Wednesday, 30 July 2014

Strange things are happening in Hungary's banking sector

Continuing my Forbes series on the mysteries of banking in Eastern Europe:
The Hungarian banking system has been a thorn in the Hungarian government’s side for quite some time. A large proportion of it is foreign-owned, which makes it more likely that there would be outflows of capital and restriction of essential lending activity in a crisis. And, of course, it’s more difficult to coerce foreign-owned banks into doing things that the government wants, such as cheap lending to favored borrowers and buying up government debt
Not only are many of its banks foreign-owned, they lend foreign currencies too. A high proportion of Hungarian mortgages are in euros or Swiss francs. Banks extended foreign-currency mortgages to Hungarian households at a time when the exchange rate to forints was favorable. But since then the international value of the forint has fallen, mainly due to a sustained period of monetary easing by the Hungarian central bank. This has improved economic conditions but left Hungarian households struggling to pay their foreign-currency mortgages.
So what are the Hungarian authorities doing about this? Find out here.

Related reading:

The trouble with Hungary.....

Potential for crisis aftershocks at Eastern European banks - Neil Buckley, FT

English: Hungarian National Bank, Budapest Mag...

Hungarian National Bank. (Wikimedia)

Tuesday, 29 July 2014

The not-so-pure retail bank

I've decided I don't like Lloyds Banking Group*. It presents itself as this pure retail bank that would never behave in such a dastardly manner as the universal banks with their greedy rapacious investment banking arms. But the reality is far different.

LBG has just been fined a total of £218m jointly by the FCA and American regulators for rigging benchmark rates including Libor. That is the crime for which the Barclays' chief Bob Diamond lost his job. But we're all used to hearing about Libor fines now: LBG is the seventh bank to be fined (and there are more to come). The seven banks fined so far, with the amounts, are as follows (chart courtesy of the Wall Street Journal):


OK, so LBG's fine doesn't look that bad, does it? It's the smallest fine of any of the big banks. But in this case the size of the total fine is not a good indicator of the seriousness of the offence. To find out what is really going on, we need to break it down.

The fine is made up of three components - £105m from the FCA, $105m from the US's CTFC and a further $86m from the US Department of Justice. The American fines are substantially lower than those imposed on other banks, reflecting LBG's lower level of overseas activity. But the FCA's fine is considerably higher than that imposed on any other British bank for benchmark rate rigging: at £105m (after 30% discount for "pleading guilty") it is the same as that issued to Rabobank. Only UBS has been fined more by the FCA for benchmark rate rigging.

Why is the FCA's fine so high? The clue lies in this letter to the Chairman of LBG from the Governor of the Bank of England:
The Financial Conduct Authority has made the Bank aware of enforcement action which it is taking against Lloyds Bank plc and Bank of Scotland plc (the Firms) in relation to manipulation of LIBOR and of submissions to the BBA GBP Repo Rate (the Repo Rate) during the period from January 2009 to June 2009. In respect of the manipulation of the Repo Rate, we understand that the motive was to reduce fees payable to the Bank under the Special Liquidity Scheme (SLS), for which the level of fees was dependent on the Repo Rate.

Such manipulation is highly reprehensible, clearly unlawful and may amount to criminal conduct on the part of the individuals involved. It reduced not only the amount of fees payable by the Firms but also the fees payable by other firms using the SLS. The Bank's calculations show that the total reduction in fees received by the Bank may have been as high as £7.76 million. 
So LBG was not only rigging Libor, it was rigging another rate too - the Repo Rate, used to price the cost of borrowing under the Special Liquidity Scheme during the financial crisis.

The Special Liquidity Scheme was put in place by the Bank of England to support distressed banks struggling to obtain market funding - of which HBOS was a prime example. Indeed according to Jill Treanor in the Guardian, LBG was one of the largest beneficiaries of this scheme. It enabled banks to exchange illiquid mortgage assets at the Bank of England for highly liquid UK Treasury bills, which these banks could then use as quality collateral against which to obtain funding in the repo markets. Banks were charged fees for this service in order to bring the cost of such borrowing close to commercial (unsecured) norms. The size of the fee was determined by the spread between 3-month Libor and the 3-month Repo Rate, subject to a 20 bps minimum: a narrower spread meant a lower payment, and vice versa.  

Clearly failing to understand that the SLS was preserving their jobs, traders routinely overstated the Repo Rate to narrow the spread to Libor and therefore reduce the fees payable to the Bank of England. The Guardian trenchantly describes this as "biting the hand that feeds them". This example of an interchange between two traders (quoted by the FCA in the Final Notice) shows how the scam worked:

Lloyds Trader A: The only thing is, I like it, we try and push it, we put
a higher rate when obviously we…

BoS Manager A: Well do you want me to put 102 for the 3’s?

Lloyds Trader A: Yeah do 102. It is just that we try and give a higher rate when we do the SLS obviously, so therefore we get a bit better yield on the book, are you with me?

And it is this, not the rigging of Libor, that explains the high fine. Two-thirds of the fine is for defrauding the Bank of England, and by extension (since the Bank is wholly owned by Her Majesty's Government) taxpayers. In addition, LBG has had to refund the £7.76m the Bank of England says it should have received. Furthermore, as the Governor's letter indicates, criminal prosecutions of the individuals involved may follow: the Serious Fraud Office says its investigation is "ongoing". No other British bank has openly defrauded taxpayers in this way. Not even RBS. So much for the wonderful retail bank culture. LBG is toxic through and through.

And that extends into Libor rigging. The FCA speaks of a "poor culture" on the money market desks responsible for obtaining short-term funding for lending (as retail banks, neither Lloyds TSB nor HBOS relied on trading for income, and nor does the enlarged LBG). We now know why they rigged the Repo Rate. But why did they manipulate Libor?

In the case of HBOS, the answer is clear. HBOS deliberately gave low submissions to the Libor panel in the last few weeks before its failure, in order to make itself look better than it actually was. This remark from a senior manager at HBOS (quoted in the CTFC's press release) is telling:
As a bank we are extremely careful about the rates we pay in different markets for different types of funds as paying too much risks not only causing a re-pricing of all short term borrowing but, more importantly in this climate,may give the impression of HBOS being a desperate borrower and so lead to a general withdrawal of wholesale lines...
HBOS certainly wasn't the only bank doing this at the time. Indeed as markets froze and real funding rates headed for the skies, it is likely that all Libor submissions were understated at this time. HBOS's behaviour is reprehensible, but understandable.

