Monday, 29 July 2013

Currency wars and the fall of empires

My new post at Pieria:
"I have been reading James Rickards' book Currency Wars. In this, Rickards reviews the use of fiat currency over the course of the last century, and concludes that the present global fiat currency system is inherently unstable and on the point of collapse. He calls for return of the gold standard to stabilise firstly the US dollar and, following on from that, international trade currency. 
I am no historian, but the first thing that struck me about this book was its partial view of history. Rickards does not discuss the reasons for the classical gold standard being abandoned in 1914. Indeed since he writes almost entirely from an American perspective throughout this book, the European historical dimension is seriously neglected. There are two major omissions:
- the background to World War I and its consequences
- the collapse of the Soviet Union.
Both of these involved catastrophic failure of fixed currency systems: admittedly only the first involved a gold standard, but really that does not matter. The chaos caused by the collapse of empire is the real issue in each case. Indeed the global dislocations arising from the First World War and its associated events reverberated for the rest of the 20th century."
The remainder of the post can be found here.


Wednesday, 24 July 2013

Anatomy of a bank run

In my last post, I argued that enforced separation of investment banking and commercial banking would not eliminate the need to provide central bank support to investment banks and other non-banks in the event of another Lehman-type collapse. There followed an extensive discussion in the comments, in the course of which it became apparent that many people simply don't understand how bank runs work. So I thought I'd explain.

The classic bank run looks like this:


Queues of retail customers outside a bank, waiting to withdraw their money. But actually this sort of bank run is very rare. The run on the UK's Northern Rock in 2007 was the only retail run in the financial crisis and the first in the UK for 140 years.

What is more frequent - and far more damaging - is a wholesale run. The Northern Rock retail run was preceded by a wholesale run that forced the Rock to go to the Bank of England for emergency liquidity assistance (ELA). And the wholesale run continued for the next five months despite ELA and government guarantees, only ending when Northern Rock was nationalised.

Wholesale runs occur when investors pull their funds all at once. "Investors" in this case means institutional investors and high net worth individuals. There were two major wholesale runs in the financial crisis, one in 2007 after BNP Paribas forced the closure of the Bear Sterns hedge funds by announcing that it could not value mortgage-backed securities used as collateral, and the other - much larger and potentially devastating - a run on tri-party and bilateral repo when Reserve Primary money market fund "broke the buck" after the fall of Lehman. It was this second run that very nearly brought down the entire financial system and forced central banks around the world to provide liquidity support not only to commercial banks but to investment banks and other "shadow" institutions.

The main risk with a classic retail run is that banks will simply run out of physical cash. The job of the lender of last resort, therefore, is to ensure that they don't. And if necessary, of course, banks experiencing classic retail runs can simply shut their doors. Unfortunately that is far more difficult with a wholesale run. Wholesale runs do not involve withdrawal of funds in physical cash. They typically involve three phases:

Phase 1: electronic transfer of funds from deposit accounts
Phase 2: increasing haircuts on collateral posted against secured borrowing
Phase 3: refusal to roll over short-term (overnight) wholesale borrowings. 

These three phases may be concurrent or sequential. But they have different effects.
  • Electronic transfers of funds can happen at any time and require funds to settle. If the institution being run upon is a commercial bank, the lender of last resort is responsible for ensuring that funds to settle are available. But if the institutions being run upon are investment banks or other non-banks, the commercial banks through which they settle transactions will need central bank liquidity support. Investment and shadow banks have no direct access to payments systems, so are forced to settle payments through commercial banks - and because of this they have deposit (transaction) accounts with commercial banks. So in a run on investment banking, the volume and value of payment transactions through commercial banks vastly increases, often in a rather unbalanced way, and there may be a high incidence of fails as the demand for funds exceeds the credit available in the transaction accounts. In effect, a run on investment and shadow banks causes a run on the commercial banks that support them. Clearly, the lender of last resort can prevent this run becoming a crisis - but there are limits to central bank support, which can be breached in a major bank run, as I shall explain shortly.
  • Increasing haircuts on collateral cause increased demand for cash. The haircut is the amount by which the value of the collateral exceeds the amount lent in, say, a repo. If the value of the collateral remains the same (this is a VERY big "if" in a bank run, as I shall explain shortly), then an increase in the haircut means that the amount lent is reduced. If the loan already exists, or (more likely) is rolled over, that means that the borrowing institution has to find additional cash to plug the gap left by the reduction in the loan amount.
  • If lenders refuse to roll over existing lending, or raise the interest rates on short-term borrowing to unaffordable levels, institutions that are dependent on short-term wholesale borrowings suddenly find that they cannot fund their commitments. If they are denied central bank liquidity support, they are forced to sell assets to raise cash. If they cannot do this then they fail in a disorderly manner. This is the most damaging phase of a wholesale bank run. This is what brought down Northern Rock in 2007. This is what brought down Lehman in 2008, followed by many other banks. This is what very nearly killed the entire financial system.
Financial institutions being "run upon" develop large holes in the liability side of their balance sheets and experience severe funding distress. However, if reliable sources of cash can be found - such as an effective lender of last resort facility - then the bank run can (in theory) be allowed to run its course: if plentiful liquidity is made available then investors may be reassured that their funds are not about to evaporate and the bank run may fizzle out.

