Thursday, 31 October 2013

Why the Fed can't taper

John Aziz has a post explaining why the Austrian school of economics is wrong to believe that the Fed can't taper because of the risk of asset collapse and hyperinflation.

I actually have some sympathy for the Austrian argument that the Fed cannot taper, but not for their reasons. They wrongly focus on base money creation as the main problem. But as Aziz says, base money creation would have to be a) far more extensive and b) have a far more direct effect on broad money to result in the hyperinflation that they fear. The real risks come from the market effects of persistent QE.

Central banks have become the largest players in global markets. It is somewhat unclear as to whether markets respond to central banks or vice versa - it's probably a bit of both - but we really can't pretend that central bank actions have no effect on global markets. The Fed is the largest and most important central bank in the world. Its actions are critical to the operation of global markets. Prices along the yield curve are governed by market view of the Fed's likely future actions - often the wrong view, because the Fed's price signals are far from clear, despite its vaunted commitment to "forward guidance": to see just how conflicted Fed price signals can be, you only have to look at Bernanke's announcement of imminent tapering followed by delay after delay. There remains a high degree of uncertainty in the markets regarding the future path of US monetary policy, which makes markets unstable and over-reactive. It's as if everyone is in a state of "amber alert" - there is a hurricane coming, but we don't know exactly when or where it will hit or how bad the damage will be.

Exactly how QE affects the economy is a matter of considerable debate. Inflation expectations tend to rise when QE commences, because many investors still think expansion of base money = inflation. But there appears to have been little or no effect on consumer prices, and it is unclear to what extent asset purchases benefit the wider economy. However, the one thing we KNOW QE does is support asset prices - all classes of asset, not just government bonds and MBS.  Global markets have become used to this support: investment decisions are now governed to a large extent by the desire either to avoid capital erosion on safe assets (hence moves into assets that give zero yield, such as cash - zero yield is better than negative yield) or find some positive yield somewhere.

Tapering is removing central bank support of asset prices. Unless not just the US economy but the GLOBAL economy is "on the up" at the time that tapering commences, the result of tapering will be a global fall in asset prices. That isn't going to cause hyperinflation, as the Austrian school thinks, but it would cause a global recession.

I'm afraid it is not US fundamentals, but global fundamentals that will determine the Fed's ability to taper. If the Fed tapers when the global economy is already in the doldrums, as it is at the moment, the recessionary rebound to the US economy would be considerable.

It would also in my view be highly irresponsible of the Fed to cause a global recession by ill-judged tapering. Because of the US dollar's pre-eminence (and the pre-eminence of USTs, too - we don't talk about that enough), the Fed is effectively the world's central bank. It is high time that the US accepted that its monetary (and fiscal) policies must be driven by the needs of the global economy, not just the US. The "exorbitant privilege" is an exorbitant responsibility, too.

Related reading:

Can the Fed taper? - Azizonomics
World Economic Outlook, October 2013 - IMF
The Ins and Outs of LSAPS - Krishnamurthy & Vissing-Jorgenson
Methods of Policy Accommodation at the Interest Rate Lower Bound - Woodford

Saturday, 26 October 2013

Three silly charts

From Fraser Nelson's Twitter stream come the following charts, with associated twitter commentary.

There are of course going to be lots of people who think my description of these as "silly" is mistaken or incomprehensible. So let me explain.

Chart 1 compares the increase in government debt with the increase in GDP since 2010. I'm afraid this is meaningless. Debt is a stock: it is taken on at a point in time, paid down at another point in time. GDP is a flow - it is national income.

As an example, imagine you have an annual income of £50,000 and you take out a mortgage of £150,000. Your debt/income ratio has suddenly rocketed, hasn't it? Shocking. But you aren't paying that mortgage back this year. You've borrowed that money over 25 years. What is your expected income over 25 years? I'd be willing to bet it's a lot more than £50,000. In fact if you expect to work for the whole period of your mortgage and your income to increase with inflation (assumed at 2%), then your income is £1,250,000 plus compound interest at 2% over 25 years. I'm not going to work that out, but trust me it is FAR more than £150,000 plus say 5% interest compounded (probably on a reducing balance basis) over 25 years. In fact it is so good that next year you might borrow some more money to do some home improvements, and the following year you might borrow some more money to study in your spare time. Now, if you overdo this, your lenders start to get a bit worried that you might not pay them back, so as a form of insurance against potential losses, they might increase the amount they charge you for borrowing - the interest rate. I know this seems perverse, since increasing your debt service costs actually increases the chance that you will default, but it would mean that they get higher returns in the short term, which reduces their potential losses.

Of course, what you spend your debt on matters, too. If you take out a loan to fund yourself through a masters degree, then you would expect your income to increase when you complete your studies, because your degree will open doors to higher-paid jobs. So again, comparing the debt with your income THIS YEAR is meaningless. You need to compare it with your projected nominal income over the rest of your working life taking into account expected increases due to your studies.

This is true for governments too. When governments borrow, they usually borrow over a long period of time, anything from 10-30 years or even more. And some of that money will go into public investment, which should increase national income in the future. In fact governments are more complicated than you, since even consumption spending can help to increase national income. It is very, very misleading to compare government debt increases with concurrent GDP increases and deduce from it that government borrowing and spending is out of control.

Just like your lenders, if lenders to government start to get worried that they might not be paid back, they increase the interest rate, which gives them higher returns in the shorter term. The risk to governments of high debt levels is the increasing cost of debt service. But at present, the UK has the lowest borrowing costs in history. Yes, I know, interest rates can rise, but government debt is mostly fixed rate - an increase in interest rates only has a marginal effect when the debt stock is mostly of long tenor, as it is in the UK. The fact is that the UK is better able to afford its debt now than it was in the early 1980s when interest rates were 15%.

So that's why Chart 1 is silly - apart from the fact that half of it is a projection, of course. Now let's look at Chart 2.

Chart 2 is the ratio of debt/GDP, projected to 2016. Now I've already pointed out that comparing these two is meaningless, because one is a stock and the other a flow. However, government debt is usually quoted in relation to GDP. But this chart does not tell the story that Fraser Nelson wants to tell. It does not indicate that government borrowing is "out of control".

You see, Chart 2 is a ratio. And the value of the ratio depends on both the numerator (the debt) AND the denominator (GDP). An increase in the ratio of debt to income tells us nothing about either debt or income. For example, if you lose your job, your debt/income ratio heads for the moon, since you have no income but still have the debt. But if you get another job at a higher income, your debt/income ratio drops because your income has gone up, and you may also use your redundancy payment to pay off some of your debt. If you take so long to get another job that you use up your redundancy payment and are forced to increase your overdraft, then even when you get another job your debt/income ratio increases: similarly, if your new job doesn't pay as well as your old one you have a higher debt/income ratio. This is because the nominal amount of your debt does not change with your income. I know this seems obvious, but when looking at the government debt/GDP ratio people often forget about the denominator. Debt/GDP can rise more than expected not because the government is borrowing more than planned but because GDP has disappointed. The Budget 2010 projections were based upon GDP growth assumptions that have proved unattainable. No wonder debt/GDP is higher than expected.