But both HBOS and Lloyds TSB also allowed their traders to manipulate Libor submissions to suit their trading positions. We perhaps might expect traders in investment banks to behave like this, and management to turn a blind eye - after all, their profits depend it. That's why investment banks need watertight controls around Libor submissions and the like, and why the absence of those controls is a sackable offence for executive management, as Bob Diamond discovered. But why on earth would retail banks allow their traders - whose job is funding and hedging, not market making - to behave like this?

It's clear from the traders' messages that traders were manipulating Libor submissions to suit their own positions, not to benefit the bank as a whole. And the traders' messages indicate that they knew perfectly well that what they were doing was market manipulation, but they thought they could get away with it - after all, everyone was doing it. But they were more like naughty children than adults - the Famous Five with swear words. I am reminded of the password for Harry Potter's map - "I solemnly swear that I am up to no good".

But this doesn't excuse senior management, any more than parents are excused for turning a blind eye to their children playing truant and causing mayhem in the local park. It was the job of executive management to set and enforce the standards of behaviour across the bank. And it seems they manifestly failed to do so. The FCA suggests that this was a sin of omission rather than commission:
The Authority does not conclude that either Lloyds Bank or Bank of Scotland as firms engaged in deliberate misconduct. Nevertheless, the improper actions of many Lloyds Bank and Bank of Scotland employees involved in the misconduct were at least reckless and frequently deliberate. The Firms, because of a poor culture on their Money Market Desks and weak systems and controls, failed to prevent the deliberate, reckless and frequently blatant actions of a number of their employees.
Nor is this the first such sin. LBG/HBOS has previously been fined SIX times for conduct offences, all but one since the financial crisis. Here's the FCA's list:
  • In September 2003, the Authority imposed a penalty of £1.9 million on Lloyds TSB Bank plc (now known as Lloyds Bank plc) for systems and controls breaches in relation to its conduct in selling high income bonds between October 2000 and July 2001
  • In May 2011, the Authority imposed a penalty of £5 million (£3.5 million after the 30% discount for settling at stage 1) on Bank of Scotland for breaches of Principle 3 and Principle 6 between July 2007 and October 2009 relating to its handling of complaints relating to retail investments
  • In March 2012, the Authority imposed a public censure on Bank of Scotland for breaches of Principle 3 between January 2006 and December 2008 relating to the management and control of its corporate lending. 
  •  In October 2012, the Authority imposed a penalty of £6 million (£4.2 million after the 30% discount for settling at stage 1) on Bank of Scotland plc for breaches of Principle 3 in relation to incorrect mortgage terms and conditions that it gave to standard variable rate customers
  • In February 2013, the Authority imposed a penalty of £6,164,327 (£4,315,000 after the 30% discount for settling at stage 1) on Lloyds TSB Bank plc, Lloyds TSB Scotland plc and Bank of Scotland plc for breaches of Principle 3 (and DISP 1.4.1R(5)) between May 2011 and March 2012 relating to their failures to pay redress promptly to PPI complainants
  • In December 2013, the Authority imposed a penalty of £35,048,500 (£28,038,800 after the 20% discount for settling at stage 2) on Lloyds TSB Bank plc and Bank of Scotland plc for their breaches of Principle 3 between 1 January 2010 and 31 March 2012 relating to serious failings in the systems and controls governing the financial incentives that they gave to sales staff.
And the FCA adds, in relation to this latest censure:
The failure of the Firms to establish and maintain adequate systems and controls in the above cases is not wholly similar to this case and, with the exception of the March 2012 Final Notice, the cases do not relate to the wholesale banking businesses of the Firms. However, all six previous matters highlight the inadequacies of the Firms (both members of Lloyds Banking Group plc) in implementing adequate systems and controls for their different business areas. 
In short, this is yet another example of long-standing management failure at LBG and HBOS. This latest censure of course relates to behaviour from 2006-2009, and the executive team then in place has long since departed. The SFO's criminal investigation may extend to them, but as the FCA concludes that the offences were individual rather than systemic it seems unlikely that any of the former executive team will face prosecution in this case.

But the last two fines were for serious failures of customer service that happened on the watch of the CURRENT team. The last was so sickening that I felt it warranted the Board's resignation. Why are they still in place, I want to know?

Related reading:

Final Notice, Lloyds and Bank of Scotland - Financial Conduct Authority

Governor's letter to Lord Blackwell - Bank of England

Response to Governor's letter from Lord Blackwell - Lloyds Banking Group

Of obseen Libor manipulation - FT Alphaville (rubbery jubbery)

*I should declare here that I do have a personal grievance with LBG. Obviously I'm not going to disclose details, as it is a personal financial matter, but suffice it to say that I experienced a level of customer "service" that was so bad I reported them to the Financial Ombudsman.

Saturday, 26 July 2014

The EU should beware of Russian interest in Balkan banks.

Especially when it is disguised.

My latest post at Forbes takes a jaundiced look at who is in the race to acquire Hypo Alpe Adria's network of Balkan banks. I'm not usually much of a conspiracy theorist, but this is the Balkans, after all - the far-fetched is mundane in that part of the world. There is something very shady going on, and I reckon the Russians are behind it.

Read about it here.

Oh, and in case the Balkans look like a black hole to you, here's a map (courtesy of Wikipedia).

Friday, 25 July 2014

No, it's not party time yet

It seems the UK is something of a poster child for economic recovery. The ONS reports that GDP has grown by 0.8% in Q2 and by 3.1% since Q2 2013. This is a pretty solid performance. And it's an important milestone, too: the UK's GDP is now back to its pre-crisis peak.

And the UK has become one of the few bright spots in the IMF's generally gloomy forecast for world growth. Upgrading the UK's growth forecast to 3.2% by the end of the year, the IMF said that the UK would maintain its position as one of the world's fastest-growing economies.

Predictably, the Coalition government and its supporters claimed this as success. George Osborne tweeted that the IMF's upgrade showed his economic plans were working:

And Matthew Holehouse,  political correspondent of The Telegraph, describes the IMF's upgrade as "a vindication of George Osborne's economic plan".

