Friday, 29 November 2013

The desert of plenty

My latest post at Pieria is my belated contribution to the secular stagnation debate. I think it's caused by the growing trend to abundance. But do we really want abundance?
Throughout history, humans have dreamed of plenty. They have longed for there to be abundant supplies not only of essentials, but of luxuries. The promise made to the Israelites wandering in the desert was that they would eventually come to a land “flowing with milk and honey”. And the vision of the New Jerusalem in Revelation is of riches beyond imagination.
Recent forecasts of forthcoming abundance, too, have focused on the benefits. Imagine a world in which everything was so plentiful that not only the essentials of life but the luxuries, too, were free. There would be no need for money, because nothing could be bought or sold; and there would be no need to work, because there would be no need for income. And if everyone believed that such “superabundance” would last forever, then there would be no need to worry about the future – no need to save or prepare in any way. There would be no point in deferring consumption in expectation of future returns: in a superabundant world, there could be no greater returns in the future. Consumption would be the only virtue. It’s a hedonist’s idea of heaven.
But these “benefits” have a dark side.....
Read on here.

Thursday, 28 November 2013

FLS and the Bank of England's independence

The UK's Funding for Lending scheme is being changed. The Bank of England and HM Treasury have announced that in future, funding obtained through the FLS may only be used to support business lending, not residential mortgages. And to encourage bank lending to businesses even more, the fees for FLS collateral enhancement are being cut.

There has been much talk of a housing bubble in the UK. Personally I am unconvinced, but there is no doubt that the residential property market is stronger than it was. And more broadly, consumer credit is increasing. Up till now the FLS has not distinguished between categories of lending: it could be used to support any lending, although it was hoped that it would particularly be used for business lending. The Governor of the Bank of England argues that broad support for consumer credit is no longer needed, and that the FLS should now be restricted to business lending. I don't disagree. In fact I think the FLS should have been restricted to business lending from the start.

It is fair to say that as funding costs for banks have been falling anyway due to market conditions - particularly the easing of the Eurozone debt crisis - FLS has become less important as a general funding backstop. And changes to regulation and support also reduce its importance. The Governor notes that the recent changes to the Sterling Monetary Framework will provide all the liquidity that banks need. And the Chancellor commends "this Government's" creation of the FPC, claiming that it will ensure that the "mistakes of the past.....will never be repeated". I can't help thinking that "never" is a very long time....history shows that all regulatory changes are eventually insufficient. There will inevitably be another financial crisis. But the FLS would do nothing to prevent that.

But as Duncan Weldon points out, restricting the FLS to business lending does suggest that the Bank of England has concerns about rising house prices and increasing household indebtedness. And if the result is that interest rates rise on new mortgages and other forms of consumer credit, then it amounts to monetary tightening. No wonder the Chancellor's reply to the Governor appears to have been written with gritted teeth. He had no choice but to be seen to support the Governor's decision, but tightening general credit conditions now could choke off the housing boom that seems to be an important part of his election strategy.

So it seems the Bank of England is testing the limits of its independence. But the real test may come later. With the ending of FLS support for mortgage lending, the Chancellor makes it very clear that he now expects Help to Buy to do the heavy lifting in the mortgage market (my emphasis):
"However, while household credit conditions and the housing market are recovering, the market for higher loan-to-value mortgages remains very restricted by historical standards. This is a significant barrier to first-time-buyers and those without a large deposit.......the Help to Buy scheme is a targeted measure designed to address this specific issue, and its ability to perform this vital function will be unaffected by changes to the FLS, which provides more broad based support for household credit".
The Help to Buy scheme - recently extended to cover existing properties and guarantee mortgage repayments for people trading up - has been almost universally panned, including by the IMF, the OECD and even the Chancellor's own department. The Bank of England has no power to end the Help to Buy scheme, but it does have a responsibility to advise the Chancellor regarding its effect on financial stability. If the FPC were to report, in (say) June 2014, that Help to Buy was inflating the house price market to the point of instability, and therefore should be ended, how would the Chancellor respond? I fear the answer is implied in the quotation above from the Chancellor's letter. My (admittedly cynical) translation:

"Ok, I'll accept you changing FLS, but don't you dare touch Help to Buy until after the election".

In the end, central banks are only as independent as politicians allow them to be.

Related reading:
The fatally flawed FLS
Britain's Money Tree - The Economist
The illusory housing recovery
The FLS early warning system

Saturday, 23 November 2013

Who should run banks?

My latest at Pieria considers who should run banks, in the light of the recent Co-Op Bank disaster:
"The hapless Paul Flowers, former chairman of the Co-Op Bank, has been arrested and charged with possession of Class A drugs. The Flowers problem comes at the end of a simply horrible year for the Co-Op, in which it was forced to withdraw its bid to take on the TSB part of Lloyds TSB, its credit rating was downgraded to junk by Moody's and the PRA imposed capital requirements on it that it was unable to meet. It admitted in its half-year accounts that it was bust and proposed a recapitalisation plan that would have stiffed 15,000 grannies, only to see it trumped by two hedge funds who made the grannies a better offer - thereby presenting the world with the extraordinary spectacle of a group of vulturesappearing considerably friendlier than the supposedly cuddly teddy bear that is the Co-Operative Group.  
"I don't intend to comment on Mr. Flowers's behaviour. The news reports speak for themselves. Though for me, the best bit was discovering that he had been chairman of a drugs charity. You couldn't make it up. 
"However, it is not Mr. Flowers's alleged criminal activities that are the main problem, nor his exorbitant expense claims, nor even his religious hypocrisy (he is a senior Methodist minister). No, the main problem is his incompetence. Among other things, in his presentation to the Treasury Select Committee he appeared to have no grasp whatsoever of the figures pertaining to the business he had been running. Jeremy Hunt asked on BBC Question Time:
"How did someone with no knowledge of banking become chairman of a bank?" "
Read on here.