Some people think that because a bank run always takes place via commercial banks even if the institutions actually run upon are shadow banks, it is only commercial banks that need liquidity support: shadow banks can be allowed to fail without commercial banks and their retail customers being adversely affected. That would be true if a bank run only involved deposit account withdrawals -  phase 1. But when phases 2 and, especially, 3 occur, that separation doesn't work. A run on shadow banks threatens the solvency of commercial banks. And that is because of the effect of a bank run on the ASSET side of the balance sheet.

Institutions being run upon have to find cash. Lots of it, and fast. If they cannot borrow, then they have to raise money by selling assets. Distressed asset sales by a number of institutions at the same time force down the market price of those assets. So a widespread run on shadow banks that cannot obtain liquidity support from central banks causes asset values to collapse. All asset classes are affected, including "safe" assets used by commercial banks as collateral for central bank funding. This is why the Fed provided liquidity support to shadow banks. It was supporting asset prices. And it continued to do so with QE and other unconventional interventions.

Collapsing asset values are disastrous not only for the financial sector but for the economy as a whole. If there was one thing that Lehman and its aftermath demonstrated, it was that the idea that investment banks can be "allowed to fail" if the result will be asset value collapse is sheer fantasy. Central banks have no choice but to support any financial institution caught up in a major wholesale bank run, whatever its status.

This is not to say that an insolvent investment bank should be bailed out by taxpayers. How we deal with imprudent financial firms that have got into difficulty is an entirely different matter from how we deal with a financial panic. I would be the last person on earth to suggest that governments should recapitalise or otherwise rescue failing investment banks. Indeed I am not keen on governments bailing out any sort of bank: government backstop without control encourages bad management and poor asset quality, which are the two biggest causes of bank failure. But denial of liquidity support to some institutions in a widespread bank run would be disastrous.

To my mind the Fed got it right in the crisis. It threw money at everything, regardless of its status, and by so doing, prevented a catastrophe. But the direction of discussion since, particularly in Europe, has been counterproductive. Cherry-picking which institutions qualify for central bank support is never going to make the financial system more robust. So my recipe would be: provide central bank support to everything and taxpayer support to nothing. And take steps to ensure that investment banks and commercial banks alike maintain good asset quality and defensive balance sheet structures.


Related links:

Grieving for Glass-Steagall - Coppola Comment
Why do we never learn? - Coppola Comment
Reducing the systemic risk in shadow maturity transformation - Krieger (NY Fed)
Repo runs: evidence from the tri-party repo market - Copeland, Martin & Walker (NY Fed) (pdf)

Tuesday, 16 July 2013

Grieving for Glass-Steagall

Glass-Steagall is dead. Rather like Soviet-era Communist leaders, it has been officially dead since 1999, and actually dead for much longer. Though there was no state funeral, the body was not embalmed or put on display and few people mourned its passing.

Well, not at the time. But fast forward to 2008 and suddenly the Western world - not just the US - exploded in a paroxysm of grief over the demise of Glass-Steagall. "If only Glass-Steagall hadn't been repealed!" people cried. "Glass-Steagall would have prevented all these banks failing. Glass-Steagall would have stopped all these derivatives being created. Glass-Steagall would have protected everyone's money". Glass-Steagall, it seems, could have prevented the entire financial crisis. Never mind that Lehman, Bear Sterns and Merrill Lynch were pure investment banks, with no retail deposits to put at risk. Never mind that AIG was an insurance company and Fannie and Freddie were government-sponsored enterprises - none of which were subject to Glass-Steagall's provisions. Never mind that Countrywide and most of the other mortgage originators that together created the largest fraud in US corporate history were pure retail lenders and therefore ALSO not subject to Glass-Steagall's provisions. And never mind that the large universal banks in the US survived the financial crisis relatively unscathed - which might not have been the case if Glass-Steagall had prevented them diversifying.

Ever since, there have been calls for its resurrection in some form or another. The UK is adopting a baby Glass-Steagall. The Eurozone is thinking about a gauzy curtain. And the US has brought in a distant relative - the Volcker Rule. But people are not happy. "WE WANT GLASS-STEAGALL! BRING BACK GLASS-STEAGALL!" they cry. Bizarrely, even people in the UK cry this. The UK never had Glass-Steagall. I wonder sometimes if people really understand what it is they are demanding.

Four years on, there is still an immense amount of nostalgia for the age of Glass-Steagall. And there are repeated attempts to bring it back in some form. The latest attempt is by Senators Warren, Cantwell, McCain and King. Warren admits that Glass-Steagall would not have prevented the financial crisis, and would not end "too big to fail", but none-the-less wants the large universal banks to be forced to divest their investment banking activities, apparently in order to improve the "culture" in retail banking. But as I've noted before, the cultural shift in retail banking away from service and towards aggressive product selling had nothing to do with investment banking: it long pre-dated the repeal of Glass-Steagall and was due to low margins and cut-throat competition in the retail banking sector.