This frankly is stretching things WAY too far. This chart from Ben Chu of the Independent places the UK's economic performance in its G7 context:

How on earth is the second slowest recovery in the G7 "vindication" of George Osborne's policies? And it's not just because the UK had a very deep recession, either. Japan - yes, you know, that country we like to think is in an eternal slump - had a deeper contraction but has recovered faster despite the tsunami and Fukushima disaster. And Germany, whose contraction was nearly as deep as the UK's, exceeded its 2008 GDP peak in Q1 2011.

In fact this chart shows clearly the derailing of the UK's recovery in 2010 just after the Coalition came to power. Note that this is BEFORE the Eurozone crisis hit in 2011: the Eurozone crisis must have affected the UK economy, but it isn't a sufficient explanation. I've also argued that high energy prices explain quite a bit of the evident slowdown from late 2010 onwards. But it is hard not to conclude, as Simon Wren-Lewis and others do, that fiscal austerity delayed the UK's recovery. Far from a vindication of the Coalition's policies, the fact that the UK is only just back to its 2008 peak after four years of Osbornomics is quite an indictment. Whatever the reason, Osborne has actually presided over the slowest recovery since the Second World War:

And it is also far too soon to celebrate recovery. There is still a long way to go: wages are still falling in real terms, business investment is still weak and the UK's external position is poor. GDP may be back to its pre-crisis peak, but GDP per capita is still some distance below (thanks to FT Alphaville for this chart):

Best keep the lid on the bubbly for a bit longer.

Related reading:

Britain's long, weird recovery in 13 charts - FT Alphaville

The stocks and the flows

There have been calls for interest rate rises to discourage risky new lending. But the Resolution Foundation shows that it is the stock of existing debt that is the real problem. Household debt still stands at over 90% of GDP, and many of these households already have difficulty paying their mortgages: there is a real risk that raising interest rates would make their debts unaffordable, forcing them into default and the economy into recession. The Resolution Foundation has important recommendations for policy makers to reduce the risks of interest rate rises. But they don't go quite far enough....

Find out more here. (Pieria)

Wednesday, 23 July 2014

QE is fiscal policy

A new paper by Johnston and Pugh of the legal department of the University of Sheffield discusses the legality and the effectiveness of QE and its relatives, including the ECB's OMT "whatever it takes" promise.

The background to this is the German Constitutional Court's ruling that OMT amounts to monetary financing of government deficits and is therefore unlawful. Although the European Court of Justice is still to give its judgment in this matter - and is widely expected to dissent - the ECB is evidently doing its best to avoid outright QE, quite possibly because of questions over its legitimacy. The ECB has stated that in its opinion QE is legal, but then it said that about OMT too. The truth is that it is by no means clear that QE is legal in the Eurozone.

So the University of Sheffield's legal eagles have had a good look at the legality of both OMT and QE with respect to the Lisbon Treaty. And they concur with the German Constitutional Court. OMT does indeed amount to monetary financing of governments. So does QE. Both are therefore illegal under Article 123 of the Lisbon Treaty.

Article 123 of the Lisbon Treaty reads thus:

1. Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.

2. Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the European Central Bank as private credit institutions.

The UK has a specific restriction on the applicability of Paragraph 1 to allow it to continue to use the Treasury's existing "ways and means" overdraft facility at the Bank of England:

10. Notwithstanding Article 123 of the Treaty on the Functioning of the European Union and Article 21.1 of the Statute, the Government of the United Kingdom may maintain its ‘ways and means' facility with the Bank of England if and so long as the United Kingdom does not adopt the euro.

But in the view of Johnston & Pugh this does not exclude the UK from the GENERAL prohibition of monetary financing of fiscal deficits in Article 123. The "ways and means" overdraft was last used in 2008 at the height of the financial crisis: that borrowing has since been repaid and the UK has no current plans to use this overdraft facility. The question is therefore whether the Bank of England's QE programme has breached the prohibition of monetary financing to which the UK is subject as a signatory to the Lisbon Treaty. The Sheffield researchers think it has.

The reasons are not straightforward. Central bank purchases of own-government debt in the capital markets are not prohibited under the Lisbon treaty. Indeed they cannot be, because that would prohibit the main mechanism that EU central banks have historically used to control inflation, namely open market operations (sales & purchases of government debt) to maintain interest rates at a target level. This mechanism is currently in abeyance because of the presence of excess reserves in the banking system, but that does not mean it will never be used again in the future. QE also involves secondary market purchases of government debt. It is therefore easy to see QE as simply open market operations on a much larger scale. But the researchers argue that this is a misunderstanding of the nature and purpose of QE.

When government debt is purchased in a QE programme, the purpose is to control the market price of that debt. From the time that QE is announced until it is ended, the central bank effectively sets a floor on the price of government debt. This applies in both limited QE programmes, such as the Bank of England's, and unlimited, such as those in the US, Japan and Switzerland.

Forcing governments to fund themselves in the capital markets rather than obtaining funding from the central bank is supposed to ensure fiscal discipline. If governments over-spend, the thinking goes, capital markets will push up the cost of borrowing, forcing them to cut back spending and/or raise taxes. But if the central bank sets the price of government debt and stands ready to buy it in unlimited quantities, there is no discipline on the government. It can issue as much debt as it likes in the certain knowledge that there will always be a buyer. There cannot be a "buyer's strike" causing the price of debt to crash and yields to spike, as happened in Greece.

And this applies whether or not the central bank is actively purchasing securities. OMT has never been used - but its effect has been to force down yields on Italian and Spanish bonds, allowing their governments to maintain high debt/dgp levels without fear of default. There is no question but that the ECB did this to preserve the Euro. But it has undoubtedly also benefited the governments of those countries.

This is why the authors argue that QE is monetary financing of government deficits even though purchases are made from investors and banks, not directly from governments. QE amounts to an unlimited central bank credit facility. It is not the prohibition of government purchases that would be breached in an ECB QE programme, it is the prohibition of overdrafts and credit lines to governments.

And this raises a further issue. There has been huge debate about exactly how QE reflates the economy, though none of the explanations offered by economists and central banks have been conclusive: it has been claimed that QE influences the economy through portfolio effects (but substituting one safe asset for another doesn't have any effect on aggregate demand), suppression of the term premium (but it's probably very low anyway), increased liquidity in financial markets (doubtful, because QE contributes to collateral scarcity), increased bank lending (bank lending has been stagnant or falling), increased corporate investment (share buy-backs due to low borrowing costs are not investment). Most people agree that QE does support asset prices in a crisis, but its effectiveness as a long-term economic stimulus is questionable.

