Wednesday, 27 February 2013

The madness of Moody's

Moody's is mad.

Not because of the UK downgrade, ridiculous though that is. Downgrading a sovereign currency issuer is simply silly. The Bank of England is the "buyer of last resort", so there is zero risk of the UK defaulting on its debt. And as FT Alphaville pointed out, downgrading a country because of the possibility of inflation breaks Moody's own definition of "default". Yes, bond-holders may be paid back in currency that is not worth what it was when they bought the bonds. But that doesn't mean they haven't been paid. "Soft" default, in Moody's definition, is not default. And anyway, inflation wasn't the risk that Moody's identified. The reasons given for the downgrade were poor growth and delayed fiscal consolidation:

"The key interrelated drivers of today's action are: 
1. The continuing weakness in the UK's medium-term growth outlook, with a period of sluggish  growth which Moody's now expects will extend into the second half of the decade;
2. The challenges that subdued medium-term growth prospects pose to the government's fiscal consolidation programme, which will now extend well into the next parliament; 
3. And, as a consequence of the UK's high and rising debt burden, a deterioration in the shock-absorption capacity of the government's balance sheet, which is unlikely to reverse before 2016."

For a currency-issuing sovereign, none of those in any way increase the likelihood of default. Therefore the UK's downgrade on Friday 22nd February was meaningless. Markets reacted immediately - sterling fell, of course. But by Monday morning they'd had time to think about it, and the gilts market stayed solid:











And later that day sterling not only regained what it had lost but rose a bit against both the Euro and the US dollar because of Eurozone worries arising from the Italian election stalemate. So much for those who argued that the downgrade meant the end of sterling's "safe haven" status. Markets thought otherwise:



Chart forGBP/EUR (GBPEUR=X)
(larger version here)

But that's not the madness of Moody's. The madness is contained in this gem of a release. Moody's has seen fit to downgrade the Bank of England, two universities, English housing associations, Transport for London  and five local authorities.

Well, it would be reasonable to downgrade the central bank if you downgrade the sovereign. And downgrading the universities that issue bonds is also reasonable, except for Cambridge (downgrading Cambridge would have been certifiable insanity). As is downgrading English housing associations and Transport for London, which also issue their own bonds. That's not the real lunacy. No, it's the downgrade of local authorities.

It seems that some local authorities in the UK have obtained credit ratings with a view to issuing bonds at some point to fund infrastructure projects. And the Greater London Authority actually issued bonds to pay for Crossrail. It seems reasonable therefore that Moody's might downgrade them. But Moody's have forgotten that unlike US states, UK local authorities do not have independent tax-raising powers. Business rates are set nationally, and household rates are capped by central government. Therefore any bonds that UK local authorities issue are de facto backstopped by the sovereign. Even the individual countries within the UK do not yet have tax-raising powers and therefore cannot issue debt that is independent of the sovereign: the Treasury has agreed in principle that if Scotland remained within the Union (which won't be known until 2014) the Scottish government could be enabled to issue its own debt when it takes on tax-raising powers as part of further devolution. At present, therefore, any municipal bonds issued by UK local authorities are effectively sovereign debt.

Now let's remember what the purpose of agency credit ratings is. It is to inform investors of the default risk of potential investments. Credit ratings agencies are of course deeply wounded after the CDO ratings failures in the financial crisis, so they are trying to redeem themselves by producing "sensible" ratings - which essentially means they don't tell us anything we don't already know. The UK's downgrade was widely expected and already priced in, and Moody's statement added nothing new to the debate. But downgrading local authorities that can't independently issue debt is simply idiotic. Investors cannot invest in the debt of local authorities whose debt is effectively guaranteed by the sovereign. All they can invest in is UK sovereign debt - even if it is called "local authority bonds".

Since UK local authorities cannot issue debt independently of the sovereign, BY DEFINITION they must all have the same credit rating as the sovereign. Separately downgrading them is nonsensical. This action does nothing whatsoever to restore confidence in Moody's. On the contrary, it makes one wonder whether they have the faintest idea what they are doing. Is anyone really going to take them seriously any more?

Related links:

Moody's downgrades UK's government bond rating to Aa1 from Aaa - Moody's news release
This downgrade is nonsense! - FT Alphaville
Talking about a sterling revolution - Financial Times

Moody's takes action on UK sub-sovereigns - Moody's news release

Local councils turn to the bond markets to finance infrastructure projects - Telegraph
Consultation opens over Scottish bond issuing power - BBC

Charts from Bloomberg and Yahoo! Finance.

Thursday, 21 February 2013

A central bank crisis

Vox has an excellent article by the LSE's De Grauwe about the austerity measures in the Eurozone periphery that were imposed by policymakers in response to a buyer's strike among sovereign bond investors. As yields soared, particularly in Greece, there was a growing belief that the cause was high levels of public debt and structural inefficiencies, and that to bring yields down it was necessary to slash public borrowing and make structural reforms. There was also concern about the lack of competitiveness of periphery economies and their high unit labour costs: had they had their own currencies, devaluation would have been the corrective for this problem, but because of the Euro this was not possible and the only solution was to force down wages. The measures adopted in a number of countries to reduce public deficits and force down wages caused GDP to collapse across the Eurozone. And they are still causing it. The Eurozone is formally in recession and shows no real sign of recovery despite the upbeat commentary from the Eurogroup. PMI figures today were ugly.

De Grauwe and his colleague show that the soaring yields were not directly to do with economic fundamentals in the periphery countries. They were a market panic. And unfortunately, the panic in the markets infected policy-makers too, who inflicted harsher and harsher austerity measures on the countries concerned in an attempt to break the spiral of rising yields and growing fears of Euro collapse. De Grauwe argues that correct response would have been for the central bank to provide unlimited liquidity - in this case, by buying bonds as required. Now, the ECB did buy bonds to some extent under the securities market programme (SMP). But it was hardly an "unlimited" response: it was small-scale, grudging and constantly attacked by Bundesbank hard men and German politicians angry about bailouts for what they perceived as "profligate" periphery states. No wonder investors didn't believe it. There was constant discussion about the possibility of various countries, not just Greece, leaving the Eurozone: there were theories about downsizing the Eurozone to a convergent core, or splitting it in two: there were fears that it would collapse completely as its predecessor the Exchange Rate Mechanism (ERM) had done. EU politicians reiterated that the Euro would survive, but analysts examining the market were divided. And throughout all this, the ECB did virtually nothing, despite the clear evidence of very tight monetary conditions in the periphery and runs on banks in crisis-hit countries. It stepped in to rescue the banking system when liquidity all but dried up in December 2011, and it bought a few bonds. That's all.

I have argued for a long time now that the problem in the Eurozone is not the fundamentals in the individual countries, it is the design and construction of the Euro. The Euro is a fiat currency disconnected from a sovereign - and that is a very strange beast indeed. To a considerable extent, the European policy makers are making things up as they go along, and therefore making considerable mistakes. Belatedly, they are now trying to fix the errors in the original construction of the Euro - the lack of a common banking system, the lack of coordination of fiscal policy, the inadequacy of the institutions created to manage it. The last of these in my view is particularly critical. The Eurosystem of central banks (ECB and national CBs) together create and manage the Euro, and there are strict limits on what unilateral actions a national CB can take: they can provide the domestic banking system with liquidity provided that the ECB gives permission, but they can't do much more than that. They have no control of interest rates and cannot use unconventional monetary policy tools such as QE. So effectively the countries that use the Euro have no control of monetary policy: their central banks can do little to protect their economies from exogenous shocks, and their governments can't do much either since EU rules prevent them using unconventional measures such as capital controls.