Friday, 22 November 2013

The other side of trade

Following on from my discussion of trade surpluses and their effects (which lots of people didn't get, sadly), I thought I would talk about the other side of trade - which is capital investment.

This speech by the ECB's Asmussen contained the following intriguing line:

"If more German savings were invested at home, the current account surplus would fall by definition".

Now I can hear you all scratching your heads. What on earth has the behaviour of German savers got to do with the current account surplus?

Nothing, actually. This isn't about German savers. It is about German national savings - the proportion of national income that is not spent or invested at home. Essentially, what Asmussen is saying is that the German national savings rate is too high.

A nation's current account reflects its net foreign income, and its capital account reflects the change in ownership of foreign assets. A nation that is running a trade surplus has an equivalent capital deficit, by definition: money leaves the country and is invested in foreign assets, rather than domestically. So poor domestic investment is a consequence of an export-dominant economic model. That's what Asmussen is talking about. The trouble is, he thinks that by increasing capital investment at home, which would reduce the capital deficit, the trade surplus would automatically fall. But I'm afraid he has this the wrong way round.

In a closed economy,

Y = C + G + I

where Y = national income, C = domestic consumption, G = government spending and I = investment. Rearranging this, we see that

I = Y - G - C

In other words, investment is the bit of income left over after all private and public spending commitments have been met. Strictly speaking, saving (S) is the bit of income left over after all private and public spending commitments have been met, but we assume that all saving is productively invested in some way:

S = I = Y - G - C.

So far so good. But Germany is not a closed economy. In an open economy, the foreign sector matters. Net exports are the difference between exports and imports:

NX = X - M

Germany has a trade surplus, so NX is positive. A positive current account balance is a contribution to national income:

Y = NX + (C + G + I)

where C + G + I = domestic demand.

We can immediately see where the desire to run a trade surplus comes from - Y may be higher if there is a trade surplus. But if Y is constant (or delta Y < delta NX), then a trade surplus crowds out domestic demand. Domestic demand is public and private spending AND INVESTMENT. Therefore, if Y, G & C are all constant, a large trade surplus crowds out domestic investment. So what Asmussen is saying is that Germany should should seek to increase I (domestic investment), which would force NX to fall.

But I'm afraid this is simply impossible. The capital deficit is a consequence of the trade surplus, not a cause, and I is a residual:

I = Y - C - G - NX

Put bluntly, the money has to come from somewhere. In China, of course, there is perhaps excessive domestic investment - but they don't have much in the way of a welfare state and they have significant financial repression, so both C and G are low and most of the national income goes into I. I suspect that attempts to increase I in Germany would be achieved by the same means - cut government spending and depress household incomes - in which case increasing I would have no effect at all on NX. So that is not what is really needed. What Germany really needs to do is to reduce NX in order to increase I, not the other way round. This could be done by cutting exports, but it would be far better if it were done by increasing imports, And actually that would be best achieved by increasing both C and G, so looser fiscal policy, really: despite my caveat in an earlier post, higher wages and lower taxes would probably result in increased imports to some degree. That would diminish net capital flows out of the country and therefore increase the amount of capital available for domestic investment.

Asmussen should have made this clear. Increasing domestic investment would be consequent upon a falling trade surplus, not the other way round. By getting the causation the wrong way round, he has missed a golden opportunity to influence German economic policy for the better.

Wednesday, 20 November 2013

Value is in the eye of the beholder

This post is written in reply to Tim Worstall's criticism of this paragraph in my post "The intergalactic trade frontier":
"It is true that export success depends on comparative advantage and international competitiveness, but these are relative terms: international competitiveness is bought at the expense of the competitiveness of others, and comparative advantage implies a near-monopoly position in the provision of some good or service."
Tim correctly pointed out that comparative advantage is not relative to others, but relative to oneself:
"Comparative advantage is not about what you are better at compared to other people. That is absolute advantage. Comparative advantage is what you are better at doing relative to the other things that you could be doing. And as such it greatly strengthens the case for trade."
I take issue with two points here. The first is, as I shall explain shortly, that what I am "better at doing" may not be what I am best at doing. (Yes, I know that sounds odd - but bear with me.) And the second is that I was never, ever arguing against trade. On the contrary, I am a big fan of trade. I want lots of it, both international and domestic. And that is why I criticise trade policies that are designed to create trade surpluses. Because as I've explained here, persistent trade surpluses do not increase trade. They may even reduce it.

But to return to the first point. If demand for all products and services is constant, then I am of course going to achieve the greatest profit by concentrating on the thing that I do best, because in a market with constant demand price differentiation is a function of product quality. In my case, what I do best is singing. So if there is constant demand for classically-trained mezzo-sopranos, and no-one is better than me, my most profitable activity is also what I do best.

But suppose that demand is not constant? Suppose that the fashion in music has moved away from classical music into pop and musical theatre, neither of which I can sing convincingly? I may be the best classically-trained mezzo-soprano in the world, but no-one will pay me to sing. Actually this isn't happening - classical music is holding up pretty well. But it's not beyond the bounds of possibility. Markets can, and do, die. And when they do, the producers of those goods and services go out of business.

Alternatively, suppose that there is a vast increase in supply. The market is swamped with hundreds of classically-trained mezzo-sopranos with wonderful voices. Indeed, this is pretty much the case, world-wide. The classical singing marketplace is saturated. So even though I am a very good singer, there are a lot of mezzos out there who are even better than me. Concert promoters are not going to prefer me to them. So although singing is my best skill, it isn't good enough to succeed in a highly competitive marketplace. Concentrating on it is not going to pay my bills.

As it happens, I can play the piano. Not well - I'm certainly not concert pianist standard - but enough to accompany exams and ballet classes, that sort of thing. And there is something of a shortage of half decent pianists. So I could make some sort of living from bad accompanying, whereas I can't make any sort of living from very good singing. Would I be doing what I am "best at", by any reasonably objective measure? No. But I would be doing what I am "better at" in comparative advantage terms.