So although Chart 2 appears sensible, it's actually as silly as Chart 1. And it is also a projection, of course.

There's another complication too, for both charts. Government debt and national income are not independent of each other. The income of government is tax revenue, and tax revenue increases with GDP. If government tax revenue increases, it can afford to borrow less. So government borrowing usually reduces as GDP rises. Conversely, when GDP falls, government loses tax revenue, so is forced to borrow more to meet spending commitments. And government spending commitments themselves increase when GDP falls, and rise when GDP increases, because of automatic adjustments in benefit payments.

Also, remember that in these two charts debt is a stock. Reduced government borrowing due to increased tax revenues does NOT mean that the debt reduces. It just doesn't increase as quickly.

And this is the problem with Chart 3. It is simply incorrect to say that Osborne is "borrowing more in five years than Labour in 13". He hasn't borrowed most of that expanse of red and pink. Over £800bn of the stock of debt existed before Osborne became Chancellor. He has, so far, added less than £400bn to the total debt stock. Even with the weird projection (why does the chart show the rate of increase of debt suddenly steepening from 2014?), he isn't going to add much more than £200bn by 2016, giving a total of about £600bn - which is pretty much the same as Labour added from 2001 (the lowest point on the chart) to 2010.  And if we assume that the projection is wrong, because GDP is increasing and that will enable the government to borrow less (ONS figures already show the public sector net borrowing requirement falling), then the eventual increase in public debt may be less.

None of these charts tell us anything useful. Nowhere is the interest cost of that debt shown, or the expected tax revenues from which it will be serviced. Nowhere is the real risk of high government debt levels explained, which - as the IMF explains - is reduced ability to absorb economic shocks. All they show is that government debt is increasing. Or, alternatively, that government is producing lots more safe securities to enable its citizens to save for their retirement. And that's a good thing, isn't it?

Related reading:

Government debt isn't what you think it is - Coppola Comment
Fiscal space - IMF

Friday, 25 October 2013

In Praise Of Hedge Funds

My latest at Pieria:
Every ecosystem needs its scavengers and its bottom feeders. They clear up the mess that others leave behind, extracting nutrients from decaying corpses and dung piles and leaving only sterile bones behind. We are revolted by them, but without them the world would be a much more unpleasant place.
So it is with hedge funds. They are the financial system's equivalent of slime moulds and flatworms. They buy up distressed companies that no-one else will touch and extract whatever profit they can from them. In many cases they leave only empty shells behind, but they sometimes turn failing companies around with ruthless restructuring programmes, in much the same way that some kinds of maggot were used in field surgery to clean up suppurating wounds. In short, they may be revolting but they serve a useful purpose.....
Read on here.

Tuesday, 22 October 2013

The lure of gold, the deceit of silver

It seems the Co-Op Group's proposals for resolving the mess its bank has got itself into have been firmly rejected by the bondholders. More specifically, they have been blocked by an unholy alliance of two hedge funds - Aurelius Capital Management and Silver Point Capital. These two put in a counter-proposal, which it seems (after extensive talks) has been accepted by the Co-Op Board. Robert Peston announced on his blog that the Co-Op Group was about to lose control of its bank.

But that's not what Euan Sutherland says. Proudly proclaiming that the Co-Op Group would retain a 30% stake in the Co-Op Bank, making it the largest shareholder, he claimed that the Co-Op Group would remain in control of the bank.

I fear this is more Co-Op Group spin. I've complained before about the less than transparent way in which the Co-Op Group communicates with its stakeholders, which at times has amounted to outright deceit. The fact is that a 30% shareholding is in no way a controlling stake. The Co-Op Group can only remain in control of the bank if the other shareholders allow it to - and in particular, Aurelius and Silver Point. So far, they are playing nice. But customers and other stakeholders should not be fooled. They are by no means as friendly as Sutherland implies.

Aurelius Capital Management (not to be confused with the German private equity firm Aurelius AG) describes itself tersely as "A private investment firm". However, press reports about its activities give a clearer indication of its true nature. Aurelius is one of the hedge funds involved in the long-running legal battle over the restructuring of Argentina's debts. Nor is this the only legal battle in which it is currently involved. From the South California Public Radio's report into the delayed bankruptcy of Tribune, the company that owns the LA Times (my emphasis):
The Tribune bankruptcy, given the sheer volume of the distressed debt, is right in Aurelius' wheelhouse, however. The hedge fund's playbook is to force its Chapter 11 opponents to endure protracted legal combat. Unlike Oaktree, which would wind up owning a piece of the post-bankruptcy Tribune and presumably be able to dictate the future management of the company (making it more of a private-equity player in this case), Aurelius is in it for the money. 
It seems Aurelius is in the habit of using litigation to force distressed debt holders to pay up. And this press release from Aurelius regarding another of its high-risk investments, IVG Immobilien, shows just how tough it can be when it is on the hunt for money (and note that this situation, like the Co-Op Bank's, involves convertible debt instruments). It is, in short, a predator.

Like Aurelius, Silver Point Capital's website says very little about it:
Silver Point Capital L.P. is a registered investment adviser focused on credit and special situations investments.
The firm, based in Greenwich, Connecticut, was founded in 2002 by Edward A. Mule and Robert O'Shea.
But that last line speaks volumes. Mule and O'Shea were formerly at Goldman Sachs, where they were experts in distressed debt and corporate restructuring. And they have become known as aggressive players in the high-yield distressed debt market. Hedge Fund Letters describes Silver Point thus (my emphasis):
Akin to their investing experience at Goldman Sachs, the firm tirelessly seeks complex situations where they can capitalize on their fundamental analysis skills and proactive style of investment management, especially with restructuring and distressed situations. 
In recent years, Silver Point has profited from high profile failures of financial institutions, including Lehman, MF Global and the Icelandic bank Glitnir. It also made money from the collapse of the Madoff ponzi empire. Currently, nearly half of Silver Point's investments are in financial industries, including equity stakes - often arising from conversion of hybrid instruments. They have history, it seems - and the Co-Op Bank is just their kind of acquisition.

Both Aurelius and Silver Point bought their stakes in the Co-Op Bank in the aftermath of the Moody's downgrade when the price of its hybrid debt securities collapsed. Both are unquestionably in it for the money. And both play hardball to get what they want. So why have they conceded control of the bank to its existing management?