I first became aware of just how vulnerable Eurozone countries are, and how little power national CBs have, in a recent conversation with two Irish central bankers who were worried about the stresses in the UK economy. If the UK went into a tailspin, they could do nothing to prevent the Irish economy going down with it because of its extensive trade links and borrowings, and they know that the ECB would do nothing. There is no institutional device in place for protecting individual parts of the Eurozone from local shocks. In real currency unions such as the United States and the UK, that device is fiscal support*. That is absent in the Eurozone.

The ECB, as the senior bank in the Eurosystem, is responsible for ensuring that the money supply in all parts of the Eurozone is sufficient to meet economic needs. De Grauwe says that it failed to do this. I agree. And it is still failing to do this. Inflation is down to the target 2% and falling, and the entire Eurozone is in recession - but has the ECB done anything to ease monetary conditions? No. It is holding the policy rate at 0.75% and the deposit rate at zero, and appears to have no plans to change this even though the Euro is soaring against other currencies as other central banks do all manner of unconventional things to improve liquidity in their own economies. The ECB simply is not acting as a central bank should.

There has been some discussion of whether the market panic that De Grauwe alludes to was irrational. I don't think it was irrational at all. Investors were given no reason to believe that the ECB would act to prevent Euro collapse in the event of a country leaving, and they had the precedent of the ERM, which collapsed after the exit of the UK in 1992. It is no accident that the countries that experienced the steepest rises in yields (and the sharpest falls after OMT) were those where fundamentals differed the most from Germany: after all, it was economic divergence with Germany that drove the UK out of the ERM. Until OMT, it all looked very much like a repeat performance, with Greece as the focal point instead of the UK.

In my view the reason why the OMT worked is that for the first time investors were given a clear statement that the ECB would not allow the Euro to collapse, even if that meant buying every sovereign bond in Europe. Admittedly even that clear policy statement was criticised by the Bundesbank, which claimed that bond-buying would break the Lisbon treaty preventing monetary financing of governments. But what right does the Bundesbank - a national CB - have to criticise the ECB and threaten it with legal action over what was very clearly MONETARY policy designed to protect the Euro, and therefore well within the ECB's remit? The Bundesbank would prefer a strong Euro and tight monetary policy because of its ridiculous fear of inflation. The Weimar hyperinflation scars run deep. But that doesn't give it the right to dictate policy to the ECB. Anyway, there is ZERO prospect of hyperinflation, or even ordinary inflation, in the Eurozone. The problem in the Eurozone is deflation, not inflation - and that has been the case for the last 5 years. The ECB should be cutting rates and looking at other ways of easing monetary conditions across the Eurozone, particularly in the countries such as Spain and Portugal where GDP is falling disastrously. That it has not done so, and shows no sign of doing so, is a measure of its inadequacy.

This is not a crisis of public profligacy, nor even of a poorly-constructed political experiment, grim though the consequences of that are. It is first and foremost a crisis created and orchestrated by an inept and politically captive central bank. The ECB is a disaster.


* I know there are debates about whether various US states will be allowed to go bankrupt, but we all know they will be bailed out in the end, don't we....a municipal Lehman would be the last thing the US government would want.

Related links:

Panic-driven austerity in the Eurozone and its implications - Paul De Grauwe and Yuimei Ji
Markit Flash Eurozone PMI - Markit
Draghi's Debt Trap - Coppola Comment
It's the currency, stupid - Coppola Comment
The failure of austerity in Europe - Touchstone Blog

The 'cello approach to monetary policy

I've mentioned in a previous post the idea of using fiscal tools to support monetary policy. In this post I want to explain what I mean.

The prevailing view of fiscal policy is that it concerns the financing of government and the behaviour of the population. It has nothing to do with monetary policy and indeed can be antagonistic to it. In this era of monetary dominance, emphasis has been on the effect of fiscal policy over the long run, and in particular the use of "automatic stabilisers" to dampen the effects of the business cycle. We can say that from the monetary dominance perspective, the best fiscal policy is one that is set up to act as a counter-cyclical buffer and then left alone.

And yet.....I have been discussing in recent posts the use of government debt as a money substitute in financial markets. That implies that fiscal policy must have a monetary effect, since government debt issuance is a key part of fiscal policy. The other key part of fiscal policy is taxation - and this too can have a monetary effect. The mistakes of the past that led to fiscal and monetary policy being in opposition to each other were due to the fact that fiscal policy was NOT seen as having a monetary effect. Sargent & Wallace's paper "Some Unpleasant Monetarist Arithmetic" presupposes that governments set their budgets without considering the likely impact on bond yields. In today's world this seems highly unlikely. If anything now it is central banks that seem less concerned about this: governments around the world are imposing suffering on their populations in order to earn the trust of international investors and prevent bond yields rising. So although Scott Sumner is (probably) correct to note that a determined central bank can always choke off expansionary fiscal policy, at present all the signs are that central banks (with the possible exception of the ECB) would do nothing of the kind. On the contrary, there are thinly-veiled cries for help from central banks to governments that appear deaf. Recently, the Bank of England came very close to telling the UK government to loosen fiscal policy.

Sadly, a generally looser fiscal stance may prove to be politically unacceptable. But I think there is a role for targeted use of fiscal tools to support a generally loose monetary policy. We can think of these targeted fiscal tools as fine-tuning. A large stringed instrument such as a 'cello usually has two sets of tuning keys - the pegs just below the scroll, which set the general pitch level: and the tailpiece keys below the bridge, which make small adjustments to the pitch that are too subtle for the pegs.
I see monetary policy and targeted fiscal tools in much the same way. The general policy stance is established by the central bank and conducted principally through interest rate policy and open market operations. But small inconsistencies, and tailoring policy to the circumstances of particular agents, can often be dealt with more easily with targeted taxation.

For example, in a twitter conversation with Miles Kimball recently about the problem that physical cash poses for negative interest rate policy, I suggested that it would be easier to impose a tax on vaulted cash and/or on large or frequent cash withdrawals than it would be to introduce a negative interest rate on physical cash or eliminate cash completely. After all, as Miles points out, a tax is the fiscal equivalent of a negative interest rate. Conversely, a tax credit (or a benefit) is a positive interest rate. Targeted taxes or tax credits can therefore be used to create proxies for interest rates in areas where monetary policy transmission is weak.

Another example might be imposing tiered taxes on bank asset expansion to limit the amount of credit that can be created. These taxes would not be like the credit controls of the 1960s, where banks could lend to a limit but then had to stop: banks would still be able to lend any amount they wished, but at an individual bank level, the more they lent the more expensive it would become. Taxation might be a more effective brake on excessive bank lending than either monetary or regulatory policy: monetary policy is too much of a blunt instrument to act at the individual bank level, and regulatory limits remove responsibility for lending policy from bank management.

Taxes like these would be Pigouvian taxation, of course - taxation designed to influence behaviour, rather than raise money. And as with all Pigouvian taxation, any money raised should not be used to finance government spending, because the whole point of the tax is that as people's behaviour changed it would eventually reduce to zero. Government cannot rely on a source of funding that is designed to disappear.*

Fiscal fine-tuning of monetary policy could also include debt issuance. Debt issuance has the same effect as reverse QE - it reduces bank reserves and removes money from circulation. Debt issuance itself is therefore by definition monetary tightening and cannot possibly be inflationary. The inflationary effects of debt issuance come from spending the money received, not from the debt itself. When debt is used to "fund" government spending, the government has already entered into the spending commitments by the time it issues the debt, so the path of future inflation is already set: it is irrelevant whether the deficit arising from those spending commitments is funded by currency issuance or debt. Furthermore, as the government's budget is a matter of public record, investors know what the spending plans are well before the debt or the currency to fund them are issued, and will respond accordingly. A very loose fiscal stance is therefore likely to result in exchange rate falls and/or bond yield rises long before the actual funding for that spending is needed. This is why a monetary authority attempting to choke off the inflationary effects of government profligacy "after the event" is doomed to fail: the intervention has to be when the spending commitments are entered into, not when the debt is issued. (This, by the way, is the reason for my caveat on the Sumner Critique that the sharp-eyed among you will have noticed in the third paragraph of this post.)