You see, in comparative advantage terms, what is "better" is whatever generates more profit, and that is determined by the market. The value of my singing is not determined by my ability but by how much people will pay to hear me sing. So although I am objectively a much better singer than pianist, if people will pay me to accompany exams but won't pay me to sing in concerts, my piano playing is more valuable than my singing.  Value, like beauty, is in the eye of the beholder.

And the fact that there is a mismatch between my objective ability (what I am "best at") and what I am "better off doing" is a function of demand and competition. If there weren't so many brilliant mezzos out there, or there were more musical events requiring mezzo-sopranos, I could make a living from singing and would not need to concentrate on a lesser skill in order to pay the bills. Comparative advantage therefore has nothing much to do with what people, or businesses, or countries are "good at". It has everything to do with what opportunities exist in the marketplace and what the competition is like. This even applies when a business creates a completely new product or service that does not exist in the marketplace (and therefore initially has neither demand nor competition): they have to create demand for it, and if they fail to do so then the product or service is worthless, however "good" it is. And if they do create demand for it, they may later be overtaken by competitors who force them out of the market they have created.

So comparative advantage is subjective: the value of the goods and services produced is determined by the market, not the producer. It depends on demand: if no-one wants to buy the product, it is worthless, however "good" it is. And it is determined by competition: however good someone is at producing the product, if others are better, they cannot compete and must produce something else instead - or die.*

Singing is, of course, a difficult thing to value. My singing may be of little pecuniary value. But it is valuable to me, because I get pleasure from it. And to the extent that I am prepared to sing for others without payment, it may also give pleasure to others. Judge for yourselves.

*If they are a business, dying may be the right solution, of course. But this can never be true for people. So people whose skills are obsolete, or who simply are not good enough at a particular job to compete in a saturated market, need support and help to enable them to develop new skills. I am fortunate: I can play the piano (and as it happens, I can teach and write, too). Not everyone has alternative skills. Really, that's the problem that the long-term unemployed have. And they need time, opportunity and financial support to enable them to develop new skills.

Trade confusion

My last post sparked a critical post from Tim Worstall and extensive comments both on his post and mine. Tim's criticism was over my use of the term comparative advantage, and I shall not address that in this post. But the discussion on both posts was fascinating. Nearly all of it missed the point.

Basically, people confused international trade with national trade policy. They are not remotely related. National trade policy that aims to achieve a sustained trade surplus does not increase trade. Indeed it may actually reduce it.

Firstly, let me address the (partly justified) criticism that I had incorrectly described international trade as zero-sum. Clearly, from the point of view of individual agents trading with each other, this is not true. One business's exports are not bought at the price of another's: people that fail to compete in one market will look for other markets where they can be more successful, so overall, competition tends to increase global trade.

But from a macroeconomic point of view, international trade is zero sum. If one country has a trade surplus, other countries must have trade deficits to the same value. The absolute volume and value of trade across the globe may indeed increase as businesses compete with each other for domestic and export markets, but that makes no difference to the nature of trade between countries. Whatever the scale of global trade, national trade surpluses and deficits always sum to zero. An increase in trade surplus by one country always means an increase in trade deficit somewhere else.*

So a national trade policy that aims to create a trade surplus is no more capable of increasing the volume or value of trade than a policy that aims to create a trade deficit. Mercantilist policy that depresses domestic demand in order to push businesses towards exporting does not increase trade. All it does is move it out of the country. Total economic activity across the globe includes domestic as well as international trade. If a trade surplus is achieved by depressing domestic demand, therefore, it has simply driven trading activity out of the country. It has not increased trade.

Similarly, mercantilist policy that imposes tariffs on imports or depresses the value of the currency in order to discourage imports and encourage exports does not increase trade. It discourages the economic activity of exporters in other countries. Clearly, if one country is discouraging imports by means of tariffs or currency interventions, exporters in other countries will look for other markets for their goods. But if the majority of countries impose tariffs and/or depress currency values in order to discourage imports, export markets are seriously diminished. Resource-rich countries with a wide diversity of production would probably survive this, but smaller countries and those with resource limitations would suffer. And worldwide, there would be a considerable decline in economic activity. There would, in short, be global depression.

Because tariffs and exchange controls reduce trade, they are frowned upon by international organisations and are the subject of numerous summit meetings and international agreements. The world is now a much less protectionist place than it was in the past, and we are in general much richer for it. Admittedly, those riches are not equally distributed: but that is not a reason to return to the protectionism of old.

However, the subtler form of mercantilism - where domestic demand is deliberately repressed in order to push businesses towards exporting - also reduces trade. This is because when domestic demand is repressed, for example by forcing down wages, imports fall as they become unaffordable. It is the equivalent of imposing tariffs on imports. If only one or two countries operate in this way, exporters turn to other markets as they would if faced with trade tariffs, although it is possible - if the countries concerned are large - that global GDP could be lower than it would have been if these countries were less repressive. But when the majority of countries repress domestic demand in order to promote exports, the inevitable result is a reduction in global economic activity.

Whatever means is used to discourage imports - tariffs, currency interventions or repression of domestic demand - the effect is to discourage economic activity. As long as the rest of the world is willing to absorb trade surpluses by running trade deficits, there may be no net fall in global trade. But for the world as a whole to achieve its output potential, countries must be as willing to import as they are to export. Therefore the desire of some countries to run persistent trade surpluses is damaging to the global economy.

Of course, some countries have trade surpluses simply because their products and services sell better than those from other countries. But to return to where we started - this is where the behaviour of individual agents becomes important. Businesses that can't compete in one market look for others where they can be more successful. In the absence of artificial constraints on trade, therefore, we would expect that national trade surpluses should be temporary: they represent market inefficiencies that should be competed away (in a financial market, they would be arbitrage opportunities). If they persist, therefore, it is because in some subtle way balanced trade is being discouraged. Therefore, countries that run persistent trade surpluses - even if they don't intend to - require structural reforms.