Well, actually it makes sense. Were this a private equity takeover, we would expect to see the management replaced and an immediate restructuring programme put in place. But these are hedge funds, not private equity firms. They don't want to run a bank - they just want to make money from it. And the Co-Op is a rather unusual bank. It has an exceptionally loyal customer base, many of whom have chosen it because of its commitment to "ethical" investment, which at the moment is unique in the market place. It also has strong links with other financial firms such as credit unions and small building societies, to whom it provides payment services. And its link with a mutual makes it popular not only with customers but with government. None of this would be lost on Aurelius and Silver Point. For them to run the bank directly would destroy its unique selling points, making it difficult for it to compete in a cut-throat financial services marketplace and eliminating any likelihood of a return to profit any time soon. This is certainly not what these companies want. So it is in their interests for the Co-Op Group to remain apparently in control of the Co-Op Bank.

But make no mistake, Sutherland and his fellow Board members will be on a very short leash. They must return the Co-Op Bank to profitability within a very short time - otherwise the hedge funds are likely to turn nasty. They will not hesitate to asset-strip the Co-Op Bank if the management fails to meet the profitability targets that they expect. And as between them they DO have a controlling stake, they can unquestionably do this. Sutherland's statement was made with a gun to his head.

The Co-Op Group may appear to be in control of its bank, but in reality it is a puppet. And the puppet masters are sharks.

Related links:
Under the Radar - Coppola Comment
Stand By Your Bank - Coppola Comment
Co-Op Group to lose control of Co-Op Bank - Robert Peston, BBC
Co-Op Bank bondholders set to seize control - FT (paywall)
The Co-Op mess, and bondholder ethics - FT Alphaville
"This bank will remain the Co-Operative Bank" - FT Alphaville

Silver P

Sunday, 20 October 2013

Chinese banks and UK taxpayers

The decision by the Chancellor to allow Chinese banks to operate in the UK as branches rather than subsidiaries has caused something of a stir. And as usual, the implications have been widely misunderstood.

This from Willy Hutton in the Guardian (in an otherwise strong piece) is typical:
Compounding the error, he has decided to allow Chinese banks to trade in London through branches. Iceland's bankrupted banks operated in Britain through branches. Never again, we said. If a bank wants to function here, it must put its own capital behind its British operations. But desperate to win the City's right to trade in renminbi, Bambi wants to waive this obligation uniquely for Chinese banks. China's banking system is precarious; non-performing loans could be as high as $5trn, proportionally far in excess of pre-crisis Iceland. At least the British taxpayer will be able to underwrite their British operations when the system crashes, as it almost certainly will.
This is simply wrong. Let me explain.

A branch of a bank is an integral part of the bank. It is not legally separated from any other part of the bank's operations, except for activities held in separate subsidiaries. So if a Chinese bank sets up a branch in the UK, it IS putting its own capital behind its British operations.

What it is not doing is ring-fencing a proportion of capital for exclusive use by the British operations, which is what it would do if the British operation were a subsidiary. This has both positive and negative aspects.

On the positive side, if the British operation got into serious trouble, the entire capital of the Chinese bank would be behind it, whereas if the British operation were a subsidiary only the capital of the subsidiary itself would be available to absorb losses: there would be no guarantee that the parent would provide extra capital. This is the current situation with the Co-Op Bank, and the likeliest outcome is that investors (though in this case not depositors) will have to take losses. Compare this with the losses incurred by the London Whale in J.P. Morgan's London office (a branch), which automatically rebounded to the American parent. Operating as a branch can ensure that local losses are fully absorbed by the parent.

On the negative side, if the Chinese bank failed, the British operation would go down with it, and any British investors and depositors would (in theory) take losses. This is what Hutton is referring to in relation to Icelandic banks. But really he is only talking about Icesave.

Icesave was the UK branch of the Icelandic bank Landsbanki.  Landsbanki was one of the three giant Icelandic banks that went bankrupt in 2008 with massive losses when capital markets froze after the fall of Lehman: the other two were Glitnir and Kaupthing. The introductory sequence of the film Inside Job poignantly talks about the damage that was done to the Icelandic economy by the expansion and sudden collapse of these three banks. What it does not mention is the damage that was done to the UK economy by the collapse of Icesave and the UK subsidiaries of Kaupthing and Landsbanki - and the refusal of the Icelandic government to honour deposit insurance for British depositors in Icesave.

The UK government compensated insured British depositors for their losses, then attempted to claim back the insurance from the Icelandic government. Iceland, bankrupted by the crisis and unable to borrow on the financial markets, refused. This sparked an international dispute: the British government used anti-terrorism legislation to freeze the remaining assets of Landsbanki in the UK, and the British and Netherlands governments took legal action against Iceland in the European Free Trade Area (EFTA) court. In January 2013 they lost their case. The court concluded that in a systemic crisis, the sovereign is not bound to honour deposit insurance.

The scars of the Icesave failure run deep. Not only did the UK government lose money: large depositors, including UK local authorities such as Kent, did too. And since then, UK regulators have encouraged foreign banks to convert their UK operations to subsidiaries.

Operating as a subsidiary means that a foreign-owned UK operation would not necessarily be affected by the failure of its parent. UK subsidiaries of foreign-owned banks have to meet UK regulatory requirements for capital and liquidity, irrespective of the capital and liquidity position of their parents. This can lead to some bizarre effects: Santander UK, for example, has a higher credit rating than its Spanish parent.

But it does NOT mean, as Hutton suggests, that the UK taxpayer is not at risk if foreign-owned banks operate UK subsidiaries. On the contrary. The UK taxpayer backstops the UK's deposit insurance scheme, which covers all depositors (including foreign ones) in UK subsidiaries of foreign-owned banks. And if is large and significant enough, a UK subsidiary of a foreign bank may be bailed out and/or closed down by the UK Government - and there is no right of recovery from the foreign parent or its government.This is what happened to the UK subsidiaries of both Landsbanki and Kaupthing.

Heritable Bank was a wholly-owned UK subsidiary of Landsbanki, and Kaupthing, Singer & Friedlander (KSF) was a wholly-owned subsidiary of Kaupthing. In October 2008, the UK Government nationalised Heritable Bank and placed KSF in administration. Heritable Bank's assets were subsequently sold to ING along with KSF's internet bank Kaupthing Edge. Depositors in both subsidiaries were compensated by the UK's Financial Services Compensation Scheme (FSCS): the FSCS itself was bailed out by the Bank of England (later reimbursed by the Treasury) and is still obtaining funds from solvent UK banks and building societies to make good its losses. The Icelandic banks were certainly not the only cause of the FSCS's insolvency, but they were a significant contributory factor. It is the cost of these bailouts that Hutton is referring to.

