Wednesday, 30 April 2014

Bad Bank Barclays

At Forbes, I explain how regulatory changes and a difficult trading environment have forced Barclays to consign half of its investment bank to the scrap heap. What is left looks very familiar, though.....

How not to solve the UK's housing problem

The UK’s Opposition leader, Ed Miliband, is to announce a program of changes to the housing rental market as part of his election manifesto. The key points will be:
  • Three-year secure tenancies
  •  Rent rises limited to inflation or local average rent rises
  • The end of rental fees for estate agents
The UK has a long and unhappy history of experiments with rent controls. Predictably, therefore, the Labour leader stopped short of describing the restricted rent rises as “controls”, preferring the term “rent caps”. The Government’s spokesman Grant Shapps, however, described them as “Venezuelan rent controls”. And the right-wing economics think tank the Adam Smith Institute, in a press release, reminded everyone how unhelpful rent and tenancy controls can be: they tend to drive landlords out of the private rental market, restricting supply and creating long waiting lists.

But I want to know where the “draconian” rent rises are that Ed Miliband considers need to be capped. Two years ago there was perhaps a case for a temporary cap on rent rises, since rents at that time were rising fast due to very tight credit conditions in the mortgage market and a serious shortage of affordable housing: though even then, a better solution would have been measures to improve availability of mortgage credit and supply of affordable housing. But according to the ONS, rents are no longer rising steeply. The ONS produces a quarterly index of private housing rentals: the most recent, for January to March 2014, shows that rents have risen at an average rate of 1.0% year-on-year across the UK as a whole. Even in London, where house prices have risen sharply, rents have only risen by 1.4%. These can hardly be considered exorbitant rent rises.  

This could of course change. After all, rents do tend to track house prices. But at the moment, rent rises are well below house price rises, which suggests that there is no shortage of rental property. This is most likely due to expansion of the Buy-to-Let market by investors looking for yield: because house prices are rising fast, returns on property are high for cash buyers, so income from rent is becoming less important.

Some property owners prefer to leave property empty rather than have to manage tenants. Miliband should note that lengthening secure tenancies is likely to increase the number of properties left empty. If a future Labour government implemented this policy, they might also wish to consider imposing a tax penalty on unoccupied properties.

But I really struggle to see what the point of this proposal is. In some areas there are shortages of certain types of property, particularly small flats, and the rents on these therefore tend to be higher. Where shortages are severe, there may indeed be unreasonable rent rises. But the solution is to provide more of this type of property, by building new blocks of flats and by converting larger properties. Imposing rent controls – for that is what they are in reality – across the entire housing market is not the way to address local shortages in particular types of property. It won’t solve the property shortage and it will simply create distortions in other parts of the market.

The ONS figures show that in general, people who are renting are currently not experiencing massive rises in the cost of shelter. The people who ARE experiencing ridiculous rises are those who would like to buy, who are being priced out of the market. Price rises in London driven by property investors are now rippling out to other areas. And far from helping people to buy at a price they can afford, the Help to Buy policy is pushing up house prices still more, making property even more unaffordable for young people in particular. It’s a disaster.

If Miliband is really concerned about high housing costs for both owner-occupiers and tenants, the most useful measure he could propose would be drastic relaxation of planning controls. He could also consider a program of social housebuilding, particularly in low-income areas. These measures would address the real root of the UK’s housing problem, which is restricted supply. Messing around with tenancy agreements and rent caps while the cost of housing is spiralling out of control might buy him a few votes, but it won’t resolve the UK’s housing problem.

Related reading:

The housing conundrum
Ed's brave housing proposal - Alex Marsh

Monday, 28 April 2014

Two posts on Greece

My last two Forbes posts are about the effects of austerity in the Eurozone periphery, and in particular Greece.

"Austerity and suicide: the case of Greece" examines recent research that claims to prove a direct link between government spending cuts and male suicide. Sadly it fails to do so because of inadequate data, but that doesn't mean there isn't a link - and it could be quite easy to prove in a different way.

"An Economics Lesson For Professor Sinn" takes apart Hans Werner Sinn's argument that rising debt/gdp levels in the Eurozone periphery are due to the European Commission failing to enforce the fiscal compact. When the economy is falling off a cliff, as it is in Greece, the only realistic way of stabilising debt/gdp is to stop the economy collapsing.