There has been quite a bit of discussion recently about the role of government debt in the monetary system. It  seems to me that the near-money nature of short-term government debt, particularly, enables it to be used as a monetary policy tool. I could envisage a role for short-term government debt issuance as a gentler form of monetary tightening in a fragile economy with a large private debt overhang where raising interest rates could be very damaging: obviously the money raised through this debt issuance could not be used for government funding, as that would counteract the tightening effect. Daniela Gabor notes that most sovereign debt management offices (DMOs) already intervene routinely in the repo markets, providing liquidity to shadow banks in much the same way that central banks do for regulated banks. What is this if not using a fiscal tool (government debt) for a monetary purpose?

There may also be monetary tools that could be used for fine-tuning, but in my view fiscal tools should be part of the toolkit. Why hamper the monetary authorities by denying them access to fiscal tools that would make their job easier?

Freeing fiscal tools from the objective of government funding would allow them to be used to control the money supply for the economy as a whole, in conjunction with monetary policy. In fact because they act directly on broad money, they can have a more immediate and direct effect on the "real economy" than monetary tools. Fiscal tools are powerful, which I suspect is one of the reasons why people are reluctant to use them. Properly applied, they can be extremely effective. Improperly used, they are disastrous. Which is why I would rather they were limited to a fine-tuning function within the "envelope" of a general monetary policy stance set by the central bank. Without that discipline the result could be very high inflation, collapsing bond yields and a currency in free-fall.

I am certainly not proposing an undisciplined fiscal policy. We learned that lesson in the 1970s. Nor am I suggesting that monetary policy should no longer be dominant. What I am suggesting is that fiscal tools have a role within the monetary framework, particularly now that government debt is widely used in financial circles as a money substitute. We should not refuse to use them because of past mistakes.

Related links:
Floors and ceilings - Coppola Comment
Some Unpleasant Monetarist Arithmetic - Sargent & Wallace
Sumner Critique - Market Monetarist
Bank of England Governor outvoted on QE - Guardian
Central banking and bubbles - The Economist
What monetary policy can and can't do - The Money Illusion
Storify: Kimball/Coppola/Sargeant
Getting Leeway on the Lower Bound for Interest Rates... - Confessions of a Supply-Side Liberal
Pigouvian taxation - Wikipedia
Sovereign debt managers and repo markets - Helicopter Money (Gabor)
When Governments Become Banks - Coppola Comment
Government debt isn't what you think it is - Coppola Comment
Central banks, safe assets and that independence question - Coppola Comment

...and the rest of my posts on safe assets, too


* The weakness in this idea is of course that government is bound to want to use the money. We've seen this already with the levy imposed on banks' wholesale funding, which was designed to encourage them to rely less on short-term wholesale funding and more on longer-term sources such as retail deposits. This has been an amazingly successful intervention: banks have improved their loan/deposit ratios from an average of 137% at the time of the financial crisis to about 105% now. Consequently, the amount of money raised from the bank levy has fallen considerably. But far from celebrating this, the Government complained about the lack of revenue, and in the Autumn Statement increased the levy to compensate. This completely misses the point!

Tuesday, 19 February 2013

Floors and ceilings

No, this isn't a post about derivatives. It's about the relationship between reserves and safe assets. I think it is  time I brought the two together and created a unified explanation of the behaviour of safe assets in the presence of excess reserves which earn a positive rate of interest. 

The "interest on excess reserves" (IOER) debate and the safe assets issue are two sides of the same coin. On one side we have the central bank and the system of regulated banks: on the other side we have non-banks and the Treasury. Together, all of these make up the financial system.  

This is how I see it working at present.

The central bank creates excess reserves through buying assets held by the private sector (QE), mostly (but not exclusively) consisting of various forms of government debt. The central bank pays interest on those excess reserves, thus creating an interest-bearing safe asset for banks (but not non-banks).

Banks won't lend when the Fed Funds rate is below the IOER rate, obviously, because they can earn more by depositing funds with the central bank. The Fed Funds rate therefore rises - which is the reason for paying interest on excess reserves, as Scott Fullwiler explains. But it can't break the IOER rate. It remains stuck between the IOER rate and the zero lower bound: 















(larger version here)

In the US, this means a "corridor" of 0 to 0.25%, with the zero lower bound as the floor and the IOER rate as the ceiling. Thus the debate on the US's supposed "floor" system entirely missed the point. What the US actually has is a corridor system with rate inversion. 

Rate inversion has some distinctly weird effects. When the Fed Funds rate is significantly below the IOER rate, banks that are short of reserves will bid it up to eliminate the difference with IOER. The two should be the same. But that ignores the effect of commercial transactions. In reality, the Fed Funds rate is usually slightly below the IOER rate, because banks can earn a few risk-free pennies by borrowing from money market funds at a rate somewhere below the IOER rate and depositing those funds at the central bank at the IOER rate. That's exactly what the European banks were doing until the ECB put a stop to it by cutting its deposit rate (IOER) to zero. This round-tripping enables banks to make some return while doing absolutely zero lending. Nice for damaged and risk-averse banks, not so good for the circulation of money in the economy.

Positive IOER also props up the short end of of the Treasury yield curve, because T-bills are a risk-free substitute for reserves. The round-trip I described above depends on banks buying T-bills to use as collateral for money market borrowing. But they won't do that if the yield is at or above the IOER rate. So T-bill yields are forced into the same narrow corridor as the Fed Funds rate, and in fact usually sit slightly below it. Here's the 3-month T-bill, for example:













(larger version here)

So short-term risk-free rates and the Fed Funds rate end up being forced into the same narrow corridor between the IOER rate and the zero lower bound. The result is gridlock. Funds do not flow freely through the financial system, but are diverted into commercial banks who sit on them: banks will lend, but only against very good collateral - which is scarce for a number of reasons including QE. The result is that non-banks experience a shortage of liquidity, while commercial banks earn money from NOT lending. And no-one except commercial banks can make money unless they take more risk, which they don't want to do (and are under regulatory pressure not to do).  

That's where we are now, I think. Now to add the Treasury side of the conundrum.

The shortage of safe assets has led to calls for government to issue more short-term debt to improve liquidity conditions in the shadow banking system. Now, suppose that the Treasury did auction additional short-term debt instruments to provide more safe assets primarily for non-banks. Settlement of that securities sale would drain central bank reserves by an (almost) equal amount, because the vast majority of payments are made via commercial banks. This reserve drain would be unsterilised, because the money would be transferred to the Treasury's deposit account at the central bank, which is not included in the monetary base. Therefore the effect of the Treasury creating safe assets for non-banks would be to reduce the amount of safe assets (reserves) created by the central bank for banks. The total amount of safe assets in the system would remain the same, but their nature would change. 

We are already used to thinking of QE as replacing debt with money. Treasury debt issuance does the opposite, i.e. it replaces money with debt. Or alternatively, we can think of QE as moving safe (non-cash) assets from non-banks to banks, and Treasury debt issuance as moving them back again. 

It is not sensible to ignore non-banks in the conduct of monetary policy, especially in a financial system as disintermediated as that in the US. Both money and government debt are needed by the financial system: the balance between the two is currently distorted and this is having untoward effects, especially on the shadow banking system whose lifeblood is the collateral that is becoming scarce. A large part of the problem is the assumption that money is solely the responsibility of the central bank, and debt is about government financing. As I've said before, for a sovereign currency-issuing government neither of these is true.  Monetary and fiscal policy are both ways of managing money: they affect the economy in different ways because of the different institutions through which they work. And short-term government debt and currency are both "money" as far as financial markets are concerned.