But the implication of Johnston & Pugh's work is that we have fundamentally misjudged the nature of QE. It has monetary effects, yes, but it is in reality a fiscal tool. It uses the central bank's ability to control market prices to enable governments to borrow and spend. This is why QE only works when the fiscal stance is expansionary. When the fiscal stance is contractionary - as it has been in most developed countries to varying degrees since 2010 - QE is ineffective.

Regarding QE as an enabler for fiscal expansion may explain a puzzle. Japan has by far the highest debt/gdp in the world, but it has very low borrowing costs. This can partly be explained by the fact that the Japanese are diligent savers, and much of their savings is held in the form of government debt: it could also perhaps be explained by the fact that investors are creatures of habit, retreating into traditional safe havens such as Japanese yen and JGBs when things get rough. But Japan has also been doing QE for far longer than any other country. Could the central bank's historical willingness to intervene in markets to control the price of Japanese debt be the reason why the JGB yield remains so low despite very high debt/gdp and poor economic growth?

But QE is also highly regressive. Doing fiscal expansion by the back door in this way virtually ensures that the money created does not go where it would have the most effect - it goes to those who least need it. The biggest beneficiaries of QE programmes are the rich, the value of whose assets rises when central banks intervene in this way - not just because the price of government debt rises, but because the price of other assets rises too due to substitution effects and the "reach for yield".

When government uses the central bank's suppression of bond yields as an opportunity to lock in low borrowing rates for the future and fund a fiscal expansion programme, then QE can be highly effective. But when governments fail to take advantage of central bank price control, QE can only benefit the economy through monetary channels which are both morally dubious and of questionable effectiveness. And when governments use QE as a cover for ill-considered fiscal austerity, QE actually transfers wealth from the poor to the rich. The weak monetary effects of QE might offset this effect to some extent, but the idea that QE can entirely negate the harmful effects of fiscal tightening in an economic downturn is not supported by the evidence. "Monetary offset" is a very nasty joke.

Johnston & Pugh's conclusion is damning:
In this paper, we have seen that, whilst QE can be argued to amount in substance to monetary finance, it is likely that the courts would not rule it unlawful. However, if a central bank did not offer justifications couched in monetary policy terms, there would be a much more serious risk of the intervention falling foul of Art 123 TFEU. The law’s emphasis on justifications and deference to central banks may not be surprising, but it does mean that there is scope for monetary finance so long as nobody admits that that is what is happening. It also means that arguably, monetary policy is outside the rule of law. It would be better for everybody if the debate was more open. 
So QE and OMT are illegal under EU treaties, but for political reasons no-one will ever admit that. This is the reason for the entirely artificial separation of monetary and fiscal policy, the monetary justifications for QE, the pretence that central banks are independent, and the charade of "fiscal discipline". The central bank must monetize debt, because the alternative is sovereign debt default and collapse of the currency: but if the central bank loses credibility, the currency is junk.

There is an elaborate charade whose sole objective is preserving the central bank's credibility. When central banks are monetizing government debt, it is the electorate, not the market, that controls the fiscal authority's propensity to borrow and spend. But if an elected government blatantly uses central bank debt monetization as an excuse for high borrowing and spending, the credibility of the central bank is toast. So everyone has to pretend that QE and its relatives don't fund the government, and politicians and voters have to be persuaded that restricting government's ability to borrow and spend is in their interests. The inflation monster is routinely invoked to terrify electorates into voting for austerity-minded politicians, and if that isn't enough, then the bond vigilantes and public debt bogeymen are called in too. And it works: not only have voters across Europe apparently been convinced that fiscal austerity is necessary even when it is clearly harming their economies, they have also been convinced that elected governments can't be trusted to manage public finances responsibly and must be restrained by unelected, unaccountable bureaucrats with their own political agendas. What an appalling erosion of democracy.

But debt monetization should not have to be a back-door exercise. In their concluding paragraphs, Johnston & Pugh call for an open debate about carefully considered outright monetization to end the disastrous austerity/debt deflation/higher debt/more austerity spiral in the Eurozone:
We have serious doubts about the efficacy of QE as a means to reflating the economy in the aftermath of a debt deflation.....Increased fiscal spending by governments would be more likely to be effective, but is currently ruled out by a belief that governments must pursue austerity in order for their countries to escape the crisis. We agree with Adair Turner that the time has come for a meaningful discussion about whether monetary finance offers a better way out of the current economic malaise, and if so, what form that monetary finance should take.
I have considerable sympathy for their argument, certainly for the depressed Eurozone periphery countries. Outright monetization is prohibited because of the fear of Weimar-style hyperinflation: but as I've explained before, hyperinflation is always and everywhere a consequence of political chaos and loss of trust. Provided that central bank credibility is maintained throughout, outright monetization of excessive legacy government debt burdens does not have to mean hyperinflation. There is still a need for fiscal discipline and structural reform going forward to ensure that debt, once relieved, does not build up again. But a one-off monetization of the debt burdens of the Eurozone periphery would do much to help Europe out of its seemingly endless slump.

Related reading:

Sacred cows and the demand for money
QE myths and the Expectations Fairy
Inflation, deflation and QE
Slaying the inflation monster
Rethinking the monetization taboo - Adair Turner
Have central banks been breaking the law? - Telegraph

Monday, 21 July 2014

The not-so-new (but very uncertain) neutral

My latest post at Pieria considers the likely future path of interest rates and central bank reaction functions. History shows that central banks delay raising interest rates for too long after a recession, then panic and raise them too much, causing another one. Will they do this again? Probably....

Read the whole post here.

FOMC meeting. Photo credit: Wikipedia

The clash of micro and macro

As I said in a recent blogpost, failing to provide microfoundations for a macroeconomic argument doesn't make the macroeconomics wrong. Conversely, providing lots of lovely microeconomic detail - right down to the "I met a man" level - does not necessarily add up to a convincing macroeconomic argument. 

