periphery countries are experiencing a credit crunch - the cost of debt is very high relative to real incomes. The ECB claims that it can do nothing more to ease this situation."

The rest of this article can be read here.