So of the Icelandic banks bailed out by UK taxpayers, only Icesave was a branch. The others were subsidiaries - exactly what Hutton suggests UK operations of Chinese banks should be. And the Icelandic disaster demonstrates that the UK government can be on the hook for the failure of both branches and subsidiaries. Hutton's argument is confused, to say the least.

The UK taxpayer's real liability in the event of overseas bank failure is as follows.

  • The UK's FSCS is not responsible for reimbursing depositors in branches of foreign-owned banks. That responsibility rests with the deposit insurance scheme (if there is one) operating in the parent country.  
  • The FSCS is, however, responsible for reimbursing depositors in UK subsidiaries of foreign-owned banks. Since the Iceland disaster, the FSCS has also bailed out UK depositors in the UK subsidiary of the Bank of Cyprus, and the UK branch of Cyprus Popular Bank (which was in the process of being converted into a subsidiary at the time of its failure).
  • The EFTA court's decision limits the sovereign's responsibility in a systemic crisis: a sovereign does not have to honour deposit insurance if to do so would bankrupt it. But this could apply equally to domestic depositors: Iceland chose not to honour deposit insurance for foreign depositors, but it could actually have refused to pay deposit insurance at all once the resources of its deposit insurance scheme were depleted. And this is also a get-out clause for the UK government - but one it might hesitate to use. 

The real problem with the Icelandic banks was not their legal status. It was their attraction to UK retail depositors, most - but as it turned out, not all - of whom were covered by European deposit insurance schemes. It is very hard for the UK government to resist rescuing domestic retail depositors even if the real responsibility lies elsewhere.

Small retail depositors in UK subsidiaries of Chinese banks would be covered by the FSCS, and those banks would also be subject to UK regulatory requirements. No doubt the Chinese authorities were not too keen on the UK regulators supervising their banks - hence the concession. However, the UK government argues that the Chinese banks would not be aiming to establish a retail presence in the UK, so there would be no need to bail out domestic retail depositors in the event of a Chinese bank failure. Osborne's strategy of allowing these banks to operate branches in the City of London does not expose the UK taxpayer to risk through the FSCS scheme, as Hutton seems to suggest. The risk is to institutional investors. 

The Chinese banks are indeed somewhat fragile: they are highly exposed to Chinese local authorities, many of which are thought to be unable to pay their debts. And as the Chinese authorities do not shrink from brutality, there is little doubt that overseas investors in Chinese banks would be thrown to the wolves in the event of the Chinese government having to rescue one or more of its banks, which may well happen at some time. But this should not bother a UK government that has made it clear that it will not rescue institutional investors that make unwise investments. After all, that is the point of the ring-fencing proposal for UK banks. If all the Chinese banks are going to do is use London as a trading post for the renminbi and a springboard for investment in the UK, it is difficult to see what direct risk there would be for the UK taxpayer.

But there is a risk for the UK economy. If London becomes the principal European trading hub for the renminbi, a crisis in the Chinese banking sector would be very destabilising for the City. And although there are many who would like the City to be less significant in the UK economy, the fact remains that the UK is a primary provider of financial services to the world and its economy is critically dependent on the health of its financial sector: the UK was more badly damaged in the 2008 financial crisis than any other major economy (pace Ireland and Iceland) and has taken longer to recover. There is no doubt that the Chancellor's concession to the Chinese banks exposes the UK economy to serious damage in the event of another Far Eastern financial crisis similar to that which destroyed the Japanese banks in 1997. I fear it is a mistake.

Related links:

UK eases rules for Chinese trading - BBC
George Osborne in China - wide-eyed, innocent and deeply ignorant - Will Hutton, Guardian
Inside Job (video)
Icelandic financial crisis - Iceland Chamber of Commerce
EFTA Court judgement - EFTA Surveillance Authority
Groundbreaking deal set to make London global currency centre for investment in China - UK Government
Chinese banks feel strains after long credit binge - WSJ (paywall)
Asian financial crisis timeline - Frontline

Tuesday, 15 October 2013

Some Incomplete Monetarist Arithmetic

My latest post at Pieria looks at modern-day fiscal dominance and its consequences:

In 1981, Sargent & Wallace published their now-famous research paper Some Unpleasant Monetarist Arithmetic. It demonstrated the difficulty that central banks have in controlling inflation when governments are hell-bent on fiscal profligacy. Coming after the fiscal and monetary policy disasters of the 1970s, it seemed like a breath of fresh air. Its recommendation of "monetary dominance" - that fiscal policy-setting should be constrained by the inflation target of the monetary authority - became the standard for "good practice" in macroeconomic management for the next thirty years.
Even today, its shadow lies long. Gavyn Davies recently suggested that the Bank of India needed to establish monetary dominance in order to get inflation under control. And Pozsar and McCulley incorporated its findings into their paper on helicopter money, although they only applied it to the circumstance where inflation was out of control due to fiscal and monetary profligacy. Indeed Sargent & Wallace themselves only apply their analysis to that situation. In effect, they assume that fiscal authorities will always be profligate unless disciplined by a monetary inflation target, and that unconstrained deficit spending will always result in higher inflation.
But the situation in developed countries today is the polar opposite...."

Read on here.

Sunday, 13 October 2013

The temples of the gods of capital

The London property market is booming. Property prices have risen by 9.7% in the last year and there is no sign of any decline. Such large price rises are, of course, only happening in London, not the rest of the UK, where property price rises are lower the further you are from London (in Scotland prices are actually falling). But the same is happening in other large cities such as New York. Prime real estate in big cities has never been so expensive - and so desirable.

Yet people are leaving London, apparently. Both the FT and the NY Times carry opinion columns by disgruntled journalists who have decided the cost of property in London is way too high and are moving elsewhere. And they report that others are doing so too. Here's Michael Goldfarb in the NYT:
"Matt, who had been looking for a house for more than three years, summed up the reason for leaving best: “I don’t want to be a slave to a mortgage for the next 25 years.” Given the astronomic rise in house prices here, he wasn’t speaking metaphorically."
So if people are leaving London, how do we explain such enormous price rises? Ordinarily we would expect what the NYT calls "London's great exodus" to cause prices to fall, not rise. But there is a simple reason, and it is due to the new role of property in the global economy. London's prices are rising at the same time as its residents are leaving for one simple reason. Property in these city centres no longer exists to provide homes for ordinary people. It exists to provide safe, high-yielding assets for the rich.  As Michael Goldfarb points out:
"This is what happens when property in your city becomes a global reserve currency. For that is what property in London has become, first and foremost."
The surplus of capital in the global economy, coupled with a growing scarcity of other safe assets, makes property in big cosmopolitan cities around the world an attractive prospect for risk-averse investors - and they are flooding into it. The FT reports that 82% of prime real estate sales in the centre of London were to overseas cash buyers. Not that they live in the properties they buy, of course. No, they rent them out. Well, at the moment they do, anyway. Though if people are leaving London, rental values on London properties should be falling. Well, they aren't - but the rate of increase is slowing, despite the huge increase in house prices:

(source: GLA London Housing Market Report)

So if rent rises are slowing, why are property prices increasing so fast? The Telegraph thinks Help To Buy might have something to do with it - it suggests that the movement from renting to ownership could cause rents to fall by as much as 5%. But the chart above shows that rises in rental values have been slowing since the beginning of 2013. That seems to be much more likely to be due to greater supply of rental property on the market relative to demand.