So here is Chris Dillow taking Tim Montgomerie to task for claiming that the UK's remarkable employment performance is due to the Coalition government's welfare reforms. Montgomerie isn't the only one making this claim: Fraser Nelson does so too in more detail, in an op-ed in the Telegraph. Both Tim and Fraser say that the Coalition's welfare reforms, by forcing lots more people into work, have somehow created a massive jobs boom. Say's Law, applied to labour markets? Hmm. Maybe I'm a bit fonder of microfoundations than I thought. I want to know where these workers really come from - the increase looks too much to be entirely due to benefit reforms. And I want a proper explanation of the jobs boom. Simply saying "there are more workers, therefore there are more jobs" doesn't do it for me. 

Here is Giles Wilkes providing a pretty good explanation for the increase in workers. No, it isn't just benefit reforms. A quarter of a million or so pensioners have returned to the labour market, for starters - and no-one is suggesting that benefit cuts are forcing them back to work (though the Bank of England might be).  Tax changes have improved incentives to work at the margin, which would draw some people into the workforce. Tax credit changes have forced some people to work longer hours in order to qualify. And above all, the squeeze on living standards caused by falling real incomes in recent years, on top of a horrible shock to both incomes and wealth, has forced people who weren't working to do so and part-timers to increase their hours. 

But what about that increase in jobs? Well, Giles says that as the supply of labour increases, we would expect its price to fall, encouraging employers to create more jobs at lower wages. And as Chris points out, the effect of pushing people into work by making life on benefits either impossible or totally miserable is to force down wages. I know I have said this many times already, but it's worth repeating it. Workfare depresses wages not just for those being forced to earn their benefits, but for everyone. So it may be that making life on benefits more miserable does increase jobs, but at the cost of lower wages. And the re-entry to the workforce of people who have a basic income (pensioners, married women with children) is also likely to depress wages, since these people don't usually face the benefit withdrawal trap that forces people to choose between benefits and employment, so can afford to take lower-paid work.

So to paraphrase Chris's conclusion: if welfare reform significantly increases the supply of labour, and all that labour can be productively employed, then in the absence of strong economic growth, welfare reform depresses wages - which might not be the message the Conservatives really want to give. They would do better to point to improving economic conditions as the principal driver of rising employment. Despite Fraser's claim that Coalition welfare reforms are popular, the macro argument seems more likely to win votes than the micro policies.

But Simon Cooke nevertheless criticises Chris Dillow for ignoring the human stories underlying rising employment. To him, the macro argument that improving economic conditions and/or falling wages are the primary cause of rising employment implies that micro policies aimed at helping individuals into work are a waste of time and money. And he disputes this, using as examples some of the real human stories that he has encountered in his work as a local politician. I don't think many people would disagree with his conclusion: getting the long-term unemployed into work is indeed hard, not least because of the barriers that society - often with the best of intentions, such as protecting the public from possibly dangerous ex-cons - puts in their way. We should respect those who devote time and energy to helping these people into work.

But Simon's argument that there is a fundamental disconnect between macro and micro policies does not follow. Chris's macro argument actually supports Simon's micro policies: if economic conditions improve and/or wage levels fall, then helping the most disadvantaged people into work becomes easier. The Work Programme seems to be doing a decent job, though it is much less clear that Help to Work justifies its cost. But it has been greatly hampered by the prolonged economic downturn. As the economy improves, the Work Programme's results will improve too - though admittedly, some of the people it will "help into work" would have found work anyway. Sometimes improving economic conditions really is all that is needed.

The Coalition has rightly been criticised for trying to force people to work who were not able to do so, for completely fouling up the administration of the fitness to work tests, and for some frankly pointless and even harmful policies (the "bedroom tax" springs to mind). But the biggest problem is that they tried to do all of this at a time when economic conditions were utterly unhelpful. If Giles is right, then the changes intended to "make work pay" (tax changes as well as benefit reforms) have actually pushed down wages and made life harder not just for the thousands who were forced into work, but for millions. That is quite an indictment of a government.

Saturday, 19 July 2014

U.S. sanctions on Russia are financial warfare

At Forbes:
On June 17, the US announced further sanctions against Russia because of its support for rebels in the Ukrainian civil war. The new sanctions are widely considered to be tough. But they are also difficult to understand. The extent of their legal and practical application is by no means clear. Yet – they are very clever. However they are interpreted, they are bad news for Russia.
Find out here how they should be interpreted and why they amount to financial warfare.

Thursday, 17 July 2014

Espirito Santo: complexity, opacity and moral hazard

There is absolutely nothing holy or spiritual about Portugal's Espirito Santo Group. It's a complex, opaque structure much of which is incorporated in a tax haven and part of which is suspected of fraud. It's impossible to regulate and some of the funding relationships are distinctly odd. And it includes a bank. Moral hazard de luxe. 

But haven't we seen this before? Oh yes. Read about it here

Wednesday, 16 July 2014

The Bulgarian "Game of Thrones"

No, not a film. Or a book. And as far as I know there are no Starks. Or dragons. But otherwise, the saga of the Bulgarian oligarchs and their political machinations is remarkably similar to "Game of Thrones". Politicians are the puppets of oligarchs, oligarchs are controlled by mobsters, banks are pawns in the game, and the people of Bulgaria pay through economic stagnation and entrenched poverty.

All three posts in the saga (so far) are linked here.

What on Earth is Going On in Bulgaria?

The Curious Case of the Bulgarian Bank Runs

The Bulgarian Game of Thrones

Bank run on First Investment Bank, Bulgaria. (Photo credit: BBC)

Tuesday, 15 July 2014

Why did they borrow?

In my last post, I placed into a sectoral balances framework Piketty's argument that rising US inequality drove the financial crisis. This is not to say, as some do, that excessive savings from China fed directly through into excessive household debt in the US. If only it were that simple. My argument is that trade dynamics between the two countries fed a capital surplus in the US, which inevitably found its way into higher household borrowing because of a relatively tight fiscal position and a sustained surplus in the corporate sector. 

Various people have criticised this on the grounds that it is not microfounded. Philip Booth of the IEA, probably my severest critic, says is "not economics". I think this is a somewhat narrow definition of "economics": just because I have not given a microeconomic explanation for a macroeconomic argument doesn't mean the macroeconomics is wrong. But we do need a human explanation for the high borrowing of low-to-middle income US households that is widely recognised as a key driver of the financial crisis. Accounting identities and global flows alone are not enough. 