How to fleece a government, Irish style

I really can't resist this.

Via Brian Lucey comes this report that Allied Irish Banks (AIB) is having some difficulty servicing its debts.

AIB was bailed out by the Irish government in February 2009 when its share price collapsed due to severe  liquidity problems and loss of market confidence. It was subsequently nationalised when the collapsing Irish property market destroyed its solvency. Currently, the Irish government owns over 99% of its ordinary shares.

But it's not the shares that are the problem. In three weeks' time, AIB is supposed to pay a cash dividend on 3.5bn euros of preference shares held by the National Pensions Reserve Fund Commission (NPRFC). AIB can't afford to pay the interest on them, apparently, despite the fact that it made an operating profit of 445m euros in 2013.

AIB has a creative solution to this. Cash shortfall? No problem. Issue some ordinary shares to pay the interest. Sounds wonderful, doesn't it? But the NPRFC is a government organisation. So the Irish government not only owns 99.8% of the ordinary shares of AIB, it has £3.5bn of subordinated debt, too - the interest on which will be paid in the form of yet more ordinary shares. Maybe I am cynical, but this sounds like a rip-off to me. AIB's net worth in three weeks' time won't be any greater, so the additional shares will simply dilute the government's holding. In effect, the Irish government will be paying interest to itself.

Mind you, this would still be the case evcn if AIB paid cash, really. After all, interest payments on debt reduce dividend payouts and retained earnings. What the Irish government gained in interest payments it would lose in lower dividends and return on equity.

But the real question is - if AIB is already fully nationalised, and it STILL can't afford to service its debts, why is it still open for business? Why isn't it being wound up? After all, the only reason this solution is possible at all is that the debt is owed to the sovereign. If it were owed to private sector lenders, this would be another bailout. AIB can hardly be considered a going concern, whatever its management might say. It's the worst type of zombie bank - draining resources from the sovereign to keep it alive, while adding little value to the economy it is supposed to serve. Wouldn't Ireland be better off without it?

Mind you, the AQR and stress tests might finish it off. I live in hope.

Friday, 25 April 2014

A bad day for Barclays

Barclays’ AGM was a stormy affair. It started with protests about Barclays’ investment policies. For Barclays directors and shareholders, even getting into the Royal Festival Hall meant running the gauntlet of World Development Movement protestors, tax justice campaigners and other pressure groups, all with placards in Barclays’ corporate colours spelling out what they regard as Barclays’ misdemeanors. Colourful, and attractive to attendant journalists. Not the sort of publicity Barclays would have wanted on the day of its AGM.  

Protests outside Barclays AGM, April 24 2014

This was bad enough. But once inside the hall, directors received a distinctly frosty reception from shareholders. And with reason: the bank is proposing to increase executive pay substantially while keeping dividends on the floor, even though its shareholders coughed up an additional £5.8bn not long ago to meet a capital shortfall.

Sir David Walker, Barclays’ chairman, made a valiant attempt to defend the indefensible. He insisted it was due to competition from other banks, particularly in the US, for highly skilled and qualified staff: 
"But we were faced last year, 2013, with a situation in which we were losing people who were crucial to the future of the investment bank in an extremely competitive environment in which total pay in some parts of the major US investment banks rose by 15% or more. Our resignation rate for senior employees in the US almost doubled in 2013. We saw significantly higher numbers of high quality people we wanted to recruit turning down our offers. In this situation, where there is a genuine threat to the health of the franchise, our duty of care is to protect value for shareholders. The challenge was the need for damage limitation and franchise protection."
And he told shareholders the pay increases were in their interests. Barclays had to keep up or risk losing key people.

But shareholders were unimpressed.  The life insurance company Standard Life complained that its members deserved better than the dismal returns they were getting, and that if Barclays could afford to pay its executives so much then it could also afford to remunerate shareholders properly:
".....we are unconvinced that the amount of the 2013 bonus pool was in the best interests of shareholders, particularly when we consider how the bank's profits are divided amongst employees, shareholders and ongoing investment in the business. The dividend was unchanged in the year and an additional £5.8bn of capital was raised from shareholders. We also believe that this decision has had negative repercussions on the bank's reputation."
And it then led other institutional shareholders in a public humiliation of the remuneration committee by voting against the pay deal that would have seen bonuses rise by 10%. Smaller shareholders didn’t mince their words either, one calling for the resignation of Antony Jenkins, the CEO, another calling for the resignation of the remuneration committee, and others making pithy remarks about mismanagement.