Warren - like many others - wants separation of investment banking from retail to prevent "insured deposits" being used to fund risky activities. Sadly that demonstrates a total lack of understanding of the real funding problems in the financial crisis, or indeed of the nature of bank lending. The problem was actually that wholesale funding - which is prone to runs, as I shall explain - was excessively relied upon to fund risky activities, including retail lending. Retail lending may be "boring", as Warren claims, but it isn't "safe". Deposits that back retail loans on bank balance sheets are at risk. If they are insured, that puts taxpayers' money at risk just as much as if those deposits were used for securities purchase.

Nevertheless, the calls for separation of "boring" retail banking from "risky" investment banking continue. And there is an important issue here. It concerns the extent to which we are prepared to provide public funds to support the activities of banks. In essence, Glass-Steagall and all its relatives are an attempt to limit the activities that can be supported by public funding - by which what people really mean is liquidity support from central banks.

The trouble is that this is actually impossible. When investment banks are separated from commercial banks they become their customers. Their cash balances sit in commercial banks, because ALL money that isn't in the form of physical notes and coins sits in commercial banks, one way or another. All financial market trading is intermediated through commercial banks. All new stock issues are intermediated through commercial banks. Payment fails don't just affect the recipients, they affect the liquidity of the banks through which they are intermediated. In practice it is simply impossible to remove liquidity support from payments arising from market trading, and very dangerous to attempt it - as the Fed discovered when Lehman fell. Remove central bank liquidity support for market trading activities and the entire market collapses like a house of cards.

There is a prevalent belief that if a Glass-Steagall separation were imposed, financial markets could be allowed to collapse without commercial banking being affected. This is completely wrong. When major customers of commercial banks fail, the banks themselves are at risk - and by extension so are their retail customers. The Lehman collapse and consequent market freeze very nearly caused the failure of the global payments network, which would have had catastrophic effects on retail customers. Central banks have to provide liquidity support for ALL payments, whatever their source, not to protect investment banks but to protect the retail customers of commercial banks.

It's not enough to provide liquidity support after the event, either. Perception of liquidity support is really important. It is the perception of illiquidity that causes bank runs. Institutional investors are nervous creatures. If they believe they might lose access to their funds, they will pull them. Note that this has nothing to do with whether or not there is a real risk of actual loss: even if lending is collateralised with good quality assets there can still be runs. When funding stresses make headline news and there is no apparent liquidity support, people pull their money from the banks affected. So when investment banks are denied liquidity support, institutional investors will pull their funds if they smell trouble - and the knock-on effect is a run on commercial banks, since investment banks are customers of commercial banks. Admittedly, all that really happens in a modern bank run is that money moves from one commercial bank to another - but large unexpected flows of money are destabilising for the banking system as a whole and can be fatal for individual commercial banks.

Liquidity management for commercial banks is a huge issue. Regulatory pressure at the moment is pushing them to increase their holdings of liquid safe assets such as government debt and to fund themselves more with retail deposits than wholesale funds. Retail deposits have traditionally been slower to run than wholesale funds: in the past this has been partly due to retail customer apathy, and partly because retail depositors have had to wait for banks to open in order to withdraw their money, whereas institutional investors can move their money by trading overnight on Far Eastern markets. But this difference is disappearing fast as internet banking makes it possible for retail customers to make payments and move money around at any hour of the day or night. If you make it easier for people to move their money, they are more likely to do so.

Matthew Klein thinks that separating deposits from lending would solve the problem, because it would mean that deposits were never used to fund risky lending. Most bank deposits are moving balances. There are payments in and out of transaction accounts of all kinds all the time: some of those are retail transactions and others come from institutional or market sources. It is not realistic to say "we will provide liquidity support for transactions from retail sources but not from wholesale ones". The same banks are at risk from payment fails whatever the sources of the transactions, and therefore so are their customers. Klein wants to protect all deposits, irrespective of their size or origin, by backing them with central bank reserves - which neatly solves the transactions problem, but falls foul of popular abhorrence of public support for large institutional, corporate or high-net-worth individual deposits.

Of course many market trades are never cash settled. And it might be assumed therefore that they do not affect commercial banks. This would be wrong. Many of them have cash margin. And cash margin is held in banks. One way or another, all money is held in commercial banks, and it isn't in practice possible to distinguish between different "pots" of money in the provision of liquidity support, as proponents of structural reform (of all kinds) seem to think. Money is money, whatever its source: if it disappears in transit - whether because of customer default, market freeze or payment system failure - its absence causes problems for both the recipient customers and their banks.

Ensuring the smooth operation of payments has become the primary purpose of central bank liquidity, because advanced economies have allowed themselves to become completely dependent on commercial banks to facilitate the vast majority of cash transactions. Separating out different bits of banking would not eliminate this need: all it would do is create the impression that some types of transaction would not be supported, which would increase the likelihood of highly damaging market freezes or runs even though post-Lehman no central bank would dare withdraw liquidity support for non-retail transactions.