The central bank is the lender of last resort - or perhaps more accurately, as Perry Mehrling suggests, the DEALER of last resort - for banks. And because non-banks don't have central bank support but can use government debt as a risk-free asset, effectively the Treasury is the lender or dealer of last resort for non-banks. Banks and non-banks together make up the financial system. Therefore we can regard fiscal policy as monetary policy applied to non-banks, and monetary policy as fiscal policy applied to banks. Interest rates are monetary taxes: taxes are fiscal interest rates. They do the same job on opposite sides of the bank/non-bank divide, i.e. controlling the total amount of "money" (in its broadest sense) in circulation. And there is of course a considerable overlap, since in reality the divide between banks and non-banks is entirely artificial: interest rate policy affects non-banks and taxation affects banks. Central banks and governments therefore are partners in the management of the financial system as a whole. 

Monetary policy - in the sense of the economic policy operated by central banks - is indeed usually dominant in practice, because the central bank is the currency issuer and because nearly all non-banks conduct their business through banks (the only ones that don't are either very small or criminal). So interest rate policy, by affecting banks' costs, affects the cost of monetary transactions for non-banks. But fiscal policy is in its own way equally powerful: in fact it could be argued that one of the reasons for insisting on central banks' independence and the dominance of monetary policy is that fiscal policy is so powerful it can be dangerous if poorly designed and managed. Monetary policy also generally works faster than fiscal policy - as Mark Carney put it, it is more "nimble". But I think there are occasions when fiscal policy is not only faster but more effective than monetary policy because it can be better targeted. The use of fiscal tools to achieve monetary policy ends is a much neglected area. I shall return to this in a subsequent post. 

Since the 1980s there has been a somewhat antagonistic stance between government and central bank. As one economist puts it, "central banks and governments are constantly sparring in a policy chess game": inflation targeting by central banks effectively dampens any attempt by the fiscal authorities to either loosen or tighten policy, and there is a presupposition that politicians can't be trusted to manage economic policy. This in my view is outdated, if indeed it was ever true. After all, a central bank is only as independent as politicians allow it to be.

Our present arrangements - monetary dominance, under-use of fiscal tools, fiscal and monetary policy cancelling each other out - cause the needs of non-banks to be neglected and encourage preferential treatment of banks. It is essential that monetary policy encompasses the whole financial system, not half of it. Whether we like it or not, things that are not banks but do bank-like things are here to stay: they have existed in various forms for hundreds of years, and although the current direction of regulation appears hostile to some of them, they perform useful functions. It's worth remembering that non-banks are not just hedge funds and SPVs - they include, among other things, insurance companies, wealth funds and thrifts (building societies). The role of the Treasury in supporting non-banks should be recognised, and fiscal tools should become an essential part of monetary policy. Therefore the antagonistic stance of central banks and governments that arose from the fiscal and monetary mismanagement of the 1970s must end. Cooperation, not competition, should be the order of the day. 

Saturday, 16 February 2013

Productivity, savings and financial crises

A research team at the ECB has issued a paper attempting to explain the origins of financial crises. This has of course been an enduring topic of analysis ever since the fall of Lehman, and just about every economist in the world has now had a go at it, with varying degrees of success.

The ECB's paper makes a valiant attempt to fit the financial system into a DSGE model of the economy that previously ignored it. The maths is fearsome and I admit I skipped much of it. But they draw some important conclusions.

Very early in the paper they accept the prevailing wisdom that financial crises are endogenously determined - in other words, they happen as a consequence of behaviour within the system, not because of external shocks to it. Now this immediately causes a problem with the model. DSGE models work on the basis that shocks are exogenous - sort of like meteorite impacts on life on earth. But using the same analogy, an endogenous crisis would be CAUSED by the behaviour of life on earth. Attempting to use a DSGE model to explain the effects of the behaviour of humans on their own behaviour is enough to drive a serious economist to drink. Admittedly there are shocks in the model, but adverse ones are regarded as secondary and the causative positive supply-side shocks they postulate happen some time before the crisis itself. They cause the buildup of the behaviour that leads to the crisis, rather than the crisis itself. This I think is an important insight, and I commend the ECB economists for sticking to their guns despite the considerable difficulty in using a model that on the face of it looks inappropriate.

They outline a typical run of events leading to a financial crisis as follows.
  • A sequence of favorable, non permanent, supply shocks hits the economy. They don't say what these are, but candidates might be reductions in key interest rates or falls in oil and raw material prices.
  • The resulting increase in the productivity of capital leads to a demand-driven expansion of credit that pushes the corporate loan rate above steady state.
  • As productivity goes back to trend, firms reduce their demand for credit, whereas households continue to accumulate assets, thus feeding the supply of credit by banks (presumably to households). 
  • The credit boom then turns supply-driven and the corporate loan rate goes down, falling below steady state. 
  • By giving banks incentives to take more risks or misbehave, too low a corporate loan rate contributes to eroding trust within the banking sector precisely at a time when banks increase in size. The credit boom lowers the resilience of the banking sector to shocks, making systemic crises more likely.
  • When counterparty fears in the interbank market rise too high, the market freezes.
From this sequence of events, we would expect to see

1) rising corporate debt to start with, then declining
2) rising productivity
3) household assets rising as corporate credit falls
4) increasing size of bank balance sheets

Did we actually see this in the run-up to the last financial crisis? Well, maybe. The UK's ONS gives a picture of rising corporate debt from 2000-2007, then a fall*:













(I've used liabilities instead of debt in this case because of the ONS's observation that PNFC balance sheets were actually more highly geared than acquisition of debt and assets during the period suggest. The whole ONS paper is well worth a read).

Household assets did indeed rise during this period. But so did their debt:



















So household balance sheets were inflating overall.  This doesn't necessarily invalidate the authors' conclusions, but the omission of household debt from their analysis I think weakens it. And perhaps more importantly, there isn't any evidence from this pair of charts that households continued to accumulate assets after corporate borrowing started to fall. Both household assets and corporate borrowing seem to have fallen at the same time.

However, the authors are right about the increasing size and riskiness of bank balance sheets. I don't need to produce a chart for this, since the accumulation of both household and corporate liabilities in a bank-dominant lending model such as exists throughout Europe must result in inflated bank balance sheets. And the increasing riskiness of bank lending and trading in the run up to the financial crisis is firmly established.

The other factor is productivity. Productivity did indeed rise hugely prior to the financial crisis:

















(larger version here)

The shock to productivity caused by the financial crisis is very evident in this chart. But more importantly, it suggests that the productivity rise prior to the crisis was unsustainable. In which case the UK economy cannot realistically return to that rate of productivity growth: a shallower curve is both more likely and more desirable. The question is whether it can bounce back to the level it reached in 2008 and then grow more sustainably. I'm not convinced. It seems more likely that productivity growth has dropped to a new, lower (and shallower) trend. This has serious implications for output and for economic recovery.

But I digress. The ECB team suggests that declining corporate borrowing and a fall in productivity lead to unsustainable (bubble) growth of household and bank balance sheets, causing increasing risk which ultimately ends in a market freeze when counterparties think the risk is too great. I don't buy this. Neither corporate borrowing nor productivity started to fall until the subprime crisis in the US, by which time household and bank balance sheets were already over-inflated and high risk. It is difficult to establish any likely causative relationship between productivity fall and increased riskiness, except in the early stages of the crisis itself. I wonder what exactly the ECB team regard as the crisis: perhaps they are referring only to the fall of Lehman and subsequent meltdown. If so, to my mind they are only looking at half the event. Lehman happened towards the end of the financial crisis, not at the beginning.