Firstly, though, I want to unpick the causes of the trade and capital imbalances. It is very easy to blame the US's trade deficit on "consumerism" and "profligacy", and praise the "prudent savers" in China and Germany. But this is to make a morality play out of economics and ignore the actions of policy-makers that encourage and even enforce high saving and/or high borrowing. The US trade deficit is pretty intractable largely because the two major surplus countries - China and Germany - do not have currencies that float with respect to the USD. Germany uses the Euro, which does float, but the Euro is persistently undervalued relative to fundamentals in Germany because of the presence of weaker countries in the union. If the currency cannot adjust, then neither the trade deficit nor the capital surplus can correct unless unit labour costs fall, which means very significant falls in wages and employment costs. This is what is happening in the Eurozone periphery: it has not happened in the US thus far because of the US's willingness to borrow and the world's willingness to lend to it. 

However, there is a cost. As Philip Booth points out, China will not be able to suppress inflation forever if its currency is under-valued. Germany, too, faces high inflation relative to others in the Eurozone if its economy is  out of equilibrium: the ECB's tight money policies keep German inflation below 2%, but this forces weaker countries into outright deflation. 

Booth also observes that "if there are positive balances in the US private, corporate and government sectors then the dollar can float down easily enough." I'm afraid this is not really true. The dollar cannot float down against the Chinese yuan because of the currency peg, and it cannot float down relative to the real exchange rate in Germany because the Euro is effectively fixed at too low a rate relative to fundamentals in Germany. This is why devaluing the dollar would not necessarily reduce the US's trade deficit, as Dean Baker thinks: China would simply adjust the yuan to maintain its desired exchange value, and Germany would tighten fiscal policy to stop a fiscal deficit developing as a consequence of a falling trade surplus in a low-demand economy. The only way to resolve the currency problem is for China to allow the yuan to float and Germany to abandon austerity. Hell might freeze over first. 

Booth's general position is that the trade imbalances between the US, China and Germany are due to low saving in the US.  I was implicitly taking the opposite position, that the trade imbalances are due to low demand in China and Germany. But In fact these are simply aspects of the same phenomenon. We can argue about whether lack of saving in the US or lack of demand in China and Germany is more important, but it is hard to do this without slipping into moral argument again: the irrational belief that saving is "prudent" and spending "profligate" is very, very strong. The truth is that for one person to be able to save, another person must spend: one person's savings are another person's debt: one country's surplus is the deficit of others. The US's deficit is as much a reflection of financial repression in China and wage repression in Germany as it is of consumerism and loose monetary policy in the US. 

Booth further argues, as do others, that if the US spent less and saved more, then its trade deficit would come down and the imbalances resolve themselves. This is true, but that wouldn't necessarily result in an increase in US exports. After all, Chinese and German demand doesn't have to rise to compensate for falling US demand. The result might simply be a reduction in everyone's trade. And to me this is NOT a good thing. It is global trade above all that pulls people out of poverty. I don't wish to see it reduce.

So that's the global macroeconomic context fleshed out a bit. Now for US domestic economics.

Johnson Nderi argues that loose monetary policy in the aftermath of the bubble bursting and the 9/11 tragedy expanded the US money supply and pushed down interest rates, encouraging borrowing. But this too succumbs to Booth's criticism - it does not explain WHY borrowing increased. After all, households don't have to borrow, and as Scott Sumner says, if their incomes are stagnating, they wouldn't really want to.  If they don't want to borrow, cutting interest rates is pushing on a string. So why did they borrow? There are several reasons.

1. Low interest rates. 

Falling interest rates give households the impression that they are better-off than they really are, because debt becomes more affordable. This is particularly true when there are variable interest rates. So they will borrow more even if their incomes are stagnating, because the debt is more affordable.
I don't find this a rational explanation. In fact I find it astonishing that the same people who think that temporary tax cuts are pointless because of Ricardian equivalence also think that cutting interest rates in the aftermath of a negative shock encourages higher borrowing. People are just as capable of understanding that interest rates can rise as they are of understanding that tax cuts can be reversed. And for this reason, I don't buy the frequently-used argument that household borrowing increased because of pressure from lenders or Wall Street, either. Household borrowing is a decision. In economics we assume that people make rational decisions. If households didn't perceive borrowing as being in their best interests, they wouldn't have borrowed.
So low interest rates alone won't do as an explanation. But they might be an amplifier for other effects.
2. Individual expectation of higher incomes. 
Booth asks: "Why would a poor individual wish to borrow if his income is not expected to increase?" But the fact that incomes were actually stagnating at that time says nothing about people's expectations. Individuals below the age of 50 tend to believe that their future income will be higher than their present one. This is a reasonable expectation, particularly for men: the incomes of prime working-age men do tend to rise as they acquire skills and experience. The picture is much less clear for women, many of whom drop down to lower income levels when they have children. Over-50s, too, tend to have declining income. And as we know - and Booth concedes - US income inequality did in fact rise during this period. So what the data actually tell us is that increasing income for some was balanced by falling income for others. The data do NOT tell us that individual incomes were stagnating, still less that individual incomes were expected to stagnate. 
For individuals to borrow in expectation of future income rises is clearly rational, even if incomes in aggregate are stagnating. Indeed, it was rational for people to believe that as growth improved, so would their incomes. The problem, of course, is that for many people their rational expectations of better jobs and higher incomes have been dashed by the reality of techological change, offshoring, and since the crisis recession, stagnation and unemployment. 
3. Wealth effects. 
Most household borrowing is against property. When house prices rise, households' net worth rises, they "feel" wealthier and are therefore more willing to borrow. 
Prior to the financial crisis, there had been no housing market correction in the US since the 1930s: households had no reason to believe that house prices might fall, especially as the Fed was giving the impression that it had monetary policy sorted and there would never be another crash. It is hardly surprising that they were willing to leverage their rising net worth. Nor is it surprising that lenders were willing to help them do this: lenders also believed that house prices would never fall, or if they did, the Fed would bail everyone out. Wealth effects don't just apply to households. 
4. Government. 
After the 9/11 shock, George Bush and others exhorted the American people to borrow and spend, claiming it was their "patriotic duty" to do so. Being a cynical Brit, I find it hard to believe that people would borrow and spend more simply because the President told them to do so. But I guess it is possible - not least because people are far more likely to do what a Government says if they think it helps the war effort. As a direct response to 9/11, the US invaded Afghanistan and later Iraq. Had there not been high household borrowing and a consumption boom during this period, the US government's borrowing would have been far higher. We could say that the tax revenue generated from the consumption boom went to finance the War on Terror.
So there are four reasons why households might have chosen to borrow and spend - some more rational than others. But their decisions should be placed in the context of the decisions of two other groups in the US: the corporate sector, and the government.