The problem it seems to me is that we have universal access to payments through the same set of commercial banks. There might indeed be a case for completely separating retail (insured) deposit-taking from everything else, perhaps in the form of a new public utility, but it would have to have its own payment systems directly supported by central banks. Would this eliminate the need for central bank liquidity support for non-retail transactions? I'm not sure, frankly. I suspect that even if retail payments were separated from wholesale in this way, there would still be untoward economic effects from financial market failure, which would hurt Main Street just as much if not more than losing their deposits. Hatred of all things non-retail is not sufficient justification for systematic dismantling of central bank support. The economic impact of such an act needs to be fully understood - which at the moment it is not.

What is clear though is that a 1930s-style separation of retail and investment banking is meaningless while all payments go through the same set of commercial banks. We forget that there were no payments systems in the 1930s. Everything was settled in physical cash. Do we really want to go back to that?

Glass-Steagall is dead. It is not appropriate for our modern banking system. Grieve for a bygone age, and move on.

Related links:

The 21st Century Glass-Steagall Act - James Pethokoukis
Daniel Tarullo questions wisdom of return to Glass-Steagall - Politico
Five facts about the new Glass-Steagall - Simon Johnson
What Glass-Steagall 2 gets wrong: Everything - Matthew Klein
Supermarket banking - Coppola Comment
How to lose 3 million dollars in one second - Chris Arnade



Sunday, 14 July 2013

The mercantilist threat to global rebalancing

My latest at Pieria:

"Bill Mitchell has been doing a series of posts on the circumstances leading to the UK's request for aid from the IMF in 1976. They give a fascinating insight into the economics of a time when trade balance and the international exchange value of the currency were the most important drivers of national economic policy. Since the great monetarist revolution of 1979 we have largely forgotten about this: nowadays it is fiscal, not trade, balance that concerns us, and we happily devalue our currencies and force down labour costs in search of elusive export-led growth. I believe we are chasing a dream.

For the last 40 years the world has been gradually rebalancing, as the West abandoned empire and colonialism in favour of free trade. Dismantling barriers to trade and freeing up world markets has not been easy, and it is fair to say that many Western countries have been more interested in ensuring that developing countries open their markets to imports than removing the tariffs and subsidies that protect their own precious industries. But the growth of supra-national companies, supported by (largely) free movement of capital around the world, has transformed the world economy. And from the point of view of the millions in developing nations who enjoy a standard of living of which their grandparents could only dream, this transformation has unquestionably been positive."

The remainder of the post can be read here.

Thursday, 11 July 2013

Economic equivalence: job guarantee and basic income

Recently there has been much discussion about whether a basic income [guarantee] or a job guarantee (JG) is the better option when unemployment is high, under-employment is pervasive and wages are low. Chris Dillow, Izabella Kaminska, Paul Krugman and I have all argued for basic income on the grounds that modern capitalism either is, or will be, incapable of generating sufficient work to provide a living wage for everyone: while the Modern Money Theorist (MMT) school argues strongly for a JG, claiming not only that it meets the moral objective of ensuring that everyone who wants to work can, but that the public sector providing jobs for the "reserve army of unemployed" can act as a form of automatic stabiliser.

I do not propose to discuss here the moral arguments for job guarantees versus basic income. Chris Dillow has addressed the argument that basic income encourages "mass skiving" very well in this post, while various papers from MMT theorists have identified the fact that most people want to work - that providing for oneself rather than being dependent on others is important for human dignity. Personally I don't think the two views are incompatible: if most people want to work, as MMT suggest, then even if they are provided with a basic unearned income they will still find useful and productive things to do that could earn them additional money. And I don't think anyone from the basic income side would dispute that the public sector might need to help those who are not self-starters to find useful and productive things to do. The idea that people need to be compelled to work is fundamentally inconsistent with the idea that "good" work is fulfilling, enjoyable and contributes to self-esteem. Some people no doubt would choose to watch TV all day, though whether this is due to laziness or demoralisation is an interesting question. But both the "job guarantee" and "basic income" schools agree that in general people want to work and should be supported to enable them to do so. They differ only on how that support should be provided.

However, MMT make claims for JG schemes that go beyond moral arguments and disagreements over the best method of delivering work. In this post on Economonitor, Randall Wray claimed that basic income was inflationary. And he and his colleagues in the MMT movement have adopted the concept of a Job Guarantee as the principal counter-cyclical fiscal policy tool in their macroeconomic theory. When unemployment is rising, so the theory goes, the public sector will buy up all the idle labour and put it to use in public sector or not-for-profit projects. This supports demand and therefore acts as a form of fiscal loosening. As the economy returns to health and the private sector starts hiring again, the excess labour hired under the job guarantee scheme finds private sector jobs, shrinking the public sector and acting as a form of fiscal tightening. It all sounds pretty sensible, doesn't it?

The principle of JG as a fiscal policy tool rests on the following assumptions.

1) The public sector is not financially constrained. It can create all the money required to pay workers under a job guarantee scheme.