A persistent trade surplus is NOT an indicator of economic strength: on the contrary, countries that are very export dependent are very vulnerable to exogenous shocks. And it does NOT improve global trade. Not ever.

* UPDATE. Jonathan Finegold has pointed out (see comments in his post) that since the deficit position confers as many economic benefits as the surplus position, international trade is not zero-sum even from the macroeconomic position. I would accept this if it were not for the moral values assigned to "deficit" and "surplus" that I identified in my previous post. When the prevailing belief of policymakers is that policy should be designed with the objective of achieving trade surplus, the game is zero-sum, since achieving this objective is only possible if others fail to achieve it.

The intergalactic trade frontier

International trade is a zero-sum game. Across the globe as a whole, exports = imports. You export something, someone somewhere has to buy it. It is true that export success depends on comparative advantage and international competitiveness, but these are relative terms: international competitiveness is bought at the expense of the competitiveness of others, and comparative advantage implies a near-monopoly position in the provision of some good or service. But exports depend on the willingness of others to import. If one large trading area such as the Eurozone runs a trade surplus, therefore, somewhere else there must be a trade deficit. This is not rocket science.

But trade balances have become part of the same economic morality play that has already seen countries with high debt castigated for "profligacy" (even when high debt is a consequence of economic collapse, not over-spending) and countries with large fiscal surpluses praised for "prudence" (even though a large fiscal surplus impedes the private sector's ability to save/deleverage). To "trade moralists", exports are good and imports bad. Therefore, the aim must be to "earn our way in the world" by exporting, while at the same time discouraging imports by fair means or foul. "Fair means" in this case is deliberately repressing domestic incomes by tight fiscal and/or monetary policy, including outright financial repression: "foul means" are trade tariffs and controls.

To trade moralists, running a large trade surplus, especially if it is accompanied by a large fiscal surplus, is "a priori" a good thing. Therefore, countries that are running trade and fiscal surpluses do not need to make structural reforms. Until recently, this was the position of the European Commission regarding Germany. Germany's trade surplus was an indication of strength, not weakness. And it remains the position of German politicians and bureaucrats.

But following the United States' complaint, the Commission - always quick to jump on the bandwagon - has decided to "investigate" Germany's trade surplus. I am perhaps being unfair: Germany's trade surplus is above 6%, the level at which EU rules say it is too large. But suggesting that Germany might need to make reforms to bring down its trade surplus has provoked German outrage.

It does indeed seem unfair to blame a country that has steadily rebuilt its economy through exporting quality manufactured products over the last decade or so. And it also seems unreasonable to expect Germany to import more. After all, German-made white goods are recognised worldwide as well-made, sound and durable, and German luxury car marques are brand leaders. If German goods are so much better than the goods produced by others that the world wants to buy them, why would German consumers want to buy anything else either? Germany's trade surplus is due to the excellence of its production. It should be congratulated, not castigated, for the hard work and efficiency of German producers.

This is the heart of the "trade moralist" argument, and the Achilles heel of those who call for more balanced trade flows. "German is best" is the belief not only of consumers in the countries that buy German goods, but also in Germany itself.  And we are talking beliefs here: like all countries, Germany has some areas in which it excels (like making luxury cars), but "German is best" does not hold across all classes of goods. But as long as people believe that it does, German-made goods will be in demand both internationally and domestically. Looser fiscal policy may give Germans more money to spend, but there is no guarantee that they will spend that money on imports. They may just "buy German".

There is no point in mourning the lack of "togetherness" in the countries of Europe. The European project is fundamentally about trade, and it is fundamentally cut-throat. That is why there is no system of fiscal transfers. European Union membership gives countries preferential trading status with each other, the Schengen treaty and EU directives ensuring the free flow of capital give countries full access to European markets, and Euro membership eliminates currency differences that discourage cross-border trade. But that's as far as it goes. There is no system of "mutual support": countries in the EU are expected to compete with each other for market share and profits, and if they can't compete, they have to make reforms to improve their competitiveness, or die. It's National Darwinism.

And on a larger scale, that's what international trade is like, too. There is no system of mutual support. Countries compete with each other for market share and profits. Supranational organisations such as the IMF encourage the dismantling of trade barriers and capital and exchange controls. Consequently, smaller countries with few natural resources either find some underhand way of drawing business away from larger, stronger ones (such as offering very preferential tax rates to international businesses) or lose competitiveness. Inevitably, smaller countries are taken over by larger ones: in days gone by this was through colonial acquisition, annexation or conquest, but such behaviour is frowned upon these days, so the takeover is more subtle - but foreign purchases of national assets and external supervision of government budgets amount to the same thing, really. Small countries that can't compete internationally don't survive as independent entities. It's International Darwinism.

To be fair, the reforms being made by Eurozone countries to improve their competitiveness do seem to be working. All of them except Greece and France are now running trade surpluses, and even Greece is projected to reach trade balance by the end of 2013:

Bruegel notes that although this is partly because the brutal repression of domestic demand has clobbered imports, it is also because exports themselves have increased. But they speculate that exports may have risen because domestic demand is so weak that businesses have been forced to seek new export markets or die. Anyway, the result is that the whole Eurozone is now running a trade surplus despite the deep depression in a considerable part of it.

But the Eurozone is not the only place where running a trade surplus is considered a moral duty. Trade moralists are in the ascendancy all over the place. Everyone, it seems, is "making reforms" to repress domestic demand and promote exports. This is not encouraging. If everyone tries to increase exports and cut imports by repressing domestic demand, the result will not be a global export-led recovery. It will be a global depression.

Trade moralists are fundamentally illogical and dangerously plausible. The idea of exporting your way to recovery is seductive. But it simply is not possible for all countries to export their way to recovery. Someone, somewhere has to have a trade deficit. At the moment that someone is principally the US* - but trade moralists are becoming louder and more vociferous there, too, and at some point the US is likely to take steps to cut its trade deficit. When that happens, the global impact is likely to be severe.