The pay deal was eventually approved by two-thirds of shareholders. But it was an uncomfortable experience for Barclays’ management. Like all executives in public companies, they are held to account by their shareholders. At this AGM, their shareholders forcefully reminded them that they cannot do as they please.

Barclays' UK Shareholders' Association, in a recent letter to Sir David Walker, complained about the proposed pay deal in the light of poor results and rubbish dividends:
"UKSA has noted the results statement put out by Barclays showing how it has performed for 2013. That statement shows, inter alia, that the profit before tax is down 32% from 2012 and that the return on shareholders’ equity has halved from 9% to 4.5%, but you have increased the bonus pool for your investment bankers by £210 million and the compensation ratio for the investment bank has gone up from 39.6% to 43.2%.
"That statement also shows that the total dividend for 2013 will be 6.5p per share. This compares with 34.0p per share paid for 2008, a reduction of 81%."
They have a point. Barclays’ performance is grim by any standards. During the AGM it issued a profits warning for its fixed income and commodities trading division, only a couple of days after rumours circulated that it was considering selling its commodities trading division. A sizeable restructuring of the FICC division – indeed possibly of the entire investment bank – now seems likely, although Jenkins wouldn’t be drawn on his plans. And to crown it all, later the same day Barclays announced that it had agreed to pay a regulatory fine of $280m for its role in the US mortgage mis-selling scandal that contributed to the 2008 financial crisis. Nor is this the only example of bad behaviour for which it is under regulatory investigation. On the face of it, it is hard to see how the executive pay rises agreed today are justified. 

But Barclays does have a problem. It is competing world-wide for talented staff whose skills are considered to be in short supply. When there are skill shortages in an industry, wages are driven inexorably upwards, particularly when contracts are fairly short-term, people do not work notice periods and there is an active recruitment industry intermediating between employers and would-be employees. All three have a vested interest in driving up wages: the employer because it believes paying generously will encourage key people to stay, the employee because he (in banking it is mostly he) believes he is worth that pay even if he has no immediate use for it, and the recruiter because his commission is determined by the pay package of the recruit. It’s not unlike the collusion that exists between the buyers and sellers of houses, together with real estate agents and mortgage lenders, to drive up prices. Everyone wins, except those who aren’t part of the game – they lose out. In the property market, the principal losers are those who can’t afford to buy and have to rent at exorbitant prices. In the senior banker recruitment market, the principal losers are shareholders, whose returns are depressed by such exorbitant pay deals.

When I was at Midland Bank in the late 1980s, we had such a pay spiral in the IT market place. The pay of people with scarce technical and business skills rocketed: contractors, in particular, were paid astronomical amounts of money to persuade them to stay (they didn’t want permanent jobs). Permanent staff were paid considerably less, but even so their pay was out of step with going rates in other parts of the bank: we had to recruit people at seniority levels far in excess of their real responsibilities just to pay them market rates.  In the end HR put their collective feet down and refused to participate in what they incorrectly termed a ”Dutch auction”. This put an end to the payment of exorbitant amounts of money to IT staff at Midland, which as Midland was desperately short of money following some very unwise investments in Latin American government debt was perhaps a good thing. Had other banks done likewise, the IT pay spiral would have been halted. But they did not – at least not then. What broke the pay spiral was the 1990s recession, which saw banks closing down IT projects and laying off staff and contractors, and – above all - the IT outsourcing trend.
The same sort of thing is happening at senior levels in banks, particularly investment banks. The EU’s bonus cap is the European equivalent of Midland Bank HR’s foot-stamping. But other parts of the world have not cooperated. Since the introduction of the EU bonus cap, American and Far Eastern banks have been able to offer far more generous performance-related pay deals than European banks. Barclays, like other banks, is finding ways round the cap – for example by raising base salaries, providing “allowances” and – particularly - paying bonuses in the form of shares. But this makes pay less flexible and less liquid, which neither the bank nor its employees really like. And it is sailing close to the wind: EU dignitaries are already complaining that such tactics breach at least the spirit of the bonus cap legislation. But at least it enables Barclays to compete for talent with the likes of Goldman Sachs. The UK's Chancellor, George Osborne, fearing that the EU bonus cap, if strictly applied, would damage banks' competitiveness and destroy London's status as a world financial centre, is preparing to issue a legal challenge to the bonus cap. Battle is joined. 