If the principal aim of a property investor is not to generate income from rentals, but to make money through capital appreciation, then rental values don't matter if the property itself is appreciating. An annualised return of nearly 10% is really pretty good. You could leave the property unoccupied and still get that return. So if you aren't planning to keep the property very long, it may not be worth your while letting it at all. However, if the plan is to keep the property as a longer-term investment, it does need to be occupied, or at least managed. Property that is not cared for by humans who have a vested interest in maintaining or improving it deteriorates. So it may be that the London market will see substantial falls in rental values while house prices continue to rise. Having a tenant caretaker protects the value of your investment.

Izabella Kaminska posits a nightmare future in which London, and other big cities, become "ghost cities":
"Imagine the scenario many years along: streets and streets of vacant properties and offices, because there’s simply no one left who can afford the rents that can make renting worthwhile for landlords. And even though high prices have encouraged large volumes of new supply to be created by developers these have ended up mostly in the hands of wealth-preservationists, going straight into dark inventory stores.
"The capital city retains value only as a retail showroom, a cultural tourist spot and/or an arts and social hub for visitors or legacy occupants. But it has all the same been significantly dehumanised because almost no-one can afford to work there. The workers have either been replaced by robots and technology, or forced (unwittingly) into servitude to a faceless overseer who grants them permission to live rent free. Yes, yes.. think Jean-Luc Godard’s Alphaville.
"Meanwhile, inevitably, the outskirt flourished as people from the city relocated to more affordable rural or regional parts of the country. This was facilitated by the internet which increasingly enabled people to work from wherever they choose."
But is this really a nightmare? Throughout history, humans have built large and beautiful places for no-one except a chosen few to live in. These places were (and still are) visited by thousands, and they were cared for by paid permanent staff, some of whom lived within their confines - and some of whom, indeed, were not allowed to leave. I refer, of course, to the various forms of temple that humans have built over thousands of years. Temples built as homes for the gods: temples where people congregate to worship their gods: temples to which devotees bring their offerings of money and goods. In days gone by, temples (cathedrals, henges, mosques, whatever you want to call them) were the focal point of the community. They were often centres for trade: markets and cathedrals are closely related - and of course Jesus threw the traders out of the Temple in Jerusalem. And they were places of refuge: people in trouble could find sanctuary in the temples of the gods.

It seems as if we are once again building temples to the gods - this time, to the gods of capital. We are making of our city centres beautiful places where people can come to worship the gods, bringing their offerings of money to spend in the art galleries, the museums, the theatres, the restaurants and the bars: places that are centres of trade, particularly in the goods of the gods (money and property): perhaps places where people who use the goods of the gods for illicit purposes can find sanctuary. Of course, these beautiful places must be maintained, so perhaps eventually there will be a class of people whose job it will be to look after the property of the gods - employed by management companies to live in the beautiful places, caring for them and maintaining the illusion of a vibrant human city. Such people would never be able to leave the city.....they would be tied tenants, owning very little but provided with the best accommodation in the world. Modern-day Levites, if you will. Or perhaps a new form of enclosed religious community.  And the rest of society could only visit the city, never live in it. Real life, except for the chosen few, would be somewhere else.

I suppose this is a nightmare, really.

Related reading:

House Price Index, July 2013 - ONS
The illogical pricing of property - Pieria
There's no point trying to live in London - Christian Oliver, FT (paywall)
London's great exodus - Michael Goldfarb, NY Times (paywall)
Dark Inventory, Death of a City edition - FT Alphaville
Modern gods and human sacrifice - Coppola Comment

Friday, 11 October 2013

The (political) failure of safe assets

US T-Bills, today:

(source: U.S. Department of the Treasury)

No, you aren't imagining it. The yield curve has inverted. The yield on 1-month treasuries is higher than the yield on 1-year treasuries. It seems markets think the USA might default on its short-term debt.

This is all because of the standoff between President Obama and Congress regarding funding Obama's "health care for the poor" (the legislation for which Congress has already passed). I'm not going to discuss the wrongs and rights of the situation here. Suffice it to say that both sides think they are right: both sides are refusing to negotiate about the health care, though they do seem to be prepared to discuss other fiscal expenditure matters: and both, it seems, are prepared to allow the USA to default on its debt rather than back down from their entrenched positions.

If the USA were Argentina this perhaps wouldn't matter too much. Argentina has a history of debt default, it is currently going through an interesting series of cases in the international courts regarding whether or not it is obliged to pay debts it defaulted on a decade ago, and it is probably going to default again even if it doesn't win the case. Most people watch this saga with some amusement, but not with any great concern. Argentina defaulting on its debt might cause some stress to the world economy, but it doesn't threaten to bring down the global financial system.

But the US is not Argentina. It is the largest economy in the world, its currency is the world reserve currency and its debt is the world's most widely traded safe asset. Short-term debt (T-bills) are prime collateral in the global secured lending markets, and the yield on the 3-month UST is regarded as the closest proxy to the risk-free rate for pricing calculations. For the US even to contemplate defaulting on its debt is destabilising: if it actually did default, the result could be catastrophe. Hence the inverted UST yield curve.

And hence, also, the anger from countries around the world at the US Government's behaviour. The BBC reports that China and Japan, the USA's two largest foreign creditors, have both expressed concern at the prospect of the US not honouring its commitments to them. Countries from Canada to Zimbabwe have warned about the consequences for their economies of  US default. And people are beginning to call into question the nature of a system of government that could potentially cause a catastrophic debt default purely through intransigence. Not being able to meet commitments because of financial mismanagement is bad enough. But failing to do so because of political gridlock is frankly appalling. The USA needs to get its act together. Playing brinkmanship with the world economy to achieve domestic political objectives is unacceptable.