This does of course imply that the country has its own central bank which has full control of currency issuance and that the government is able to finance all spending by central bank money issuance. This is not true in the European Union (yes, I do mean the EU not the Eurozone, and yes, it does include the UK).

2) There is no limit to the numbers or the types of job that can be provided by the public sector.

3) The sort of public sector projects that would typically be staffed by job guarantee workers would never be undertaken by by the private sector, so there is no risk of "crowding out".

I have considerable issues with all three of these. To my mind they raise serious questions about the relationship of the public and private sector and the nature of the work that each undertakes.

Firstly, if the public sector really is financially unconstrained, why are there any jobs at all that can be taken on by the "army of unemployed" in an economic downturn? Why would there be a reserve buffer of public sector projects that in good times don't need to be done?

If money is not a constraint and the amount of work is unlimited, then the only constraint on public sector projects is availability of labour (apart from self-imposed constraints such as byzantine regulations and idiotic planning restrictions). But if the financial sector is financially unconstrained and there is so much useful and productive work to be done, then shouldn't it routinely outbid the private sector for labour? After all, the private sector is financially constrained - which is why it doesn't create enough jobs for everyone - so the public sector should always be able to get the labour it needs. There can't be any real labour constraint if there is no financial constraint. Yet the MMT theorists argue that job guarantees should be temporary jobs only, paid below the equivalent private sector level so that when employment picks up the JG workers return to the private sector. And they insist that that job guarantee projects should not "crowd out" private sector ones. The only explanation I can think of for this is that the MMT theorists don't consider public sector work to be as important as private enterprise. This is worrying. The public sector provides vital infrastructure without which private enterprise cannot operate, such as roads, rail networks, education (developing the labour force of the future), health care (keeping the workforce working). Is this work really not as important as private enterprise? And couldn't much of it actually be done by the private sector anyway, at least in good times? Most of it is not cyclical, either. Are we really only going to have teaching assistants and elderly carers in recessions? Are we really only going to do essential repairs to schools, hospitals and roads when there are lots of unskilled unemployed people in need of work? What a terrifying prospect.

At the moment there are indeed many public sector jobs that need doing. But that is because dereliction of duty by politicians and executives in the public sector, and public sector budget constraints (unreal though MMT believe them to be), mean that essential infrastructure investment has not been done and public sector staffing is too low to do everything that is really needed. So yes, at the moment the unemployed could usefully be put to work doing things that have been left undone over the last few years. But this does not form the basis for a long-term flexible staffing arrangement. Once the public sector realises it is financially unconstrained, it has no reason to leave things undone in future. So in order to create a buffer stock of jobs for future unemployed, the public sector would deliberately have to leave things undone, or under-staff key functions such as education. This is madness. Either things need doing - in which case, if you have no financial constraints, you do them - or they don't.

It may be that what JG proponents have in mind is some sort of two-tier job classification in the public sector: the vital jobs that are needed all the time, and the less important ones that only get done when there are unemployed people to do them. And there is the additional constraint that these less important jobs must not be ones that the private sector could take on (remember the stipulation that there must be no "crowding out" effects). I find myself struggling to imagine what these jobs might be that are so unimportant that the public sector doesn't bother to do them except when there happens to be a surplus of labour, and so unproductive that the private sector doesn't want to do them even in good times.

Of course, there are always things that are "nice to have" but aren't essential. Unemployed musicians could provide concerts for schoolchildren: unemployed artists could brighten up run down areas with street art. I feel somewhat sad that these things would only be available when times were hard, but I agree that they are hardly vital functions. But I'm really not convinced that there would be enough of these "nice to have" things to occupy an army of unemployed, many of them unskilled. I suspect that what would happen in reality would be that the public sector would routinely under-staff itself and use the "army of unemployed" not as an automatic stabiliser, as MMT suggests, but as a cheap form of public sector labour, enabling them to cut costs by delaying essential repairs and maintenance until there were enough unemployed to do the work. And if - as some have suggested - the countercyclical labour buffer would exist ALL the time to a greater or lesser extent, then the temptation to drive down wage levels in the public sector as a whole to the JG level would be enormous. The JG level is supposed to be well below private sector remuneration levels to encourage them to move back to the private sector when employment picks up. But if there were always unemployed available to do public sector work - admittedly varying amounts of it - why would you bother to employ permanent staff at all, or if you did, why would you pay them any more than the JG level? Financially unconstrained the public sector may be, but there are enough politicians out there on cost-cutting soapboxes to ensure that the public sector will remain under pressure to keep costs down, if only so that taxes can be cut for those who fund politicians' campaigns. The result surely would be dissatisfaction and high turnover among public sector staff. I know the counter-argument to this is that only lower-skill functions such as teaching assistants, nursing auxiliaries and elderly carers would be affected, but does continuity and job satisfaction not matter for them and for the people for whom they care? Just because a job is low-skill doesn't mean it is unimportant. And anyway, who says teachers can't be unemployed?