But what exactly do banks mean by “talent”? And how scarce is this "talent" in reality? Could it be that it is actually more common than bank executives realise, but they have been led to believe that talent is scarce and expensive - perhaps by headhunters looking for good commissions? This reminds me of the arguments of so-called "entrepreneurs", who argue that they deserve exorbitant rewards because of their rarity - an argument ably debunked by Chris Dillow. Anyway, should banks really be recruiting people who are principally motivated by the size and flexibility of their pay package? Are people motivated solely by money the sort of people who should be running substantial parts of what is at least to some extent a public service?

Self-reinforcing pay spirals are unsustainable, because they drain money from other important functions – including business investment, in which shareholders should be at least as interested as they are in dividends. So the real question is whether these exorbitant pay deals are really necessary. If they are not, they must be ended, in the interests of all concerned and especially the owners of the business. 

Some of Barclays’ shareholders put their collective feet down at the AGM. Although the pay deal was passed, Barclays’ management will not forget that. I admire the action taken by Barclays’ shareholders, and I hope shareholders of other large financial organisations follow suit. But it won’t be enough. Shareholders can only influence the executives of the companies whose shares they own: admittedly, big institutional shareholders such as Standard Life can influence the pay deals of more than one bank, but even they cannot influence pay deals across the entire market. It seems unlikely that shareholder resistance alone will be sufficient to end exorbitant pay deals for senior bank executives.

But regulators can influence pay deals at ALL banks.  Perhaps it is time for regulators to take more interest in recruitment practices that routinely involve offering very large pay packages. And above all, perhaps it is time for international cooperation between regulators to put an end to this pay spiral. It would be nice to think that the EU’s bonus cap would force banks to “grow their own” talent and give opportunities to people not currently in the senior banking elite. But unless regulators in other countries follow suit I fear it will be circumvented and eventually ignored by both banks and regulators. We need worldwide regulatory intervention to curb bankers' pay.  

UPDATE: RBS has just been forced to scrap plans to pay bonuses of up to 200% because UKFI says it will vote against the scheme. UKFI manages the UK Government's 81% shareholding in RBS. Amazing how effective an official shareholder with a controlling interest can be. 

Thursday, 10 April 2014

So what exactly can the ECB do, anyway?

My latest post at Forbes considers what the ECB's alternatives are for easing in the Eurozone:

The ECB is not going to do QE, or indeed any other form of monetary easing at the moment. But they are talking about it. And for the moment, it seems, talk is enough. The Euro is up and bond yields are down, even for Greece (which isbravely attempting to return to the capital markets this week). European stock markets are worrying about the Ukraine crisis. It’s back to business as usual.
But as Andrew Clare of Cass Business School caustically remarks, “markets won’t be satisfied forever with hot air”. Unless Euro area inflation somehow reverses its current downward trend – which seems unlikely, since the world is on a general disinflationary trend at the moment and the Euro area is hardly a stellar performer  – the ECB will eventually be forced to do more than talk.

Read on here.

UPDATE: The ratings agency Fitch is rather more positive about the ECB buying SME loan securitisations than I am.

Monday, 7 April 2014

GDP and its critics

I've just finished reading Diane Coyle's excellent book on the history of GDP. For a measure that has only been used since the 1940s, GDP has amassed an extraordinary following. Whole economic theories now depend on it. 

But there are those who argue that GDP is fundamentally flawed and should be replaced. Sadly, some of them show a lamentable lack of understanding of accounting and the methods used to calculate GDP. For example, here is Steve Forbes:
GDP represents the value of all final products and services. It ignores all the steps that go into the making of these things. It’s sort of like looking at a carton of milk and paying no heed to everything that goes into creating that milk and getting the carton onto the store shelf.
GDP thus gives a distorted picture of the economy. How many times do we read that consumption represents 70% of the economy and therefore it’s important to “stimulate demand” by increasing government spending?
And he goes on to recommend using gross output (GO) instead of GDP, arguing that it "measures the economy in a far more comprehensive and accurate manner".