However, the remainder of their analysis is excellent. Their DSGE modellling establishes the following principles.
  • Financial crises are associated with unusually high and rising productivity.
"One striking result that emerges from this experiment is that the typical banking crisis is preceded by a long period during which total factor productivity is above its mean. In some 20% of the cases, crises even occur at a time when productivity is still above mean. This reveals one important and interesting aspect of the model: the seeds of the crisis lie in productivity being above average for an unusually long time. The reason is that a long period of high productivity gives the household enough time to accumulate assets beyond the banking sector's absorption capacity...."
So a highly productive household will save more. But Broadbent's chart shows that households are accumulating both assets AND liabilities. Assets, after all, include houses, which most people buy with debt (mortgages). And there is no reason to assume that this behaviour is homogenous, either. The bifurcation of the labour market that has been going on for well over a decade now suggests that high earners acquire net financial assets, while lower earners acquire net financial liabilities (debt). Households' balance sheets are polarised between high-debt and high-savings, with a substantial proportion of households having both - with savings mostly in illiquid form. This places their balance sheets under pressure when income falls due to productivity collapse. I think the authors miss this.
  •  Sustained periods of above-average productivity feed credit booms, creating large financial imbalances that are ultimately unstable and cause crises to break out without exogenous shock.
"We measure financial imbalances by the distance between banks' absorption capacity and banks' core liabilities. The smaller this distance, the larger the imbalances, and the less resilient to adverse shocks the banking sector. Typically, a distance of less than, say, 5% reflects large fi nancial imbalances..... 70% of systemic banking crises break out in the year after fi nancial imbalances have reached this threshold. This result con firms that most crises in our model break out endogenously, without an adverse exogenous shock happening at the same time." 
Or putting it another way, high gearing in banks increases their risk. Well, who'd have thought it.
  • High levels of household savings in good times are destabilising. 
....in our model, crises are more likely to occur in good, rather than in bad, times. This is due to the asymmetric e ffects of permanent income mechanisms on fi nancial stability over the business cycle. Bad times in the model are typically times where productivity is low and the household dis-saves....the fall in savings makes (all things being equal) crises less likely. Hence, in bad times, the dynamics of savings tend to stabilize the financial sector. In good times, in contrast, productivity is high and the household accumulates assets, which....makes crises more likely. In this case the dynamics of savings tends to destabilize the financial sector. This asymmetric e ffect of savings is the basic reason why credit-boom led crises are so prevalent in our model.
So their argument is essentially that high levels of household savings (presumably including physical assets such as houses, which are used as collateral against household borrowing) increase the riskiness of the financial system. This is particularly interesting, because it is the opposite of what is normally argued. But household savings are the liabilities of the banking system, and secured lending depends on good collateral, so a high level of household savings increases banks' fragility when also associated with low levels of loss-absorbing equity - the second bullet point above.
 They go on to draw the following important conclusions from their model:

1) Risk averse economies are more prone to crises.
T|his is really important. Prudential saving by households fearing a crash actually makes the crash more likely, and makes its effects worse. The quest for safety perversely creates the very disaster that the savers fear.  Moneyweek readers, please take note.

2) Economies with a highly elastic labour supply are more prone to crises.
This also is really important, especially given the prevalent belief that flexibility in the labour force is a good thing and countries should undertake labour market reforms to increase flexibility. This research suggests that flexibility in the labour force increases the amplitude of the boom-bust cycle, as households work more in good times and less in bad times. That suggests that there is a trade-off between business efficiency and economic instability. Some loss of business efficiency due to labour market inelasticity might be a good thing.

3) Contract enforceability and efficient banks reduce the likelihood of crises. (Though if crises do occur they can be worse). If the bulkheads on the Titanic had been higher the ship wouldn't have sunk.

4) Higher uncertainty is conducive to crises.
This bit is really interesting. They suggest that technological shock influences the likelihood of crisis: adverse technology shocks increase it, because households save prudentially and corporate borrowing falls, making the financial sector more fragile. Positive technology shocks, on the other hand, decrease the likelihood of crisis. The question in my mind is how to distinguish positive and negative technology shocks: "robots ate my job" is a negative shock to households but potentially a positive one for firms if their return on capital improves as a result. The authors don't develop this enough and there is room for lots more research on this subject. Intuitively it seems likely, if the primary cause of financial instability is high levels of household saving reducing banks' loss absorption capacity, that general uncertainty about the future would make crises more likely unless government applied pressure to banks to maintain or increase loss-absorbency.

And that I think is where we are now. We are in a period of uncertainty about the future and fear of technological change. Our economies are highly risk-averse, as is evident from the crashing yields on "safe haven" assets such as high-quality government debt and currencies. Elasticity is increasing in the labour force as self-employment, temporary and casual working increases and permanent full-time employment falls. And corporates, households and government alike are paying down debt and trying to save. The only ingredients missing are bank lending and productivity growth. Sadly the authors don't model the present stagnation as a repressed financial crisis.


Related links:

Booms and systemic banking crises - Boissay, Collard & Smets (ECB)
Corporate sector balance sheets and crisis transmission - ONS
Decoupling of wage growth and productivity - Resolution Foundation
Bifurcation in the labour market - Coppola Comment
The deadly quest for safety - Coppola Comment
The end of Britain? - Coppola Comment
Perverse incentives and productivity - Coppola Comment
The self-employed will not save the economy - Flip Chart Fairy Tales
Productivity and the allocation of resources - Broadbent (Bank of England)
Deleveraging - Broadbent (Bank of England)

The ECB researchers' analysis amounts to a flawed re-engineering of Minsky's financial instability hypothesis (which they briefly mention at the beginning of the paper) and Goodwin's growth cycle model (which they don't mention at all). I've therefore added a link here to Steve Keen's paper on the same subject. He uses chaotic system dynamics rather than a DSGE model.
Finance and economic breakdown: modelling Minsky's "financial instability" hypothesis - Keen

*I'm using UK data throughout this post because the paper is written from a European perspective and the UK is the principal financial centre in Europe. US lending markets are very different from European ones because of the dominance of capital markets. Europeans, including the UK, rely much more on banks.

Tuesday, 12 February 2013

Bifurcation in the labour market

Recent reports on the UK jobs market have once again been surprisingly upbeat. The FT, reporting on the North of England and the Midlands, noted that jobs were being created at quite a rate (paywall). The ONS confirmed this in its Regional Labour market statistics for 23rd January. Employment is rising, particularly in the West Midlands and the Yorkshire and Humber region, and unemployment is falling, especially in the North East. Things are definitely looking good. Though there is still that productivity puzzle....

There's another puzzle, too. BDO produced a distinctly pessimistic report suggesting that business confidence was at an all-time low and we shouldn't expect recovery any time soon. But the Guardian reports that ICEAW & Grant  Thornton have produced a similar report saying that business confidence is at a two-year high. I wonder how two accountancy bodies managed to achieve such different results, and what this inconsistency tells us about the real state of the UK economy.

The prevalence of temporary and part-time job creation, coupled with lack of capital investment, suggests businesses are uncertain about the future - which rather supports BDO's argument that business confidence is low. If that is the case, then maybe it is reasonable to assume that at some time in the future businesses will convert these into full-time permanent jobs. It would be nice to think so. But I'm not convinced.

Businesses like to have very flexible workforces. Just-in-time staffing - bringing in temporary or agency workers to meet staffing needs on a day-to-day basis - enables efficient use of financial, physical and human resources. And some workers are happy to meet this need. But not all are. The question is therefore how many of the people currently forced into temporary or contract working really want to work like that, and for those who don't, how we move the economy towards generating the full-time permanent jobs that they really want. This is a social engineering problem which would be anathema to free-market fanatics. And it may prove intractable anyway. I think there is another, much more fundamental problem here.