However.....the USA could argue that it did not ask the world to become dependent on its debt as the primary safe asset in world markets, and therefore the consequences if it defaults are not its problem. Some in the USA do indeed argue this, and they perhaps have a point. Government debt - any government debt - does not exist purely to lubricate international markets, as the BIS seems to think. Nor does it exist to provide safe assets for risk-averse international investors. The purpose of Government debt is firstly, to fund government expenditure until sufficient tax revenue can be obtained to meet spending commitments, and secondly, to enable the citizens of the country to save. At its most basic, government debt has no international purpose.

But it is not that simple. The fact is that international markets need safe assets, and at present the only country that can produce them in the quantity required is the USA. When the USA was downgraded, FT Alphaville considered alternatives to US Treasuries as a safe asset, and concluded that there weren't many. Markets concurred: the downgrade passed almost unnoticed and AA became the new safe asset standard. Nothing has changed since. There are no more safe liquid assets from other sources in the market than there were when the USA was downgraded. So if the USA does default on its debt, markets will be in the extraordinary position of having to regard as "safe" securities that are technically defaulted, because there really isn't anything else.

There have of course been questions recently about the future of the US dollar as global reserve currency. Various suggestions have been made regarding its eventual replacement: the Chinese yuan, the IMF's SDR, the Euro, a completely new international currency, or even a multipolar world in which there is no single reserve currency. At present there is no clear front runner. But at least it is being discussed. The future of the world's primary safe asset is not being discussed at all.

Yet the present situation is that the global financial system is critically dependent on the quantity and quality of US debt issuance. US domestic political shenanigans therefore threaten global financial stability. But US domestic politicians behave as if it has nothing to do with them. Hence the angry comment from the Times of India (quoted by the BBC) that the USA is "holding the world to ransom". Unfortunately there is no solution to the present conundrum other than for the USA's politicians to resolve their differences. But we urgently need to consider what alternatives there could be to US Treasuries as a primary source of global safe assets in the future.

So what alternatives might there be? Well, it is by no means obvious. China is large enough to take over from the US as primary provider of safe assets,but it has such a large trade surplus, and such huge reserves, that domestically it does not need to issue debt and it is likely to be unwilling to do so. Russia, also, is probably large enough, but its credit history is distinctly ropy (it defaulted in 1998) and it seems unlikely that the global markets would trust it enough to rely on its debt as a primary safe asset. Japan has enough debt but nowhere near enough GDP to support its use as a primary global safe asset partly or wholly replacing USTs: its debt/GDP ratio is already by far the largest in the world. Other countries with a good credit standing such as Germany, France and the UK are simply too small.

There is, of course, an obvious future contender - and that is Eurobonds. The combined might of the Euro area countries could easily support production of safe assets of a similar quantity and quality to USTs. They would need to be backed by the ECB, just as USTs are implicitly backed by the Fed. Many people have suggested Eurobonds as a solution to the Eurozone crisis, but to my knowledge no-one has suggested Eurobonds as a competitor to US Treasuries in the safe asset marketplace. But once again, the obstacles are political.  Hell would freeze over before Germany agreed to this. Which is something of a pity. The world really does need an alternative source of safe assets. Either that, or the US Government must accept that it really is the world's bank, and stop allowing domestic politicians to play fast and loose with the world economy.

Related reading:

When governments become banks - Coppola Comment
Government debt isn't what you think it is - Coppola Comment
Safe assets and Triffin's dilemma - Coppola Comment
Pari Passu Saga series - FT Alphaville
Global rebalancing and the Bancor - John Aziz, Pieria
International liquidity in a multipolar world - Eichengreen
Are the G20 and IMF in the process of creating a global currency? - Global Research

Oh, and we've played this scene before, of course:

The price of distressed Treasuries - FT Alphaville (2011)

Sunday, 6 October 2013

A question of justice

People of libertarian persuasion are often very keen on the idea that Government should "defend property rights". Their view is that the assets they own are theirs by natural right, and it is the Government's job to defend that right.

I find this view bizarre. As I've noted before, there are no "natural" property rights. The law of the jungle, which is the law that holds when all other laws are unenforceable, says that the only property you "own" is what you can defend. If something bigger and stronger than you comes along, points at your property and says "I'm having that", you may put up a fight, but in the end you will lose, and then it is no longer your property. Humans have operated like this for thousands of years, particularly over land. Nearly all wars start when a country that thinks it is bigger and stronger than other countries points to a neighbouring country and says "I'm having that", and the neighbouring country says "You try it and see what you get". Both sides then call in favours from friends, and the result is an ugly and expensive spat with far-reaching economic consequences.

Territorial wars are, of course, the most extreme example of "law of the jungle" fights over property. But in fact disputes over the ownership of property occur all the time, and the law of the jungle still operates. Yes, these days the battleground has become the courtroom, and swords and guns have become money: but those who have money are still able to defend their property far better than those who don't. Small businesses, for example, can be bankrupted by the failure of their customers to pay on time: they can take their customers to court to obtain settlement, but they need money to do that, and if they don't have any money (because they haven't been paid), their right to payment for the goods & services they have provided can't be enforced. The law of the jungle says that if you aren't big enough and strong enough to take something from another person, you don't own it. In our modern, non-violent world with lawyers and judges, that means if you don't have enough money to enforce your property rights through the courts, you effectively don't own your property. There may be a law that says you do, but if it can't be enforced, it is not the law actually in operation. What is actually in operation is simply a less violent version of the law of the jungle.

But Government doesn't "defend" property rights, anyway. It creates them. The natural law is "I'm bigger and stronger than you are, so I'm having that". Government, pressured by people who believe that things they have are theirs by right even if they can't defend them, creates laws that say that what you have, you own, and no-one else can have it however big and strong they are. And it creates the legal infrastructure to enable those laws to be enforced. Well, more or less. Too often those laws are not enforceable in practice, not just because people don't have enough money to enforce them, but because it isn't easy to define what we mean by "ownership" or "property".

The legal infrastructure created by Government to protect individual "rights" incorporates within itself the right for Government to take some of the property of its citizens in order to fund itself.  But our libertarian friends are horrified by the idea of taxes, especially capital taxes. Government taking your property from you by force is a betrayal of what they regard as the primary function of Government, namely to "defend property rights". This is illogical. Without taxes, Government could not function and the laws created by Government could not be enforced - including the "property rights" beloved of libertarians. Confiscation of property by Government is necessary if it is to "defend" the right to own property.

Of course, a dysfunctional Government may confiscate far more of your property than it needs to function, with the balance going into the pockets of corrupt officials. But as I've already explained, the only "natural" property right is "It's mine because I'm bigger and stronger than you". And Government is unquestionably bigger and stronger than you. So in taking more of your property than you think it should, it is acting in accordance with natural property rights. In fact it is really being quite kind by only taking some of your property. The law of the jungle would allow it to take everything you have.