As the chart shows, the US government's fiscal position deteriorated sharply when the dot-com bubble burst. President Bush was under pressure from Congress to restore the budget balance that had been achieved under Clinton. Fiscal policy was therefore relatively tight during this period despite the war effort - note the reduction in the budget deficit from 2004-2008:

What is more mysterious is why the US corporate savings rate was rising for much of this period:

and why it was apparently investing its surplus more in US property and its derivatives than in overseas FDI. It is hard not to conclude that stagnating wages and a rising corporate surplus were related: it seems the corporate sector preferred to lend to its workforce (indirectly) rather than paying them. And Booth and Sumner are probably right that financial innovation encouraged the corporate sector to invest in US property-backed securities rather than supposedly riskier projects overseas - or even in much-needed infrastructure development in the US. A capital surplus is not necessarily well spent. 

It is astonishing that one paragraph in Piketty can generate so much debate. I don't pretend to have covered everything even though this is my third post on this subject and as usual it is far too long and rambling. Piketty may or may not be right that inequality was a principal cause of the high borrowing that led to the financial crisis: my analysis above suggests there is more to it than that. But clearly there is far more still to discuss: the reasons for the corporate surplus, for example - and above all, the effects of war.

Related reading:

Sumner on Piketty
Perverting Piketty - Unlearning Economics (Pieria)

Friday, 11 July 2014

Inflation is always and everywhere a political phenomenon

My latest at Pieria picks apart the irrational basis for beliefs about inflation:
"So we don't understand the causes of inflation, we don't agree about what we mean by inflation and we have no reliable means of measuring it. Yet we are absolutely terrified of it. And we want government (via its central bank) to make sure that inflation NEVER HAPPENS. How very dare government rob us of our precious savings by means of inflation!
Underlying this statement, and indeed all statements about the control of inflation, is a powerful and fundamentally irrational belief. Inflation can be prevented by government. Therefore, if inflation happens, it is because government has allowed it to. Inflation is therefore always and everywhere a POLITICAL phenomenon."
There is lots more - and a worrying conclusion. Read the whole piece here

Creeping nationalisation

The FOMC June meeting minutes reveal an interesting discussion about the conduct of monetary policy in an era of excess reserves. The principal policy tools are to be interest on excess reserves (IOER) and the Fed's new overnight reverse repo facility (ONRRP). IOER has already become the principal tool for controlling short rates, and there was some discussion as to whether ONRRP is really needed as well. But in a world where USTs perform the same function for non-banks as reserves do for banks, it makes sense to control both.

The FOMC do at last appear to have accepted that excess reserves are here to stay for the foreseeable future. They still talk about “normalisation” of policy: some members clearly still hanker after a speedy return to the “old ways”, wanting target ranges for the Fed Funds rate still to be published and hoping that overnight reverse repos (ONRPP) will eventually be phased out. But ten years from now, when the system still has excess reserves (it will, trust me) and they are still using IOER as the principal policy tool, will they still describe elimination of excess reserves and return to Fed Funds rate targeting as “normalisation” of policy? I suppose they might. After all, desire to return to some form of gold standard still lingers in some quarters, more than forty years after Nixon suspended dollar gold convertibility. It can take a very long time for people to realise that a change billed as temporary is actually permanent.

But perhaps more importantly, it is beginning to dawn on the FOMC that this extended period of ZIRP/NIRP and excess reserves is fundamentally changing the nature of finance. The relationship between the central bank, commercial banks and the markets is being distorted in all sorts of incalculable ways. The FOMC have now caught a glimpse of where this is all heading – and they don't like what they see.

The watershed was the introduction of ONRRP. For the first time, the Fed is lending directly to non-banks. Well, ok, what it is lending is USTs, not cash – but as it is lending them in return for cash on which the Fed will pay interest, that is not so different from IOER on excess reserves. The Fed has opened the door to direct involvement in the real economy, and the FOMC has finally realised it is lost in the wilderness without a map.

ONRRP enables certain non-banks (money funds) to obtain a primary banking service directly from the Fed. To be sure, it is only deposit-taking at present, and there are clearly no plans whatsoever to allow money funds to make payments directly from their Fed deposit accounts. But money deposited at the Fed is money that is not being used to fund other activities. Admittedly this is actually the point – ONRRP is intended to remove money from circulation. But the FOMC is concerned that things could easily get out of hand. If money funds get into the habit of using the Fed as their moneybox, what are the implications both for monetary policy and for commercial banks? Would monetary policy in future be primarily concerned with influencing the behaviour of non-banks? Do commercial banks have any future if non-banks can transact directly with the Fed?

Here's the passage in the minutes where the FOMC define their fears about the future (my emphasis):
“While generally agreeing that an ON RRP facility could play an important role in the policy normalization process, participants discussed several potential unintended consequences of using such a facility and design features that could help to mitigate these consequences. Most participants expressed concerns that in times of financial stress, the facility's counterparties could shift investments toward the facility and away from financial and nonfinancial corporations, possibly causing disruptions in funding that could magnify the stress. In addition, a number of participants noted that a relatively large ON RRP facility had the potential to expand the Federal Reserve's role in financial intermediation and reshape the financial industry in ways that were difficult to anticipate. Participants discussed design features that could address these concerns, including constraints on usage either in the aggregate or by counterparty and a relatively wide spread between the ON RRP rate and the IOER rate that would help limit the facility's size. Several participants emphasized that, although the ON RRP rate would be useful in controlling short-term interest rates during normalization, they did not anticipate that such a facility would be a permanent part of the Committee's longer-run operating framework. Finally, a number of participants expressed concern about conducting monetary policy operations with nontraditional counterparties.”
The rest of the discussion in this paragraph is all about how to prevent a fundamental reshaping of the financial landscape. Maintaining a significant spread between ONRRP rates and IOER should encourage money funds to place deposits with banks rather than the Fed, since we can assume that call deposit rates would be at or above the IOER rate. And limiting usage of the facility should discourage risk-averse money funds from using the Fed as a super-safe deposit facility. ONRRP is intended as a monetary policy tool, not a mattress for scared money funds to stuff.