It seems to me that we have a labour market that is bifurcating - splitting in two.  It's like a city in a developing country: there is a "core" of highly-skilled, highly paid and largely protected people for whom businesses compete internationally, surrounded by a growing "shanty town" of low-skilled, poorly paid and increasingly insecure workers. This applies in both the private and the public sector, by the way - in fact I think the trend has been evident in the public sector for longer. What seems to be disappearing is the middle - the routine, well-defined and fairly skilled jobs that are the bread-and-butter of the middle classes. Why is this happening?

AGCAS and the Work Foundation produced a fascinating report in 2011 called "The Hourglass and the Escalator". In this they postulate that increasing automation is eliminating routine semi-skilled jobs and forcing people into lower-skill, lower-paid jobs. This is contrary to the way we normally think about automation. It is usually assumed that automation first eliminates the low-skill jobs. But that doesn't seem to be the case. Low-skill jobs are being created in ever-greater numbers. It's the medium-skill ones that are vanishing.

Most of the temporary and part-time jobs currently being created are low skill, very low waged and extremely insecure. The Financial Times recently discussed (paywall) Amazon's warehouse operation in Rugeley. Amazon, it seems, is employing mainly temporary workers who can be dismissed without notice and offering the "carrot" of a permanent job if they are really, really good - which few are. Obviously this is only one large employer, but it seems likely that others are doing similarly. The interesting thing is that Amazon is using people to do a warehousing job that would seem an obvious candidate for automation. And Amazon is definitely not short of money. So why is it using low-wage, low-skill temporary workers instead of investing in cutting-edge automation?

Amazon says it is because people actually do the job better than robots. With the state of automation at present, this may well be true. In fact most of the low-skill, low wage jobs currently being created don't lend themselves particularly well to automation at the moment. A high proportion of them are service jobs, ranging from childcare to waitressing to supermarket checkout operators. And the fact is that people prefer to be served by people. They don't like dealing with machines. So the smiling barista who serves you coffee in Costa is an essential part of the business. But baristas, checkout operators, cleaners are substitutable. Lose one, you can just buy in another. They don't have unusual skills that are difficult to replace, and although getting on with customers is important, it is not a unique ability. I suppose these jobs too in due course will be automated - but we aren't there yet.

But this isn't the whole story. Your average barista is not paid a great deal and may be on a temporary contract. If he is, then he can lose his job tomorrow. And if he is actually self-employed - and the trend is towards self-employment for low-skill jobs - then there are no employment overheads either. He costs little to employ, you pay him only his wages and when you don't need him you get rid of him. You can't do that with a robot. Robots, like other plant, require up-front capital investment. Automating Amazon's entire warehousing operation would be extremely expensive. Why would they do that when they can use temporary workers on a just-in-time basis at much lower cost? To my mind it is no accident that they chose to site their warehouse in a depressed area with high unemployment due to collapse of the mining industry. They wanted a large pool of desperate people with obsolete skills.

So part-time and temporary jobs, and growing self-employment, may not be a transitional stage on the road to economic recovery. They may instead indicate a fundamental change in the labour market. Perhaps insecure working is the shape of things to come for the majority of people. If so, it raises fundamental questions about the way in which society operates. How do you plan for the future if your job can disappear at any time without notice? How do you get finance for a house, or a car, if you have no reasonable certainty of future income? In fact, if you don't know if you will have a job tomorrow, you aren't going to spend money unless you absolutely have to, are you? So I would expect the rise in temporary work and self-employment, particularly, NOT to be accompanied by a rise in GDP. People stuck in insecure work with frequent spells of "resting" don't spend money. They save it. Ask any actor.

But job insecurity and robots are only half the problem. The other half is skills. Businesses are constantly moaning that they can't get the skills they need, and blaming the education system for failing to provide workers with the right skills. Actually they have been doing this for as long as I can remember, so it is clearly an intractable problem. Now if there really was a skills shortage in the economy, shouldn't there be high vacancy levels? But vacancies have fallen considerably since 2007. So what are businesses really complaining about?

HR magazine notes that businesses expect to recruit in 2013. It is evident from the report that they mean  highly skilled professional jobs. And businesses clearly worry about the availability of these skills. The HR article implies that businesses are competing with each other for "high performers", and increasingly the competition is international. But the definition of "high skill" is changing. We know that many graduates now are taking low-skill jobs because they are unable to find jobs that use their skill set. And professional recruitment sites for executive jobs show how high the bar has been set - no wonder most graduates don't measure up to it. Masters degrees, PhDs, professional qualifications, languages and years of experience - and contacts. You have to have contacts. Actually that's mainly why you need the qualifications and experience. Only by spending time at a top university and in the right businesses can you build up the network of key contacts that you must bring with you to a top job. Even today it is not what you can do that is really important - it is who you know

What businesses are really complaining about is the inability of the Government to provide them with a competitive edge. It is rent-seeking, pure and simple. They don't have the time to grow their own top talent, because jobs are no longer for life and top talent knows perfectly well that the way to build a career is to change jobs. So they are looking to the education system to do it for them. Next time you hear a business leader moaning about the broken education system and the lack of skills in the workforce, try to hear the fear underneath the rhetoric. "If I can't find and retain the best performers, I'm dead"......

Is it reasonable of business to expect the education system to provide it with specific job-related skills? I don't think so. Education is about developing the individual, not meeting business needs. And if business can't recruit the skills it needs at the price it wants to pay, what chance does education have of recruiting good teachers of those skills? Anyway, talented people do wonderful work in business whatever their academic background. I know very few people who still work in the field in which they did their first degree (I am currently an exception). It is the personal skills - critical thinking, time management, independence and so on - that develop in the course of advanced education that are of most importance to business. Focusing on job-specific skills misses the point and runs the risk that market changes will render these skills obsolete. We have far too many people already with obsolete skills.....

In fact obsolete skills are a large part of the problem. The world of work is changing very fast - faster than at any time since the Industrial Revolution. And just as in the Industrial Revolution those who couldn't change their ways suffered, so those who can't adapt to the information revolution and globalisation are suffering. The middle-class jobs of the past are not coming back. The question is, what will replace them? I don't think we can see clearly yet where the new jobs will come from, or in what ways work will change in the future.

What is clear to me already though, is that the boundary between education and work is blurring. Learning is becoming a life-long process: with the advent of the internet, it has never been so easy to research and study anything that takes your fancy, and use it not only to inform your mind but to improve your work performance and develop new lines of business. Business should be a partner in the development of lifelong learning strategies. At present it seems willing to provide learning opportunities for the core, but not for the increasing number of people in the "shanty town". That is why business is struggling to find the skills it wants - it has disengaged from the process of creating them.

Business re-engagement with the growing "shanty town" of low-skilled, poorly paid and insecure workers is essential for economic recovery. And it seems to me that fostering this re-engagement is the role of government. It seems a pity that at the moment government is only too happy to encourage business in its preference for insecure, low paid, short-term working for the majority coupled with excessive remuneration for a protected and increasingly international elite. There can be no recovery while government and business preside over the progressive impoverishment of large numbers of people. After all, business only prospers if the economy does, and the economy only prospers if people do.