To show why this is seriously flawed, I need to explain a bit about how GDP is calculated. Experts on this will no doubt call me out on being far too simplistic - GDP is an incredibly complex measure and its calculation is close to being a black art. But this post is not aimed at experts. It's aimed at ordinary people whose opinions are swayed by the likes of Steve Forbes. 

GDP can be calculated in three different ways - the expenditure approach, the income approach and the production approach. The first of these adds up all the forms of expenditure in the economy, giving us the familiar formula:

GDP = C + I + G + (X-M)

where C is consumption spending, I is investment spending, G is government spending and (X-M) is net exports(imports).

Steve Forbes complains that imports are treated as negative for GDP. But this is a no-brainer. If you buy imports, money leaves the country. If you sell exports, money comes into the country. Purchases of imports are therefore correctly a negative for GDP. (But profits from sales of products made with imported goods are positive.)

The second way of calculating GDP adds up all the sources of income in the economy:

GDP = W + P + R + I + D+ (T-S)

where W = wages & salaries, P = corporate profits (or operating surplus), R = rents, I = interest, D = depreciation and (T-S) = net taxes after subsidies.

As total spending = total income, the first and second methods should give approximately the same result, though measurement errors do create some difference. 

But it is the third way of calculating GDP - the production approach - that Steve Forbes is complaining about. It takes gross output (yes, THAT gross output) and eliminates intermediate outputs to give the gross value-added output for the economy. Like many, Steve Forbes does not seem to understand why intermediate outputs are eliminated. But it is because intermediate outputs are used to create final output. To show this, I'm going to use Steve Forbes' own example of milk production. (Please note the figures are entirely fictitious. I have absolutely no idea how much it actually costs to produce, package and market a litre of milk.) 
  • Farmer X has a herd of dairy cows. The cost of maintaining his dairy herd is $1,000. They produce 1,000 litres of milk which he sells to a supermarket for $1.10 per litre. Gross sales are $1,100 and profit is $100.
  • Manufacturer Y produces the cartons for milk. Production cost is $200 for 1,000 cartons and he sells the cartons to the supermarket for 25 cents per carton. Gross sales are $250 and his profit is $50.
  • The supermarket puts the milk into one-litre cartons and sells it to customers at £1.80 per litre. The supermarket's unit costs are $1.10 + $0.25 = $1.35 per litre and they have staff costs and overheads amounting to a further 15 cents per litre. So if they sell all the milk, the gross sales revenue is $1800 and profit is $300.
The gross output is the total sales revenue from all three of these, i.e. $1,100 + $250 + $1,800 = $3,150. But there's a problem. Since the supermarket has to pay for its supplies, the sales revenue of the suppliers is already included in the supermarket's production cost. So by adding in the suppliers' sales revenue, we are double counting. This is the same problem that accountants face when creating group accounts: if you include sales from a subsidiary to its parent, you artificially inflate the sales revenue of the whole group. It's known as grossing-up. Here we are talking about supply chains, but for national accounting purposes the same applies. If you include intermediate outputs, you gross up the private sector's value-added contribution. To obtain an accurate figure for value-added GDP, therefore, we need to eliminate the intermediate outputs. When you do this, it is evident that only the supermarket's sales contribute to GDP. The rest disappear. 

So GDP does not recognise the value of intermediate outputs. But that doesn't make GDP wrong, any more than a set of consolidated group accounts is wrong because it has eliminated intra-group transfers. What Steve Forbes is proposing is replacement of consolidated business output with grossed-up business output to make the contribution of business to the national economy look bigger. I think they call this "cooking the books". 

Currently, the US's National Income and Product Accounts only show gross output by sector. It is now planning to produce overall gross output figures as well, in parallel with GDP figures (this is the change that Steve Forbes is crowing about). This is a good addition to the national accounts: we do need to understand the contribution of intermediate producers, and sector analysis isn't always adequate since final products may be made from intermediate sources in several sectors. Also, in these days of global supply chains, intermediate sources may not be in the same country as the final output, in which case the intermediates arguably should be regarded as imports and their cost deducted from gross output (no wonder Steve Forbes wants imports to be treated as positive!). So gross output will be a useful measure. But it is not by any stretch of the imagination a replacement for GDP. 