Unless, of course, new export markets can be found. Have we made contact with alien civilisations yet? We urgently need to establish a trading post somewhere in the vicinity of Alpha Centauri.....

UPDATE. Tim Worstall has pointed out that in the first paragraph I actually mean absolute advantage, not comparative advantage. Correction accepted, sort of - though comparative advantage only works if you also have competitive advantage.

FURTHER UPDATE: Since lots of people have found this post, especially the first paragraph, confusing, I've explained it more fully here.

Related reading:

Report to Congress on International Economic & Exchange Rate Policies - US Treasury
Balance of trade adjustment in the Euro area - Bruegel
The US Treasury is right about Germany's Eurozone policies - Yanis Varoufakis

*The US is a special case. Its enormous trade deficit in goods and services is best regarded as the flip side of its market leading position in the provision of currency for global trade, rather than as an indicator of poor competitiveness. And it is also the market leader in safe assets (USTs), which are better regarded as tradeable goods than debt that has to be repaid. More on this in a later blogpost.

Sunday, 17 November 2013

City-states and empires

My latest post at Pieria looks at the future of the nation state:
 "At the recent conference on The Future of Cities hosted by The Economist, Benjamin Barber of City University argued that nation states would become redundant, replaced by a global network of co-operating (and competing) cities. "Even under good leadership, states will become increasingly dysfunctional", he declared. And he explained that that this was because "we live in an interdependent world of global cross-border challenges":
  • global warming and climate change
  • terrorism and war - increasingly cross-border
  • global pandemics - public health is becoming a global concern
  • immigration
  • technology
For Barber, the problem is that nation states are not capable of tackling these global cross-border challenges. This is not caused by poor leadership, but the "inherent limitations"of territorial sovereignty. Barber sees a return of the "city-states" of medieval times, reinvented in 21st-century form. The future lies not with sovereign states, or even groupings of states such as the European Union, but with mega-cities."
Will it be replaced by a global network of mega-cities, as Benjamin Barber thinks? Will it be superseded by supranational groupings such as the EU, as Willem Buiter thinks? Or will we continue to muddle along with a mixture of all three? Read on here.

Monday, 11 November 2013

Smart cities, smart people

My latest post at Pieria considers the impact of "smart" technology in city development, and warns that although technology brings considerable benefits, there are also significant dangers.
I recently had the pleasure of attending The Economist's conference on the future of cities. At the heart of the conference was a thoughtful presentation by Richard Sennett of the LSE on "smart cities".
"Smart cities" are a much-hyped phenomenon. Technology providers have promoted "smart" solutions to urban challenges, with varying degrees of success. All too often, their ideas have foundered on political and bureaucratic obstacles, or have proved unworkable because of conflict between the vision of clean technological solutions and what Sennett describes as the "messiness" of people's lives....
Read on here.

Sunday, 10 November 2013

Demographics and dependency

This is probably a pretty rubbish post, but then it was a rubbish debate, and I'm not proud of my own contribution to it. I did get things slightly wrong. But not as wrong as others.

Once again Fraser Nelson has tweeted graphs he doesn't really understand and drawn the wrong conclusions from them. Here's the first graph he tweeted, with his comment:

It's from this article by The Economist. The source matters, as will become apparent shortly.

And he then went on to say this:

The first chart is the dependency ratio - the ratio of working to non-working people in the population. And the second shows the rising proportion of over-65s in the working population. On the face of it, the second should influence the first. But actually they aren't related - and neither of them is much use.

The usual calculation of the dependency ratio assumes that people are working between the ages of 16 and 64. The Economist's chart doesn't say this, but it is reasonable to assume that it has been created on this basis. This of course is wrong at both ends. Fraser Nelson rightly points out that a rising number of over-65s are remaining in the workforce, or re-entering it. But neither Fraser Nelson nor The Economist mention that the number of 16-25 year olds in the workforce is falling rapidly as more and more of them spend longer in education and training. This more than offsets the increase in over-65s working.

However, the main reason for the rising dependency ratio is that people are living longer. The Economist points out (my emphasis):
Between 2013 and 2037 the nation’s population is expected to grow by 10m, to 73m. But the growth is not evenly spread between the generations—which means that a demographic crunch is coming. The number of people aged 75 and over will increase by 87%, to 9.3mThe number of people of prime working age (between 30 and 60) will increase by just 3%.
This is The Economist's main point - that the proportion of non-working people in the population is set to rise significantly due to increasing longevity. This rests not only on the assumption that immigration and fertility levels don't change, but also on the assumption that over-65s remain economically dependent. The Economist has actually left this question open: there is a large gap between its "prime working age" and the age at which it assumes no-one is working, which is 75. It's probably fair to assume, therefore, that The Economist knows that some over-65s work and is expecting more to do so. The question, therefore, is whether over-65s working would make a significant difference. We know that more of them are choosing to work. Does this mean that fewer over-65s are, or will be, economically dependent?

Well, not really. Fraser Nelson's second chart shows that just over 250,000 over-65s have re-entered the workforce since 2010 - hardly a majority. But what the chart doesn't show is that most of these are working part-time, they all receive a state pension and other benefits, and many are also receiving corporate and private pensions. They may be working, but overall they are still dependent. To eliminate their economic dependence there would have to be far more of them and they would collectively have to be earning enough for their pensions and benefits to be taxed away. That is a simply huge cultural shift. The fact is that the vast majority of over-65s expect to live primarily from pensions, including the state pension, and work is simply a means of topping up their pensions. The currently planned rise in the state pension age is not enough to make a huge difference to the hours collectively worked by over-65s, especially as many people gradually reduce their working hours long before they actually retire. The state pension age would probably have to be at least 70 for there to be a significant reduction in over-65s' economic dependence.