This brings me to another important point. The unemployed are not a homogenous group. Yes, a lot of the unemployed at the moment are unskilled - but that is because they are pushed out of jobs by people with greater skills, even if those skills are not needed for the job. If a JG scheme existed, we might expect that the skilled might be less willing to accept unskilled jobs, and the "unemployed army" might become more diverse. In which case we then have a problem. Is the public sector going to provide basic unskilled jobs to the skilled - in which case those people run the risk of skills decline and long-term unemployment? Or will it attempt to match skills to jobs, since it supposedly has no limit on the numbers and types of job that can be created? If the latter, then the statement in the above paragraph that only lower-skill functions in the public sector would have high turnover and depressed wages can't be true. It would be essential to keep wages depressed at ALL levels in the public sector to ensure that people did return to the private sector when appropriate employment was available. And there would be a real risk of chronic under-staffing of vital work such as teaching and nursing in the expectation that skilled unemployed people would be available to plug the gaps - and if they weren't, then either permanent staff would have to cover or the public sector would have to resort to private sector agency staffing. Once again, we hit problems with lack of continuity of care and the possibility of poor or inconsistent service.

Some versions of the JG scheme include microfinancing of the self-employed, and allowances for training. And some envisage that people would be able to devise their own "jobs", although they would have to be approved as suitable by those who run the JG scheme. This seems more sensible to me - but it is getting much closer to the concept of basic income. And this is where I want to address Wray's complaint that a basic income would be inflationary.

Wray's claim that basic income is inflationary rests on the assumption that people on basic income wouldn't work. As I've already explained, I don't think this is true. Yes, people on basic income would have to find things to do rather than be given things to do - although they could be helped. That doesn't mean they would do nothing, or that what they would do would be unproductive. And if the majority of people on basic income were doing useful and productive things, then it is hard to see how a basic income would be seriously inflationary.

However, it is fair to say that a basic income does directly reflate the economy. Indeed as I've noted elsewhere, it is intended to do exactly that - to support demand. In that respect it is exactly the same as a JG. Wray's belief that basic income would be inflationary but a JG would not seems to stem from his idea that JG would be countercyclical, whereas basic income would have no cyclical effects. This would be a fair criticism if JG really did act as a countercyclical fiscal measure, but as I've explained above, I don't see how it could in practice. Therefore both basic income and JG have the same potential to be inflationary, because they both directly support demand. They should both be used therefore in conjunction with appropriate monetary policy and possibly countercyclical taxation, too (although this is perhaps of less value because of Ricardian equivalence). Tcherneva additionally suggests that JG wages should be variable to prevent the inflationary effects from debasing the currency. This is a nice idea in theory but I seriously question whether it could ever be implemented in practice. Cutting incomes that are already close to poverty level purely to support the currency is likely to be politically difficult and is certainly unacceptable from a humanitarian perspective.

So to me, at any rate, it seems that basic income and JG would be likely to have similar economic effects.* I find it surprising therefore that the debate between the two sides becomes so heated. It seems to me that the fundamental difference between JG proponents and supporters of basic income lies not in their economics but in their view of human nature.

JG proponents are essentially managerialist. They think that people have to be told what to do or they won't do anything useful. Basic income supporters, on the other hand, are liberals: they believe that if people are supported and their basic needs are met, they will find useful and productive things to do.  I suppose which you prefer really depends on how much of a control freak you are. Personally I would prefer a basic income, and I admit that is because I am shockingly liberal and really don't like being told what to do. But even a JG scheme would be better than the present situation, where the threat of unemployment is used to force people to do unsuitable jobs for rubbish wages. Sadly I suspect neither a JG nor a basic income is likely to happen in reality. There are too many vested interests who are well suited by the use of unemployment as a labour market discipline.

Related links

The case for basic income - Stumbling & Mumbling
Time to take basic income seriously? - FT Alphaville
Sympathy for the Luddites - Paul Krugman (NYT - paywall)
The changing nature of work - Coppola Comment
A surprising case for basic income - Samuel Brittan
Are more jobs the answer? The BIG bait and switch - Randall Wray (Economonitor)
Basic income vs capitalism - Chris Dillow (Pieria)
The wastefulness of automation - Frances Coppola (Pieria)
Job guarantee: it's really not that difficult - 3spoken
Employment guarantee programs: a survey of theories and policy experiences - Kaboub
Beyond full employment: the employer of last resort as a institution for change - Tcherneva
Job guarantee or basic income? - Tcherneva
Final report 2008 - Centre for Full Employment & Equity (Australia)
In praise of idleness - Bertrand Russell ("chill, dudes....")
Adios, el bonko - Guerilla Economist (nicely sceptical of both basic income and JG!)

* I should add though that JG could actually have deflationary effects if public sector wages were kept permanently depressed in order to encourage migration of JG workers to the private sector. JG is I think a more complex tool and its effects would be less easy to predict than basic income.