But it is the conclusion that Steve Forbes draws from this that worries me. Returning to the familiar expenditure equation GDP = C+ I+ G+ (X-M), Steve Forbes in effect argues that grossing-up business output would considerably inflate the importance of I in relation to C and G, since all those intermediate outputs would have to be included in investment spending. This would, in his words, "put business and investment in their rightfully large place". But this is bizarre. In what way is milk bought daily from a farmer "investment spending"? It is simply a cost of production and therefore belongs in C, not I. If you are grossing up, then businesses consume too.  

Of course, it suits businessmen like Steve Forbes to claim that the driver of the economy is business output and consumption is an optional extra. But the sole purpose of business output is consumption. Businesses don't produce products unless there are people willing and able to consume them. Without C, there would be no I.

And this brings me to Steve Forbes' view that government spending is a negative. In days gone by, when governments mainly raised money to finance wars, this was a reasonable view: money spent on wanton destruction leaves the country never to return. But that's not what the majority of government spending is used for these days. Most government spending goes into the economy: whether or not it is effectively spent entirely misses the point. Businesses sell to government just as they sell to households. Government spending should therefore correctly be seen as positive in the GDP expenditure calculation, just as household consumption and business investment are. 

So Steve Forbes's criticism of GDP is ill-informed and irrational. But GDP is certainly not without its problems. Its extreme complexity makes constant revision inevitable, and even with all that complexity it is still at best only a rough indicator of economic growth. If the inputs to the GDP calculation change significantly, the result can be large swings in apparent economic standing that have nothing to do with reality - for example, Nigeria has just reported an 89% increase in GDP that is entirely due to rebasing the components of GDP. And it leaves out all sorts of things - such as unpaid "home work" - for no particularly good reason other than that they are difficult to measure. Critics of GDP complain that it doesn't measure wellbeing (true), it doesn't adequately account for intangibles (also true), it gives greater importance to "making stuff" than providing services (true, but not surprising given when it was invented), and it ignores depletion of natural resources. All of these are valid criticisms. 

Coyle gives a good summary of these criticisms in her book. But she then dismisses most of them. Replacing GDP, or changing it to include other factors, is not the point. The real problem is that we are expecting far too much of GDP. There cannot be "one measure to rule them all". The fact that GDP focuses narrowly on measures of expenditure, income and output is not a bug, it's a feature. We need other measures as well. Coyle suggests a "dashboard" of economic indicators for policymakers to enable them to judge the health and prospects of the economy and set policy accordingly. GDP (nominal and real) would be included in this dashboard but would not be the sole driver of monetary or fiscal policy. 

As I am no fan of single targets such as CPI or NGDP, I like Coyle's idea. I am encouraged by the fact that both the Bank of England and the Fed are now using a "basket" of indicators, though they have not yet ended the primacy of the inflation target, because we still have not exorcised the 1970s inflation demons. But I am hopeful that we will gradually move towards a more balanced approach and start to include other indicators such as wellbeing and sustainable resource use in our measures of economic health. 

Sunday, 6 April 2014

Why labour markets don't clear

New Keynesians argue that sticky wages prevent labour markets from clearing. I disagree - I think labour markets can eventually clear. But we don't allow them to do so, because the social costs of are far too high. At Pieria, I explain why this is. Read the whole article here.

Wednesday, 2 April 2014

On the persistence of inadequate ideas

For years now, I have been complaining about excessive focus on "diaphragmatic support" in singing tuition*. Although breathing involves the diaphragm, support of the vocal tone actually uses deep core muscles, and the diaphragm is not under voluntary control anyway so telling students to "support from the diaphragm" is pointless.

And yet the other day I found myself teaching diaphragmatic support.....because for one student, it was the right technique. She needed a counterbalance to her tendency to pull in her upper abdominals (shrinks the waist but is disastrous for singing). In effect, she was singing as if she was wearing a corset. And therefore she needed a singing technique specifically designed to counteract the constrictive effect of a corset. For her, it worked. For most people, it is unnecessary.