But actually the dependency problem is far more widespread than the dependency ratio chart shows. Those of working age who are economically inactive because they are students, or incapacitated, or full-time carers are counted in the working population, distorting the ratio considerably. And even more worrying, many people who ARE working are net recipients of benefits, because their wages are so low that they have to be "topped up" with state benefits which effectively wipe out their tax and NI contributions. These people are not contributing to the support of the elderly. On the contrary, they are competing with them for a share of tax revenues. And there are a growing number of them due to the bifurcating labour market and the decline of middle-income skilled jobs.

So Fraser Nelson is correct that the first chart is nonsensical - but not for the reason that he gives. The dependency ratio is a crude measure that takes no account of the actual economic contributions made by people in different circumstances and at different stages in their lives. A few over-65s working mainly part-time to top up their state pensions doesn't invalidate the ONS's dependency ratio calculation. But a large number of people dependent on state benefits to top up their wages does. We don't just have a demographic problem. We have a low wage problem.

Related reading:

Britain's demographic crunch will arrive suddenly - The Economist
Global greying - FlipChart Rick, Pieria
Bifurcation in the labour market - Coppola Comment
Analysis on the living wage - IFS
Workers kept their jobs but one third faced nominal wage freezes or cuts - IFS

Friday, 8 November 2013

About that ECB interest rate cut

Consumer price inflation in the Eurozone has been below the target of 2% and falling for quite some time. But until now, the ECB has been sitting on its hands. Inflation some distance below target didn't appear to bother it - most likely because the (unbelievable) forecasts for Eurozone recovery created inflation expectations in the 1.5 - 2% range, so it saw no need to act on what was assumed to be a temporary problem.

So why did the ECB, in a complete reversal of its previous stance, suddenly cut the refi rate to 0.25%? Well, Eurozone consumer price inflation has touched a record low of 0.7%, driven by falling energy prices and stagnant prices in other sectors. But inflation expectations are still where they were before, based on expectation of a strong Eurozone recovery.

Here is a Eurostat chart showing Eurozone inflation rates by country as of September 2013:

And Reuters reports that German inflation has unexpectedly fallen to 1.2% in October. Well, well. German inflation is below target and falling. So the ECB is doing what the ECB does - responding to German monetary indicators. I suppose this is inevitable, since Germany is the dominant economy in the Eurozone. But it just shows how impossible a one-size-fits-all monetary policy really is where there are such disparities of size and competitiveness between countries in a monetary union. Monetary policy is inevitably driven by the needs of the largest, even if it is actually damaging to the smallest. 

And damaging it certainly is. The monetary policy transmission mechanism in Europe depends very much on banks. And European banks are a dysfunctional lot. They are loaded up with poor quality sovereign debt, which bizarrely they can STILL hold without additional capital allocation even though it is anything but risk-free. And they are deleveraging at a rate of knots (chart from Morgan Stanley via Business Insider):

Screen Shot 2013 11 05 at 5.10.43 AM

When banks deleverage, broad money falls. Eurozone M3 has been falling for most of 2013 (chart from the ECB's Statistical Data Warehouse):

Click here to see the full series
Eurozone banks don't want to increase risky lending. They are busy reducing balance sheet risks. So they don't want to lend to businesses in riskier parts of the Eurozone. SME lending rates in Spain and Italy are far higher (£) than they are in Germany, which makes those businesses uncompetitive. This refi rate cut is not going to mean lower rates for them: it will mean lower rates for German businesses, already benefiting from the Eurozone's bifurcated credit market. So the Eurozone countries that really need lower interest rates aren't going to get them, because of dysfunctional banks and worries about sovereign solvency. Instead, their competitiveness is going to be hammered again. 

The problem is that cutting the refi rate pushed down the value of the Euro. It fell like a stone when the rate cut was announced, and although it rose a bit it didn't return to its previous value.

This will provide a boost to German exporters - who are the last people in the world to need such encouragement. Coming on top of Germany's generally mercantilist stance ("hands off our trade surplus"), it is difficult to see how a falling Euro would improve domestic demand. It seems more likely that it would increase exports. 

No doubt some people will argue that a falling Euro would benefit periphery exporters. But I'm afraid they are mistaken. I've already pointed out that this rate cut will reduce borrowing costs for German businesses but not for periphery ones. The fall in the Euro will mitigate high borrowing costs for periphery businesses to some extent, but it will also benefit German businesses in addition to the benefit they will get from lower borrowing costs. Overall, therefore, German businesses will benefit more than periphery ones. This rate cut actually worsens the periphery's competitiveness problem. Of course, it can be argued that German and, say, Spanish exporters don't directly compete because they are in different markets. But if Spanish exporters are competing with, say, Chinese, the fall in the Euro will make little difference (because the yuan is managed) and the ECB's inability to influence lending rates to Spanish businesses means that Spanish exporters will benefit not at all: meanwhile Germany will do even better in its export markets. 

In fact a falling Euro is helpful to nobody. The Eurozone as a whole has a trade surplus. Yes, periphery countries still have trade deficits, although these are reducing - but the trade surplus in the core is so enormous now that the periphery deficits no longer offset it. The Eurozone as a whole does not need currency depreciation.

So the ECB's actions in support of Germany actually make matters worse for the periphery. And it is still sitting on its hands in regard to the real problem in the Eurozone, which is the deepening depression in Southern Europe and Ireland. In fact I fear that it is not sitting on its hands, it has washed them - because it seems to me that the ECB is actually incapable of dealing with the depression in Southern Europe. 

Scott Sumner argues that the ECB is not yet out of firepower and that fiscal policy is impotent because rates are still above zero. But I fear Sumner is making a fundamental mistake. The Eurozone is not a homogenous area. Real rates in the periphery are far higher than they are in Germany, and the bifurcated credit market makes it impossible for the ECB to force down rates. The ECB simply is not in control of monetary conditions in the periphery. Conversely, real rates in Germany are probably negative: I doubt if this rate cut is anywhere near enough to raise inflation in Germany. The divergence between the periphery and the core widens all the time. There are still things the ECB could do, but a short run-down of some of them shows how limited they are:

1) It could do another round of long-term loans (LTROs). The problem with this is that it is a racing certainty that the new LTRO money would be used yet again to buy up sovereign debt, which would reinforce the disastrous dependency of sovereigns on banks and vice versa. 