Monday, 8 July 2013

The wastefulness of automation

My latest at Pieria:
"Chris Dillow observes that "one function of the welfare state is to ensure that capital gets a big supply of labour, by making eligibity for unemployment benefit conditional upon seeking work." And despite noting that when jobs are scarce, paying some to "lie fallow" so others can work might be a good thing, he concludes that "this is certainly not in the interests of capitalists, who want a large labour supply - a desire which is buttressed by the morality of reciprocal altruism and the work ethic." (emphasis mine). Basic Income, therefore, is not going to happen because capitalist interests, claiming the moral high ground, will ensure that it never gains political traction.
"But what if capitalists DON'T want a large labour supply? What if automation means that what capitalists really want is a very small, highly skilled workforce to control the robots that do all the work? What if paying people enough to live on simply is not cost-effective compared to the running costs of robots?  In short, what if the costs of automated production fall to virtually zero? 
"I don't think I am dreaming this. I've noted previously that forcing down labour costs is one of the ways in which firms avoid the up-front costs of automation. But as automation becomes cheaper, and the efficiency gains from automation become larger, we may reach a situation where employing the majority of people at wages on which they can afford to live simply is not worthwhile. Robots can produce far more for far less." 
The remainder of the article can be read here.

Thursday, 4 July 2013

What derailed the UK recovery?

Here's a horrible chart:



It comes from ONS's Economic Review for July 2013.

There are a couple of key things that this shows. The first is systematic underestimation of the damage to the UK's economy. The 2008/9 recession was deeper than previously estimated and output remains lower. But the second is to my mind more interesting.

The 2008/9 recession was originally thought to be similar to the 1979 recession. We now know it was quite a bit deeper and lasted longer. But the shape of the curve was actually more like the 1990 recession, which unlike the 1979 recession involved a property market crash. Indeed the two lines parallel each other nicely - even with the revision - until the 10th quarter after the crisis. Then it all went wrong: even though the second dip shown on the original line has now turned into simply a flattening of the curve, the economy stopped recovering then and there has been little growth since.

It is all too easy to blame this on the Coalition government that took office in May 2010 with a deficit-cutting agenda. But at the time, the economy was growing and the big issues were government finances and inflation. No-one thought that GDP was at risk: the trajectory was for a recovery similar to that in the 1990 recession, and there was no particular reason to think that it would fail. Even when the economy tipped into recession in Q4 2010, the ONS review for February 2011 blamed it on bad weather.

The abrupt change of growth trajectory suggests that a pretty major exogenous shock hit the economy towards the end of 2010. But finding out what that shock was, and why it derailed the recovery so comprehensively, requires some detective work.

Despite numerous claims that the recovery was "killed by austerity", there is actually nothing very obvious on the Government's part to explain such a change at that time. The economy was already slowing in the third quarter of 2010, which is before any of the Government's spending cuts took effect. There was the increase in VAT to 17.5% - but really that should not have been sufficient to knock the economy off course, since all it was doing was reversing a previous reduction. And the second VAT rise didn't happen until January 2011.

There is one very obvious external shock - the Irish sovereign bailout in November 2010, to which the UK government contributed. Ireland is one of the UK's most important trading partners and the two financial systems are deeply interconnected. A major shock to the Irish economy would inevitably rebound to the UK. But....was that bailout really such a shock? It was widely expected, and the Irish banking system whose failure made the bailout necessary had already been moribund for two years. The conditions of the bailout would involve harsh austerity measures in Ireland, which would affect the UK's exports and the activities of UK companies in Ireland - but those would take time to kick in. And anyway, is the rebound from a shock to an economy the size of Ireland really capable of knocking the UK out of orbit? I am unconvinced. Ireland obviously had some impact, but I think we need to look elsewhere for the main cause.

In fact another look at these curves suggests an alternative explanation for the UK's trajectory change and stagnation. From Q4 2010 onwards, the curve looks less like the 1990 and 1979 curves, and much more like the 1973 one. It's bumpy - which suggests a series of shocks rather than one single shock. Now we know that the 1973 crisis was triggered by an oil price shock and was characterised by energy shortages, although it also had a bit of a banking crisis attached. And it involved high inflation - admittedly much of this was domestically generated due to loose monetary and fiscal policy fuelling a wage-price spiral, plus the devaluation of sterling, but the oil price shock itself also increased inflation due to the UK's external energy dependence. Do we possibly have a similar situation from the second half of 2010 onwards?

I think we do. The UK's CPI inflation at that time was surprisingly high and rising:

Historical Data Chart

source: Trading Economics. 

The ONS says that the principal cause of this was imported energy costs. Now, it is not the world price of oil so much as the domestic cost of energy and fuel that affects economic performance. Here is a nice graph showing UK road fuel prices from March 2010 to March 2012:


















Source: DECC.

So from September 2010 to June 2011 road fuel prices - both petrol (gasoline) and diesel - rose by about 17%. That would particularly have hurt three groups: the haulage business; businesses that depend on frequent stock deliveries; and households where the principal earner(s) are essential car users.

Industrial fuel prices also rose considerably at this time. The graph shows actual prices rebased to 2005, which is not entirely helpful. So I have also shown the percentage increase from October 2010 to October 2011 for each fuel category and for total fuel:















































































































Source: DECC.