Related links:

The Hourglass and the Escalator - AGCAS
Private sector helps spur UK jobs growth - Financial Times (paywall)
Amazon unpacked - Financial Times (paywall)
Regional labour market statistics 23rd January - ONS
Labour market statistics, January 2013 - ONS
Perverse incentives and productivity - Coppola Comment
Business confidence "hits new low", says survey - BBC
Britain "should avoid triple-dip recession" - Guardian
UK directors predict job creation and slowdown in redundancies - HR magazine
Thousands of graduates forced to take menial jobs - Daily Mail
Unemployment and the labour market, 1870-1939 - Timothy Hatton

Sunday, 10 February 2013

On the unintended consequences of new Government targets

This is something of a cautionary tale. I think it's about time I explained why the financial crisis completely passed me by, except as a mildly interesting news item. The truth is, I was ill at the time. At the end of October 2007, after I had spent several months waiting for scans and doctor's appointments, and nearly 2 months waiting to see an NHS consultant, that consultant told me in no uncertain terms that I needed a major operation and why hadn't I been to see him sooner. Sigh. NHS bureaucracy.....

Anyway, I signed up for the operation and was told that the waiting list was 4 months, during which time I would be provided with drugs to keep me going. Those drugs made me feel terrible but at least they kept me functioning, though I gradually became iller, of course - time doesn't stand still when you are on a waiting list. I continued working - with some difficulty - and waited for the call.

In January 2008 I received the long-awaited call. But it wasn't from the consultant's secretary to arrange my op. It was from someone offering me the option of switching to a private hospital some distance away from my home, with the incentive that I would have the needed operation quicker - as I recall they said within 2 weeks.

Naively I agreed to this, because it meant I could get the whole business over with and get back to normality. Because the private hospital was in a different area, the operation would be performed by a different consultant. I assumed that my notes would be sent to the new consultant. And since the time until the operation was short, I expected to hear from the new consultant within a few days. So when I hadn't heard anything after a week I rang the new consultant myself.

I was horrified. Not only did this new consultant know nothing about me, he insisted that before he could do any operation he had to see me and make his own diagnosis, and until then he couldn't give me any timescale for my operation or even confirm that I would have it at all. And the earliest appointment he could give me for the consultation was in 3 weeks' time.

It dawned on me that after waiting for over 2 months, I had simply been removed from the waiting list.

I didn't know why. And I didn't know what to do.

Fortuitously I saw a client a few days later who told me that she was on the waiting list for the same operation. She had gone on to the waiting list more recently than me and therefore came under the Government's new Patient Pathway scheme, which specified a maximum time of 18 weeks from referral to treatment. In conversation with her, it became clear that the new Patient Pathway did not apply to me, because I was already on the waiting list when it was introduced. It began to look as if I had been removed from the list to make way for patients who had to be treated sooner to comply with the new government targets.

Well, I am not one to put up with being treated like that, so I rang the original NHS hospital and demanded to be reinstated on the waiting list. This time I spoke to the consultant's secretary, who was happy to reinstate me at my original position. And she also asked me who had contacted me to offer me the transfer to private treatment. So I gave her the name of the person who had rung me.

"That's odd", she said. "No-one of that name works here. But we've had external advisors in to help us manage our waiting lists in the light of the new Government targets. Maybe it's one of them".

I left it with her to investigate who had been responsible for removing me from the waiting list, and resumed my wait. A couple of weeks passed and she rang me again, offering me a choice of two dates for the operation. I opted for the one that suited me best. Then she made this devastating remark:

"We want to thank you for drawing this to our attention...."

It turned out that the "external advisors" had been contacting people like me and offering them treatment that they had no authority to offer, purely in order to reduce the waiting lists and enable the hospital to meet the new targets. I don't know how many people were affected, and whether anyone else complained. But many people are more accepting of disruption than I am. To this day I wonder whether there were others who simply accepted the offer without question, and what happened to them.....

There are two morals to this story. The first is that Government targets designed to improve outcomes can perversely make outcomes worse for some people. Particularly when the Government employs private providers to help the public sector to meet those targets, pays them on results, and doesn't supervise them properly.

And the second moral is that being stubborn and bloody-minded can be a very good thing.


Related links:

Final report from the inquiry into the Mid Staffordshire NHS Foundation Trust - Francis
Perverse incentives and productivity (updated version) - Coppola Comment
The Work Programme - DWP


Friday, 8 February 2013

Perverse incentives and productivity

The UK's labour market is something of a puzzle. Employment is at an all-time high, but unemployment is higher than might be expected from the employment figures and productivity is falling like a stone. Numerous explanations have been put forward for this apparent inconsistency, most recently by the ONS, the IFS and the TUC. Even FT Alphaville had a go at it. Needless to say, none of these bodies agree on the causes. I've read all these reports, and in my view all of them make useful contributions. If there is one certainty in this matter, it is that there isn't a simple explanation.

But I think they are missing something. The other day I wrote a post asking why there was such a rise in employment when unemployment was apparently not falling a great deal. Who are all these new people, where have they come from and why weren't they working (or unemployed) before?

This sparked an intense debate on twitter about the nature of the new employment. And from it emerged a picture of perverse incentives that I think goes a long way towards explaining not only the difference between employment and unemployment, but also the falling productivity since mid-2011.

The story starts with the ONS's report that 367,000 of the new "jobs" are actually people registering as self-employed. The TUC observes that this is 40% of all new jobs and the vast majority are sole traders. 60% of these new self-employment registrations have occurred since 2011 and the vast majority of people registering as self-employed (84%) are aged 50 or older. A high proportion are men. They work longer hours than employees and earn much less. RBS notes that the remuneration of people in self-employment is generally far lower than the pay of those employed. And it has not recovered since the financial crisis. Average self-employed incomes are still 5% below their 2008 level, whereas average employed incomes are 10% above the 2008 level. The rise in employed income is quite a bit less than inflation in the last five years, so the employed have suffered a cut in their real incomes. But the self-employed have taken a real beating. With real income collapse on that scale, you would expect self-employment to be falling, not rising. So the rise in self-employment is distinctly puzzling.

The ONS also reports that there has been a vast increase in part-time employment (including self-employment) and a corresponding fall in full-time. Many people say they can't get full-time work. And there is evidence that a high proportion of jobs created are low-skill and poorly paid. All of this supports the IFS's argument that labour is relatively cheap compared to capital and that companies are therefore substituting cheap labour for expensive capital investment. Forcing people to work with inadequate capital reduces their productivity: this may therefore be a contributory factor in the productivity puzzle. But it doesn't explain the rise in self-employment.

We know that the rise in employment in the last 18 months far exceeds the fall in unemployment. Therefore many of these jobs must be people who were neither working nor seeking work (unemployed) before. They aren't people who lost their jobs in the recession: the rise in unemployment in 2008/9 more-or-less matches the fall in employment. So they must be new entrants. It seems we are seeing an influx into the workforce of older people who perhaps had taken early retirement, expecting to live off their savings, and are having to return to work because very low interest rates have clobbered their fixed incomes. We are also seeing the entry into the workforce of people who previously were on other benefits, notably disabled people - many of whom may also be over 50 - and single mothers, though I suspect many of these people are pushing up the unemployment figures rather than adding to the employed total. And the employment figures, though not the unemployment figures, may also be pushed up by students working their way through college or university. Whatever the cause, the fact is that far more people are now working than was the case even 2 years ago, and a high proportion of these are over 50.

The problem with trying to return to the workforce when you are over 50 and have been out of it for a while is that you are perceived as being out of date, your skills have atrophied and there are younger people with more recent relevant experience. It is extremely difficult for older people, particularly men, to find work in a squeezed jobs market. In my twitter debate a number of older people commented that they had been forced to turn self-employed because they could not get a job. They were supporting themselves with what Rick calls "odd jobs" - casual work in a range of largely manual or low-skill occupations. This is consistent with the ONS's report that the most common areas of self-employment are cab/taxi driving, "other" construction services, carpentry & joinery, and farming. RBS says there is also a rise in the number of people claiming to be self-employed "managers", which is a useful catch-all for formerly high-skill retired people returning to the workforce. The picture is one of older men, and to a lesser extent women, trying to replace lost benefits or supplement private pensions with casual work until they reach the state retirement age. Entrepreneurial, this isn't.