2) It could cut the deposit rate to negative, thus charging banks for safe assets. The problem with this is, of course, the existence of physical cash. To have much impact, the depo rate would have to be quite significantly negative, in which case there is a serious risk that banks will simply hoard vaulted cash instead. Alternatively, they could buy up sovereign debt instead of hoarding cash....which creates the same problem as LTROs. And it is worth remembering that German bunds are substitutes for Euro reserves: the short-term yield on bunds would therefore also drop into negative territory. Should we really be paying to lend to the German government? 

3) It could stop accepting weekly deposits. Various people seem quite keen on this idea. The deposits in question are used to sterilise the money issuance consequent on the ECB's buying of some sovereign debt as part of its normal open market operations. But I don't see how it could possibly work. The ECB can't stop banks leaving money in their reserve accounts. The amount of reserves in the system is what it is, and someone has to hold them. The idea that reducing reserve requirements or eliminating the requirement for open market operations to be sterilised will give banks more funds to lend shows a lack of understanding of how the banking system works, which is worrying given that one of the people suggesting this is a member of the ECB's governing council. Banks don't "lend out" deposits. And they don't "lend out" reserves.

4) It could do some form of QE. Exactly what assets it would purchase is not clear. It could be based on the ECB's list of eligible collateral, but this is very extensive and much of it decidedly dodgy: the Eurosystem governors may not be too happy about the ECB actually owning this stuff (as opposed to simply accepting it as collateral). So presumably the assets the ECB would purchase would only be "safe assets" - i.e. government debt. This immediately causes a problem. OMT - the pledge that the ECB made to buy up periphery government debt under exceptional circumstances - has strict conditionality attached to it. Is the same conditionality going to apply if these assets are purchased as part of a general QE programme? If so, then the ECB would be making fulfilment of its mandate to ensure price stability conditional on fiscal rectitude by periphery government - so much for ECB "independence". And if not, then what credibility would OMT have any more? So QE is either impossible or useless while the OMT conditionality exists.

What the ECB really needs to do is improve monetary policy transmission to the periphery. This could involve the following:
  • direct purchases of corporate and sovereign bonds
  • some form of GSE structure to pool and securitize SME loans so that they could be purchased as well
  • in Spain, Ireland and Portugal, direct purchases of residential and commercial mortgages
And it also needs to reflate the periphery economies. This would mean either "helicopter drops" or purchases of sovereign debt. The two could be combined, which would amount to a form of QE targeted at distressed sovereigns. But that means removing the conditionality of OMT, which exists to avoid the charge that the ECB is monetizing the debt of fiscally irresponsible sovereigns. Monetization of sovereign debt is explicitly outlawed by EU treaty. Even though OMT is so hedged around with conditionality that it has never been used, it has already been subject to legal challenge. I have no doubt that if the conditionality were removed to allow the ECB to reflate the periphery economies, there would be howls of protest and a spate of lawsuits from Germany, which has an almost religious belief that monetization will inevitably lead to hyperinflation despite the complete lack of evidence that reflation in a depression has any such effect. 

Reflation of Germany cannot be done by monetary policy alone, either. For Germany to recover, the whole Eurozone must be healed. While Germany continues to insist that the problems of Southern Europe are not its concern, it too will remain in the doldrums. Though there are plenty of people in Germany who are very happy with zero inflation: there has been extensive criticism of the ECB's action from German media concerned about rising property prices and poor returns to savers. The ECB may be doing its job, but the principal beneficiary doesn't seem to want it to do so. 

As far as I can see all the actions that the ECB really needs to take are politically impossible. I have been severely critical of the ECB's handling of the Eurozone crisis: it has gone way beyond its mandate in imposing fiscal conditionality on sovereign states, and it has failed to address the deepening depression in a growing number of Eurozone states. But I acknowledge that the real problem is the political set-up in the Eurozone. It is not just OMT that is so hedged around with conditionality that it is virtually useless. It is the ECB itself.

Related reading:

ECB reacts to below target inflation with a rate cut - Georgie Markides
A central bank crisis - Coppola Comment
The ECB's very own tapering problem - FT Alphaville
Two more nails in the Keynesian coffin - The Money Illusion

Wednesday, 6 November 2013

Inflation, deflation and QE, redux

I've suggested previously that QE could actually be deflationary. I looked at it from several perspectives - collateral effects, the monetary transmission mechanism, distributive effects, even Peter Stella's "deadwood" inhibiting bank lending. But I have to admit that the evidence in support of my deflationary hypothesis was thin and the case not proven. All I could demonstrate was that QE is not directly inflationary and whatever stimulative effect it has is weak at best.