Household energy prices rose even more (again the chart is rebased to 2005 prices, so I have included the table showing percentage year-on-year increase). The rise in domestic gas prices was a whopping 20.3% from Q4 2010 to Q4 2011, and the total rise across all types of fuels was not a great deal less, at 16.2%:







Source: DECC. 








So the picture is one of a promising recovery being kneecapped by an energy crisis
. The VAT rise in January 2011 only added to the problem.
Now, enthusiasts of monetary policy will tell you that exogenous supply-side shocks don't have as big an impact on economic performance as they did in the 1970s because central banks can offset the damage. I think the entire world now knows that I am sceptical about the claimed benefits of unconventional monetary policy, but I'm prepared to be convinced that central bank intervention would have helped here. If the Bank of England was doing it, of course.  But it wasn't. The first round of QE was from March to November 2009. And the Bank of England did no more monetary easing until October 2011. Furthermore, in 2010 it withdrew the Special Liquidity Scheme that had kept the UK's damaged banks afloat.  Simon Nixon of the Wall Street Journal claims that this amounted to a tightening of monetary policy which directly caused the slowdown of the UK economy in the last quarter of 2010. I'm not sure I would go quite that far, though it undoubtedly contributed to tight credit conditions for households and SMEs. But certainly the Bank of England did absolutely nothing to ease the tight monetary conditions caused by the exorbitant energy price rises for business. And the Coalition government, elected as it was on a deficit-cutting platform, chose to ignore the evidence that energy price rises were strangling businesses and crippling households. It imposed a sharp fiscal consolidation at the same time. 

Personally I'm inclined to exonerate the Bank of England here. The usual response to high consumer price inflation would be to raise interest rates. But that would have been completely the wrong medicine for an economy in which private sector debt was very high and the financial sector badly damaged, and it would have been terrible for companies facing high and rising energy costs. For an inflation-targeting central bank, doing nothing amounted to monetary easing, since it involved turning a blind eye to the fact that CPI was well above target. The ECB did raise interest rates at this time, and some people have suggested that it was this action that triggered the Eurozone crisis itself - the catastrophic rises in bond yields that drove some sovereigns to near-default. Personally I think the ECB's rate rise was like the UK Government's VAT rise - it didn't cause the problem, but it added fuel to the flames. 

  But I'm not nearly so happy about the UK Government's behaviour. In my book, dealing with the consequences of a negative supply-side shock is the responsibility of the fiscal authorities, not the central bank. Osborne's programme of front-loaded fiscal austerity was similar in spirit to Geoffrey Howe's approach to dealing with the UK's economic problems in 1979. And to some extent the situation looked similar. There was an oil shock in 1979 which contributed to the recession, but the main issues at that time were fiscal discipline and supply-side reform. I suspect that the Government thought the situation was indeed similar and that therefore fiscal reform was more important for the economy than compensating for the negative energy supply shock by, for example, cutting fuel duty and suspending green levies on household and business energy bills. And to be fair, fiscal reform was also the principal concern of many economists, investors, market advisors and international institutions, not to mention the British public that had elected the Coalition government (admittedly with a very small mandate). So despite the evidence that the economy was weakening, the Government went ahead with its spending cuts and tax rises. 

But the situation was actually very different from 1979. There was no sign of the wage-price spiral that had driven inflation throughout the 1970s: real wages were falling and people were even taking nominal wage cuts in order to stay in their jobs.

Fig 1: Median hourly earnings exc overtime, all employees, UK and London

Source: ONS. 

The private sector - companies and households - was highly indebted and desperate to deleverage. And the financial sector was badly damaged. In short, the economy was extremely fragile. So the combination of a negative energy supply shock with the tightening of lending conditions, the Irish bailout and the Government's austerity drive was enough to knock it from growth to stagnation. Perhaps some more monetary easing would have helped, but the prospect of even higher inflation was just too much. 

Energy prices flattened out in the second half of 2011 then rose again from 2012 onwards, not continuously but in fits and starts. Businesses and households continue to face high and rising energy costs, a growing number of households are in fuel poverty - having to choose between heating their houses and buying food, and business expansion is hampered by the high cost of energy.


Energy consumption fell catastrophically due to the financial crisis and the oil price shock of 2008 (no, we don't talk much about that either!) then fell again from 2010 onwards, almost certainly due to high prices: 


















Source: DECC.

Environmentally this is maybe a good thing, but economically it is disastrous. When businesses cut energy consumption due to rising costs they also cut production. When households cut energy consumption due to rising costs they do fewer activities and travel smaller distances. So expensive energy is a serious drag on economic growth.
Even now, few people talk about the impact on the economy of rising energy costs.  And yet the future is likely to see energy becoming ever more expensive until we finally accept that the hydrocarbon fuel industry is in terminal decline and the future lies with other, newer energy technologies. And while energy consumption remains constrained by high prices and scarcity, growth will remain a distant dream.

Related links:
Economic Review, July 2013 - ONS
Economic Reviews 2010-11 (index) - ONS
UK Energy Statistics, March 2012 - DECC
How Mervyn King lost the battle of Britain's banks - Simon Nixon, WSJ
The Perfect Storm - Tullett Prebon