This might contribute to the productivity problem. Older people may be less fit and energetic than younger ones, so might be slower - though they may have more experience, which would offset this to some extent. And they may not have a great incentive to work hard, since many are simply marking time until they are able to retire. Also, I hate to say this, but people who have been on incapacity benefit for years, or bringing up children, and are now forced to return to the workforce are not likely to be highly productive, at least to start with. But I don't think this is a sufficient explanation of the productivity drop. Older people may be slower but they aren't useless. And what about all the younger people apparently accepting part-time work instead of full-time? How are they surviving, with hugely reduced hours and falling real incomes? No, there must be something else going on too.

The BBC's Five Live programme yesterday suggested that work programme staff were actively encouraging people to register as self-employed if they were doing a small amount of low-skill, low-paid casual work such as cleaning or gardening. This was supported by a number of people in my twitter debate from their own personal experiences. Now why would job centre staff do this? Well, here is perverse incentive no.1. Getting people who are doing small amounts of casual work off the unemployment register benefits both the claimant and the job centre staff, since it relieves both of the burden of signing on (and off), managing constant claim changes due to casual work and dealing with conflicts between the requirements of job search programmes and the work already being done by the claimant. And it flatters the Government's unemployment figures.

But these people are not necessarily doing much paid work. As I said above, entrepreneurial they aren't. They are living hand-to-mouth, doing odd jobs for low pay interspersed with periods of no work. How can they afford to do this instead of claiming unemployment benefits?

This is where the second perverse incentive comes in. The self-employed, and the part-time employed, can claim tax credits. Working tax credit kicks in at 30 hours for a single person aged 25-59 with no dependents, and at 16 hours for people with dependents, people 60+ and people with disabilities. For a couple, working tax credits start at 24 hours between them of which one person must work at least two thirds. The number of hours a couple had to work to claim working tax credits was raised to 24 in April 2012 (previously it was 16 hours between them). At the time, Unison claimed that the effect would be that some couples would simply stop working - but tougher rules for out-of-work benefits may have forced them to remain in work. One of my twitter commenters stated that he did eight hours a week of very poorly paid self-employed work so that he and his partner could claim working tax credits.

The ability of part-time and low-paid workers to claim tax credits creates a perverse incentive for employers, too, because reducing hours instead of laying people off when companies are experiencing financial problems or depressed sales becomes a realistic alternative. In previous recessions, people have lost their jobs. Many people have commented that this time round, companies have held on to labour but reduced hours and wages. In my view this has been made possible by the existence of working tax credits. When put together with the reluctance of companies to invest in capital at the moment, there is clearly an incentive for companies not only to hold on to existing workers but to create low-paid part-time jobs to keep businesses "ticking over", knowing that people who really want full-time work will accept those jobs because tax credits will top up the wages. This seems like a good thing, because it keeps people in work, but if it means that companies are substituting cheap labour for capital investment and technological innovation, it does not bode well for future growth and prosperity.

But the biggest perverse incentive of all is in the realm of self-employment. Consider someone who is doing odd bits of paid work mainly for friends and family, interspersed with periods of no work. That person has no way of knowing what his hours of work will be from week to week. But to claim tax credits, he must be working a certain number of hours per week. So in his claim, that's what he states. He's not being untruthful: he is stating what he WANTS AND EXPECTS to work, not what he is actually doing at the time of the claim. The newly self-employed are business startups in the eyes of HMRC, so are not likely to have low productivity questioned for at least a couple of years. And as I pointed out above, job centre staff may be actively encouraging people who do casual work to register as self-employed. The assumption by both HMRC and DWP is that newly self-employed people are spending significant amounts of time promoting their business, so actual hours of work can considerably exceed paid hours. And this may indeed be true.

But self-employed work, particularly in services, is actually declining at the moment due to the fall in real incomes of the employed, who are the customers of the self-employed. So our newly self-employed are actually finding life very hard indeed and desperately need the tax credits in order to survive. The choice they have is between giving up the casual work and registering as unemployed, or overstating their hours of paid work. Which would you choose?

For me it is telling that the drop in productivity appears to coincide with the massive rise in self-employment since 2011, which itself is driven by changes to benefit eligibility criteria as well as the Bank of England's monetary policy. I know correlation doesn't necessarily imply causation, but I'm unimpressed with coincidences, especially when correlation would help to explain a perplexing phenomenon. Now if the new self-employed were genuine small business startups, then the fact that they appear to have low productivity in the short term would not be a problem - indeed it would indicate that the new business owners were doing significant amounts of unpaid work to develop their businesses, which would be a good thing. But as far as I can see, that is not what the evidence shows.

What emerges is a picture of mainly older and less able people forced back into the workforce, doing insecure, low-paid and low-skill work and managing to survive on starvation levels of remuneration only because of a generous system of tax credits. If this picture is accurate, it is appalling. Far from indicating that the economy is on the verge of recovery, the apparently high employment levels coupled with low productivity may indicate that it is in terminal decline. For as Rick points out, the only economies that rely on high levels of subsistence-level self-employment are very poor ones. Over-tight fiscal policy, callousness towards the less able, unnecessary risk-aversion by companies and banks, and unhelpful monetary policy are turning the UK into a basket case.

UPDATE. I have just found and read the Government's document from December 2012 describing the operation of the Work Programme intended to help the unemployed back into work. The link is here and I have added it below. From the document:
"Service providers are paid almost entirely for results - defined as sustained job outcomes for participants"
Service providers are entirely from the private sector and are paid on results. Quite generously paid, too, and the payments continue the longer the participant remains in work. Which of course if they are self-employed they will be, even if they aren't doing much, because the alternative is going back on to the Work Programme, losing benefits and waiting months for JSA to catch up. The Trussell Trust notes that benefits delay is one of the two main reasons why people use food banks. So there is an incentive both for providers to push participants into self-employment and for participants to remain in self-employment even if they aren't earning very much.

But there is no supervision of how providers achieve their results. This is deliberate policy designed to give providers a free hand in how they design their work programmes:
Previous UK welfare-to-work programmes specified in varying levels of detail what interventions providers had to deliver. The Work Programme, in contrast, gives providers far greater flexibility to design programmes that will work, using their experience and creativity. Rather than asking providers to make one-size-fits-all services work for a wide range of participants with varying needs, government is providing freedom for providers to personalise support for the individual in a way that fits the local labour market. This is sometimes referred to as a ‘black box’ commissioning approach. 
The combination of payment by results with no supervision of how those results are achieved is clearly an incentive to providers to focus on achieving results without consideration of actual outcomes for the participants concerned.

The Work Programme came into operation in June 2011 - which was when employment started to rise and productivity to fall. Is that a coincidence? Judge for yourself. I know what I think. This programme may be successful in terms of numbers, and is no doubt rewarding the providers handsomely, but at what cost to people's lives and the UK economy?

Related links

Self employed workers in the UK, February 2013 - ONS
The Productivity Conundrum, Explanations and Preliminary Analysis - ONS
The IFS Green Budget, February 2013 - IFS
TUC Economic Report, February 2013 - TUC
UK productivity puzzle possibly solved? - FT Alphaville
Startups or upstarts? self employment in the UK - RBS
Benefit changes timetable - Turn2Us
Work advisers "pushing jobless into self-employment" - BBC
Don't encourage the odd-jobbers - we have enough already - Flipchart Fairy Tales
What sort of countries have lots of self-employed people? Poor ones! - Flipchart Fairy Tales
The Work Programme - DWP
Fix the bureaucracy, for heaven's sake! - Coppola Comment