The point is that although support of the vocal tone does indeed come from deep core muscles, the diaphragm itself plus the intercostal muscles and upper abdominals (which are incorrectly called the "diaphragm" by most people) still have a role to play, and when they don't do it adequately, the rest of the system doesn't work properly. But that doesn't mean that they should be the only - or even the main - focus of technical singing tuition. We can say that "diaphragmatic support" is an inadequate but occasionally helpful description of the role that the diaphragm and associated muscles play in the physical generation of singing tone.

Now, you don't really think this post is about singing technique, do you? Of course not. I am using this as an analogy for the money multiplier, about which there has been a fierce debate in the economics blogosphere ever since the Bank of England produced its (now notorious) paper on money creation.

I have been saying for years now that the money multiplier does not adequately explain how money is created in a modern fiat money economy. In particular, the idea that banks are passive intermediaries who simply respond to injections of central bank money by creating more loans is fundamentally wrong. Banks actively determine the amount of "inside money" circulating in the economy. When they create loans or buy securities, inside money increases. When loans are repaid or written off, or securities are sold, inside money reduces. The constraints on bank lending are multiple and complex, and don't include reserve availability (though the price of reserves is a constraint). The Bank of England's description of the process is broadly accurate.

Having said that, though, as a descriptor of the relationship between inside and outside money in the economy, the money multiplier is not wrong. It is merely inadequate. For example, I might look at this chart:

and conclude that there was no credit bubble in the run-up to the financial crisis - in fact if anything, lending slowed. I would be wrong, wouldn't I? Indeed I would. The money multiplier did not move, because the production of M0 was tracking the production of M1 (which was leading which is not obvious, but they were approximately correlated):

The money multiplier was therefore pretty much constant, not because banks weren't increasing lending but because the central bank was increasing base money in response to the increase in bank lending, or perhaps vice versa. When base money and M1 are so closely related, the money multiplier tells us very little about aggregate demand. No wonder various "modern money theorists" describe the money multiplier as a myth.

But of course that is how things worked before the 2008 crisis. Since the crisis, central banks have been creating base money at an unprecedented rate. And now our money multiplier might actually be some use, since base money is no longer simply responding to reserve demand - it is exogenously determined. Oh wait, though....LSAPs cause M1 to increase too, because most purchases are made from investors rather than banks. Therefore M1 itself is now to a considerable extent exogenously determined. So the money multiplier now tells us even less than it did before.

Of course, you might believe that the behaviour of one monetary aggregate gives you enough information to enable you set a credible path for future growth and/or inflation, and you don't need to concern yourself with the mechanism by which this controls aggregate demand. But if this is your belief, then you are similar to a singing teacher who is not remotely interested in the behaviour of the deep core muscles but believes that getting the diaphragm properly braced will automatically result in the whole skeleto-muscular system working efficiently to produce the desired singing tone. I suppose it's possible, but it seems a pretty heroic assumption. Is there really a reliable mechanical relationship between base money and broad money that can be exploited solely by controlling the base without taking account of the role of bank lending decisions in the multiplier effect? It seems most unlikely to me.

Monetary wonks may at times find the money multiplier to be the most effective way of explaining some particular aspect of the monetary system, just as I found diaphragmatic support an effective technique for my "virtually corseted" student. Indeed I used the money multiplier myself recently in a post about the IS-LM model in an endogenous money context. It is therefore occasionally helpful. But I don't think it is by itself an adequate description of how the monetary system works. And I can't see how the money multiplier is remotely suitable for teaching to first-year economics undergraduates, or first-year students of banking and finance for that matter, unless it is accompanied by modules that explain how bank lending and broad money creation work in practice.

I'm with Simon Wren-Lewis on this. At undergraduate level, the money multiplier is long overdue for replacement with an accurate description of how money creation actually works in a modern fiat money economy.

Disclaimer: I was taught the money multiplier myself as a first-year MBA student. 

Related reading:

Two first-year multipliers: their truth, beauty and usefulness - Nick Rowe
The Uselessness of the Money Multiplier - David Glasner (Nick Rowe smackdown)
Money creation: propagating confusion - Stephen Williamson

* In classical singing, diaphragmatic support technique braces the upper abdominals and intercostals to keep the diaphragm taut as breath is released, enabling the student to maintain constant subglottic pressure. In classical acting, diaphragmatic support involves a hard outwards push from the upper abdominal muscles, creating a powerful edged tone. The classical acting version is used in contemporary musical theatre. You really wanted to know that, didn't you?