Until now, that is. Soc Gen have looked at QE.....and they have concluded that its effects may indeed be deflationary. Their reasoning is somewhat different from mine. Here's their argument in full (their emphasis):
QE is by design set to be inflationary, yet we were asked several times last week whether the opposite could hold true; i.e. that QE is in fact proving deflationary. 
* No credit = no recovery
In theory, a permanent increase in money supply results in a proportional increase in all money prices. Central bank asset purchases boost money supply, but this “inflationary” impact of QE is only temporary as the assets are in the future set to either be sold to private investors or redeemed to central banks, thus exerting a “deflationary” impact. For QE to be efficient, this argument would thus suggest that central banks (Fed, BoE, BoJ … and even the ECB!) should simply forgive their considerable holdings of debt (mainly government debt) thus making the increase in base money permanent. In the case of the US, cancelling the $2tn of Treasuries held by the Fed would also offer a quick fix to the debt ceiling issue.
This somewhat tongue-in-check argument merits qualification. Indeed, there is base money and then there is broader money aggregates. While QE has boosted the former, the impact on the later has been modest to date due to still lacklustre credit channels.
This ties in with our long-held view that the key to sustainable recovery lies with corporates regaining sufficient confidence to borrow, to invest and to hire (and not to swap equity for debt via share buybacks).
Moreover, tempting as a cancellation (or a restructuring to perpetual zero coupon bonds) of government bonds held by central banks may sound; we are concerned that such a policy could ultimately prove inflationary in a bad way (think Weimar Republic). Indeed, this goes to the very heart of the argument as to why QE is not printing money.
*An unintended consequence of QE's external channel 
It can reasonably be argued that QE in advanced economies generated significant capital inflows to emerging economies, boosting credit. In China, this liquidity combined with a further boost from domestic government policies found its way to fixed asset investments. This led initially to a welcome demand boost for commodities and a wide variety of capex goods. Today, however, the result is that China suffers significant excess capacity and poor capital returns, not to mention a shaky shadow banking system that China Economist Wei Yao has written extensively about. Excess capacity is deflationary and the means to deal with it is to shut it down. Indeed, we expect China for now to exert deflationary pressure on the global economy.
While in China, the impact of QE was observed mainly on the supply side, other economies such as Brazil and India saw the effect concentrated on the demand side, via consumer credit channels. Initially, local currency appreciation masked this inflationary aspect of QE. When Fed taper talk earlier this year hit the tapes, however, a new dilemma appeared for central banks in these economies as local currency depreciation added to domestic inflationary pressures at a time of slowing growth momentum. Contrary to China's deflationary impact on the global economy, we do not expect to see these inflationary forces to be exported. As households struggle to deleverage balance sheets, the end result, however, could prove deflationary.
Unproductive investment is by nature ultimately deflationary. This is a point also worth recalling when investing in paper assets fuelled by QE liquidity and not underpinned by sustainable economic growth.

In effect, Soc Gen argue that the expectation that QE will be unwound in future negates the "inflationary" effect of the temporary increase in base money. This is a sort of Ricardian equivalence. I've long thought that Ricardian equivalence is too narrowly defined: it is perverse to assume that temporary tax cuts don't work because of the expectation of future tax rises, but temporary interest rate cuts DO work despite expectation of future interest rate rises. And it is equally perverse to assume that temporary increases in base money have a stimulatory effect when temporary tax cuts apparently don't. Kudos to Soc Gen, therefore, for pointing out that temporary increases in the monetary base due to asset purchases might simply be ignored and therefore ineffective.  

Cancelling the assets would make the increase in the monetary base permanent and therefore impossible to ignore. However, I'm personally unconvinced that cancelling the assets currently held by central banks would necessarily be inflationary, since central banks have a range of tools for controlling inflation even without the presence of large amounts of readily saleable assets on their balance sheets. 

But I do think Soc Gen's argument that unproductive investment is deflationary bears consideration. For whether temporary or permanent, if the money created by QE is not productively invested, it is useless. And if corporates don't want to invest productively - perhaps because as Soc Gen says, they lack the confidence to do so - then no amount of QE will make them do so. 

Furthermore, QE money that is not productively invested in the countries where it is issued but is diverted into over-investment in other countries will ultimately prove deflationary. Soc Gen's argument is that China's overcapacity problem arises from such over-investment. They further argue that as QE is withdrawn, other emerging markets will be forced to defend their currencies at the expense of their domestic economies. If they are correct, then Western QE can be said ultimately to have deflationary effects in emerging markets. 

Whether QE is "intrinsically" deflationary remains unproven. But the argument that it can indirectly have deflationary effects seems now to be well grounded. 

Related reading:

Inflation, deflation and QE - Coppola Comment

Thanks to Tom Bowker for providing the Soc Gen research.

In defence of big banks

Yes, I know.....big banks are bad things. They are widely believed to be systemically dangerous and a serious threat to the economy. "Break them up!" is the cry. But the facts say otherwise. My new post on Pieria gives a bit of a history lesson on financial crises and concludes that the most systemically-dangerous banks are not the most obvious ones.....
"My comment on the BBC's Newsnight programme that failures of big banks are very rare and that RBS was an "aberration" caused something of a storm. Some people said that they were "shocked and horrified" that I was "defending TBTF". Others complained about the behaviour of big banks in recent years. But I did not defend TBTF, and I did not defend the behaviour of banks. My comment was simply a statement of fact. Big banks fail very rarely. RBS's failure was the first failure of a big bank in the UK for over 100 years."
Read on here.

Friday, 1 November 2013

Regulation, regulation, regulation

My latest post at Pieria is the second article from the ICAEW's recent conference on the Future of Banking. It reviews the scope and extent of regulatory change since the 2008 financial crisis, and asks whether we are maybe overdoing it?

Bad behaviour by banks was the primary cause of the 2008 financial crisis. Victoria Saporta of the PRA describes the pre-crisis period as the “partying phase”. Banks increased their leverage, in some cases to more than 60%, which left them very vulnerable to even small shocks to asset value. And they reduced their liquid assets, which combined with their high leverage made them highly exposed to damaging runs. But banks were not the only partygoers: household debt/income ratio grew to over 160%, concealed by low mortgage spreads that did not reflect the true risk of the lending.
In contrast, the aftermath of the crisis is a time of “healing” - repairing damaged banks and fixing the vulnerabilities that existed pre-crisis. Since the crisis, banks have been improving their capital and liquidity positions. There is a popular perception that this has been at the expense of lending to the wider economy, but in fact the global increase in banks’ capital ratios has been mostly driven by accumulation of retained earnings, not by restricting lending. Banks are now in a much stronger position than they were even a year ago.
But it’s not over yet.  Extensive changes are being made to the regulatory environment within which banks must operate. Structural reforms aimed at segregating activities regarded as "risky" from vanilla deposit-taking and lending business are being introduced in the US, UK and Europe. Macroprudential regulations intended to make balance sheets safer are also being tightened: banks already face higher capital and liquidity requirements, and further measures are being discussed. And conduct regulation - perhaps the most intrusive of all forms of regulation and supervision - is taking shape in the UK. 
Read more here