What our libertarian friends really want is for Government to "defend" the property rights that they would LIKE to have - namely that what they have, they own, and no-one - not even Government - can take it from them.  I don't have any problem at all with the idea of Government defining and enforcing an alternative set of property rights that are more "just" than the law of the jungle, if that can be done. But to claim that these are "natural" property rights and Government is merely "defending" them is simply wrong. If property laws are more "just" than the law of the jungle, it is ONLY because Government makes them so. And if Government can impose "just" laws regarding property ownership, why should it not impose "just" laws in other areas too? The problem is, of course, that the "just" property rights beloved of the libertarian right conflict with other "just" laws, such as the right of workers to a living wage, and the right of those who cannot work to the means to live. But why should laws that primarily benefit the rich override laws that primarily benefit the poor?

There are many things that people consider to be their "right" that have no basis in law. Positive returns on savings, for example. There is no "right" to positive returns on savings: in fact, as I discussed here, there is not even any right to return OF savings. It may be "just" for Government to protect people who have planned their retirement income on the basis of positive returns on savings that fail to materialise. But there are many equally "just" causes - such as the need for people on low incomes to be able to afford a place to live. Securing "justice" for savers by raising interest rates would mean injustice for people struggling to afford over-priced houses and high rents. And this brings me finally to the entire question of "justice" in property rights. This is a huge topic, and I shall only scratch the surface of it here: but I hope that it will encourage debate about what "justice" means in relation to ownership and property. It is nowhere near as simple as our libertarian friends like to think.

Our libertarian friends consider it "just" that laws should defend their right to assets they have acquired through their own efforts and/or inherited. But consider the following.
  • Is it "just" that an industrialist should become very rich while paying starvation wages to his employees and expecting the state to top up employees' wages with in-work benefits? 
  • Is it "just" that an employer should expect the state to provide a highly skilled and educated workforce while squirrelling away profits in tax havens to avoid having to pay for the education and training of that workforce?
  • Is it "just" that a country's creditors can demand, and receive, payment at the expense of the well-being and even the lives of the citizens of that country? For that matter, is it "just" that lenders can "dip into" the bank accounts of people to whom they have lent money, leaving them with insufficient money even to buy food?
  • Fred Goodwin was hounded by the press and by public opinion until eventually he was forced to relinquish part of his pension - a funded pension that was his property according to his employment contract. Is it "just" that public opinion should override contractual employment rights when an employee behaves recklessly but not illegally?
  • Is it "just" that a fit and able person of 65 should be able to stop work and live off the taxes of others, including people who are considerably less fit and able but just happen to be younger?
  • Many elderly people who own valuable houses want their care when frail to be provided by the State so that their houses can be inherited by their children. Is it "just" that the taxes of those who are too poor to buy property of that value should support these elderly so their children can be enriched?
  • Most inherited land was at some time seized by force from others. Is it "just" that inherited land should be regarded as the rightful property of the descendents of those who seized the land? What about the "just" property rights of the descendents of those from whom the land was seized? 
  • When slavery was abolished, the UK government compensated slave owners for the loss of their property. Was it "just" for it to do this? Did those slave owners have any "just" right to property acquired through owning and managing slaves?
I could go on  - there are so many areas where the "justice" of property rights is questionable. Please add your own in the comments.

To sum up, though: the libertarian notion that the primary purpose of government is to "protect individual property rights" is partisan and illogical. If a government is to create and enforce "just" property rights as the libertarians would like, then it should equally create and enforce other "just" laws - including some that might involve forcing the holders of property to share what they have with others. To do otherwise is to prefer the haves over the have-nots, to construct law that benefits the rich at the expense of the poor, the powerful at the expense of the weak. And that is not the hallmark of a just society.

Related reading:

The extent of evil - Coppola Comment
Libertarian Party Platform
The Nozickian case for Rawls' difference principle - Matt Bruenig
Non-aggression never did any argumentative work at any time - Matt Bruenig
The problem of ownership - Frances Coppola, Pieria
Lender, beware - Frances Coppola, Pieria
Leviathan - Thomas Hobbes

(h/t Unlearning Economics for the Bruenig links)

Wednesday, 2 October 2013

Joseph, John and Gideon

I've noticed some people using the Biblical story of Joseph as justification for their idea that personal saving is a Christian virtue. And indeed, the concept of "rainy day savings" is essentially the same: save up in the good times so that you have savings to see you through the bad times. But in reality the story of Joseph has nothing to do with individual saving. Indeed, Joseph's actions actually made it more difficult for the people of Egypt to save for the coming famine.

You see, Joseph was not saving for himself. Joseph worked for Pharoah. And Pharoah and his court were the Government of Egypt. So Joseph was a Government minister. Rather a senior one, actually: he was the Ancient Egyptian equivalent of the Prime Minister. He "ran the land of Egypt" on Pharoah's behalf.

So when Pharoah's dream prophesied that famine was coming, Joseph created grain mountains to feed the population. Has anyone ever considered how he managed to do this, given that he was a Government official? Well, there are two possible ways. Either all the grain belonged to Pharoah and was distributed to the population by a beneficent government, or it was produced by private sector farmers who were taxed in kind (in the Bible they call this a "tithe"). So in order to build up the grain mountains either Joseph restricted distribution to the private sector, or the private sector was heavily taxed. Either way, the private sector - the population - ended up with less grain during the good times than they would have done if the Government were not saving. Now, they might of course have eaten all the grain and become grossly fat, then starved in the famine.....and indeed that was probably the assumption made by Joseph. After all, everyone knows that people are feckless and the nanny state knows best. So the population were prevented from eating the grain. But they were also, of course, prevented from saving it - as some would have done.

In fact Joseph saved up so much grain that he was able to export some. So he not only taxed the population so heavily they couldn't save, he then sold the receipts to foreigners - including his family. Isn't that corruption? Really Joseph was not a good role model for Government ministers. And no way can his story be taken as promoting the virtue of individual saving. On the contrary, it promotes the virtue of GOVERNMENT saving in order to feed a population that, it is assumed, does not save.

The story of Joseph is a great example of Keynesian economics. John Maynard Keynes advised that Governments should run surpluses in the good times to build up reserves against future scarcity. Joseph and Pharoah did exactly that - and to their credit the population survived (as did the rest of the world including Joseph's family, apparently). What we will never know, of course, is whether it was necessary. Had Joseph not taxed the population so heavily that they couldn't save for the coming famine, would they have saved? Was all that building up of grain mountains really necessary? My guess would be that some would have saved far more than they needed, and others wouldn't have saved nearly enough - and then there would have been food fights. Joseph's action was about keeping the peace as much as providing food.

Of course, the problem for governments that don't have resident prophets is knowing when you are in the good times and when  - or if - they are going to end. The Brown government didn't save during the good times because it did not expect the good times ever to end. Although it wasn't that there weren't prophetic dreams or people to interpret them, it was more that Pharoah wasn't listening to them. Whereas Pharoah did what Joseph said, Gordon didn't do what John said. Consequently the UK government did not have much in the way of savings at the time of the 2007/8 crash. Admittedly there was no famine, but there was a serious recession which caused production and tax revenues to slump. So the UK government borrowed heavily to prop up the collapsing economy. That, not "profligate spending" prior to the collapse, is where most of the debt increase under the Brown government came from. It was pure Keynesian stimulus spending in a recession, but financed with debt instead of reserves because of the lack of Government saving in the preceding boom. And it worked. The economy was recovering - until it was derailed at the end of 2010. That's when everybody got scared about the scale of the borrowing needed to prop up the economy, and decided that borrowing to stimulate the economy was a bad thing and what was really needed was spending cuts and tax rises to "get the debt under control".  Withdrawal of the Keynesian stimulus and its replacement with austerity at a time when the economy was still weak might have had something to do with the fact that the recovery fizzled out. Simon certainly thinks so.

Now, three years later, we seem to have the beginning of a recovery. And suddenly here is Gideon announcing his conversion to Keynesiansim. Having failed to listen to what John said for the last three years, he's become a fervent believer, apparently. I don't know if he went anywhere near Damascus, but he's seen the light. "I want the UK to be running a surplus in the next Parliament", he cries with evangelical fervour.

Except that actually he STILL isn't listening to John, or (for that matter) to Joseph. John and Joseph both say that governments should build up reserves IN THE GOOD TIMES. It is now the back end of 2013 and the good times have not yet returned: the ONS's review for October 2013 contains some promising statistics, but it really is far too early to be claiming that the economy will be performing well enough for a fiscal surplus to be either achievable or sensible in the next Parliament, which is less than 2 years away. The economy is still a long, long way from full capacity. Furthermore, the OBR's figures show that the Government will probably still be net borrowing in 2017-18:

And the Government has missed every deficit reduction target since it came into office anyway. Running a surplus in the next Parliament frankly looks like a pipe dream. It is very worrying, especially for savers, that Gideon apparently thinks this is achievable.

Reducing a deficit is economically the same as saving, and in the absence of a trade surplus Government can only save at the expense of private sector saving (for a mathematical explanation of that statement, see the Footnote). So if Gideon actually puts into practice his harebrained scheme to force a fiscal surplus in the near future, people will find it even more difficult to save than they do at the moment: their incomes will fall, their debts will rise and they will have even less discretionary income to set aside as savings. Moreover, those who do manage to save can look forward to even worse returns than they have at the moment, because the Bank of England will be forced to loosen monetary policy even more to stop the economy going back into recession.  For Gideon to achieve his goal of a fiscal surplus, financial repression must become the new normal.

Neither Joseph, John nor Gideon appear to support Dave's idea that personal saving should be "rewarded". Joseph's story promotes Government saving, but only in the good times and only when you have reason to think there is a famine coming. John's recommendations are consistent with Joseph's. Neither of them is promoting personal saving: indeed, if John's recommendations are followed, people must rely more on the Government to save on their behalf, since Government running surpluses will limit their own ability to save. And Gideon apparently intends to follow their advice, though he doesn't seem to understand it. After all, he presumably agrees with Dave. He really should read John properly. Or Joseph. And do the maths.

Related reading:

Genesis 41 - NIV
George Osborne: We'll run a budget surplus - BBC
Cameron rules out "mansion tax" - BBC
Fiscal space: what does the IMF mean? - NIESR
Austerity and living standards - mainly macro
Economic review, October 2013 - ONS
Economic & fiscal outlook, March 2013 - OBR
What derailed the UK recovery? - Coppola Comment
One swallow - Coppola Comment
George Osborne's misconceptions about countercyclical fiscal policy - Azizonomics


For those readers who like maths (and for Gideon), here's an algebraic explanation of the Joseph story.

The relationship of private sector and public sector savings is given in the sectoral balances equation:

S - I = (G - T) + (X - M)

where S = saving, I = investment (in this case the amount of grain planted for future crops), G = government spending, T = tax revenues, X = exports and M = imports. Let's express our story of Joseph in terms of this equation. By the way, we are of course using grain as the monetary unit.

We know that while Joseph was building up Government reserves, he wasn't exporting grain. We can assume therefore that X - M is zero. Therefore we have the following:

S - I = G -T

We also know that Joseph was saving grain in the Government's barns. So (G - T) must have been negative - the amount of tax revenue (in grain) exceeded the amount of grain eaten by the Government and its beneficiaries. Therefore (S - I) must also have been negative. The Government's grain mountain was only possible because the private sector DIS-saved.

During the famine itself, of course, G - T turned positive as tax revenue collapsed (no-one was producing any grain) and Government spending increased (Joseph dished out grain to the population). And Joseph also exported grain to other famine-hit regions. So should we assume that X - M is also positive? Was Joseph engineering an export-led recovery?

No, he wasn't and we shouldn't. What Joseph was doing was selling Government assets. It's not correct to regard X - M as positive: Joseph's aid to his family was part of G, not X, and when they paid for it (in something inedible such as silver), the receipts went into the Government's coffers, so were part of T. We still haven't got any private sector external trade. So X - M is still zero even though Joseph is exporting. In fact economically the net effect of Joseph's aid to his family is zero, except that it may have deprived the Egyptian population of grain they needed to eat (part of G was diverted to Joseph's family).

So the result of reducing the surplus (G - T) might be expected to allow (S - I) to increase. Except that it was a famine, of course. Which means that national income was falling. Here's the national accounting equation :

Y = C + I + G + X - M

where C = amount consumed, other variables as before. Note that S, which is private sector saving, is missing. However, Y in this equation includes taxes (the income of the public sector). If we want just private sector income Ypriv, we need to subtract T from both sides:

Ypriv = Y - T = C + I + G - T + X - M

However, we know that (G - T) + (X - M) = (S - I), so Ypriv = C + I + (S - I)

So if private sector income Ypriv is falling, then although (G - T) is increasing and (X - M) is zero, (S - I) actually doesn't increase as a proportion of Ypriv. If C and I remain constant (the population gets enough to eat and all seed corn is planted instead of being eaten), then  if Ypriv falls, (S - I) must also fall. People really don't save when there is famine.