But it's nonetheless another step down the slippery slope that leads to the death of commercial banking, and indeed to the complete re-ordering of the financial system. We have actually been heading down this slope for a very long time, but the speed of travel has increased considerably since the financial crisis.

Commercial banks are slowly dying. The activities that were formerly profitable are either illegal, immoral or simply not profitable any more. And the core activities that society wants and needs are also unprofitable, at least if they are done in the way that society has come to expect – free-while-in-credit transaction accounts, inflation-level interest on deposits, fixed low margins on lending. Meanwhile, commercial banks face stiff competition from new competitors – not new banks, though there are some of these, mostly backed by large retail organisations – but an astonishing and ever-increasing range of mostly internet or phone-based providers of deposit-taking, lending and payments services. Unlike the new providers, banks are having to meet higher capital and liquidity requirements and comply with tighter regulations, while suffering margin squeeze because of low interest rates and a continual drain of dissatisfied customers. And they are still facing legal costs and fines for their past misbehaviour. It's a very tough world for banks at the moment.

And they are paying the price. The big investment banks are already breaking themselves up, and they will be followed in due course by the big universal and retail banks. What has not been achieved through regulation may yet be achieved through market forces.

But society still needs financial intermediation. And it seems that financial intermediation cannot operate without a government backstop. Deposit insurance is implicitly government backed, though the EU is trying to pretend it is not. Last-resort lending by central banks to distressed financial institutions is also implicitly government-backed, as are the various forms of cheap funding provided to banks by central banks in the last few years in the interests of economic recovery (the latest being the ECB's TLTROs). Bank balance sheets contain increasing quantities of government-backed assets in the form both of reserves and government debt. So do the balance sheets of non-banks such as insurance companies and pension funds, because of new regulations requiring them to hold higher quantities of safe liquid assets. Actually, so do the balance sheets of many corporations, who prefer to keep their surpluses in the form of 100% guaranteed government debt rather than in a bank deposit account where they risk a haircut in the event of bank failure. And the widespread use of USTs and other government-issued safe assets as collateral in repo markets means that non-bank deposits are effectively guaranteed by government even if they are not deposited in banks. Many forms of lending, too, are also government-backed, including export finance, small business lending and - increasingly - mortgages.

So the super-safe backstop offered to money funds by the Fed is only the latest in a long line of implicit government guarantees propping up the financial system. Far from ending government support of the financial system, the developments of recent years have actually made it MORE dependent on the state.

Markets, too, have become government-dependent. Markets watch central banks all the time, anticipating their actions and responding to their announcements. And exceptional monetary policy by central banks has impacted market functioning. QE reduced the supply of safe assets, raising their price, while the additional money flowing into markets as a result of QE blew up bubbles in various other classes of asset, both safe assets (gold, commodities, fine art and above all real estate) and high-yield assets. It is hard to say what market prices would be like now if no central bank were doing QE, and we are unlikely to find out any time soon: the US is withdrawing QE, but Japan is currently doing the largest QE programme it has ever done and the ECB may also soon be forced (reluctantly) to do some form of asset purchase programme. China has been doing yuan QE for a while, but if dollar liquidity becomes an issue it may be forced to repo out its USTs, which would reinforce the Fed's ONRRPs and make control of dollar liquidity more difficult. And of course the Swiss have been quietly controlling the Swiss franc market for ages. To prevent the Swiss franc rising, they've done the largest QE programme in the world relative to the size of their economy. 

In fact the entire financial system is becoming completely dependent on government. In our quest to make the financial system safe, we have made its very existence as a private sector function impossible. Central banks are no longer just players in a market: they dominate and control the market. And financial institutions are guaranteed, backstopped and regulated by government in every area of their business. Some parts of their business amount to public utilities, and there are growing calls for those areas to be explicitly supported or even taken over by government – I am thinking of universal payments systems, basic banking services (transaction accounts, small deposits and vanilla lending) and the money creation aspect of lending. And flows of funds around the system are routinely guaranteed by central banks, even if that means extending central bank support to non-banks. The economic cost of allowing that flow of funds to be interrupted even for a few hours or days is just too great.

For years, the FOMC members have blindly presided over creeping nationalisation of the financial system. Now they have opened their eyes, but it is too late. There is no going back now. For better or worse, the financial system is firmly wedded to government, and in particular to the US government (including its sidekick the Fed).

And that raises some interesting prospects. David Beckworth wonders whether Fed could take over all transaction and payments services: we could all have checking accounts (current accounts, in UK parlance) at the central bank. Izabella Kaminska argues that central banks should issue e-money in direct competition to the likes of Bitcoin, providing everyone with their own central bank e-money wallet and completely bypassing all commercial bank payment services as well. Personally I would like to see government provide safe savings vehicles for its citizens, recycling those funds into long-term investments in infrastructure and technology.

There are dangers, of course: state guarantees without supervision are easily abused, while over-regulation and rigid central planning suppress useful innovation. But reshaping the financial system as an agency of government offers an opportunity to repair the dislocation between the financial world and the real economy and restore the service function of finance. We should welcome it.

Tuesday, 8 July 2014

Explaining Piketty: inequality and the financial crisis

Ryan Bourne complains that my takedown of Sumner didn't actually address Sumner's main criticism of Piketty. Indeed, that is is a fair complaint. I was so busy disagreeing with Sumner that I failed to explain Piketty. So I shall remedy the oversight now.

Here's the paragraph from Piketty that Sumner critiqued:
"In my view, there is absolutely no doubt that the increase of inequality in United States contributed to the nation’s financial instability. The reason is simple: one consequence of increasing inequality was virtual stagnation of the purchasing power of the lower and middle classes in the United States, which inevitably made it more likely that modest households would take on debt, especially since unscrupulous banks and financial intermediaries, freed from regulation and eager to earn good yields on the enormous savings injected into the system by the well-to-do, offered credit on increasingly generous terms."
This paragraph does need some explanation. It is far too easy to interpret Piketty as saying that stagnant labour wages encourage low-to-middle income people to borrow. Clearly this is nonsense: under normal circumstances we would expect stagnating wages if anything to discourage borrowing, since people would delay leveraged purchases until their wages started to improve. But it's not the point. Piketty is doing macroeconomics. This is about sector balances*, not the rational behaviour of households.

When low-to-middle incomes stagnate but top incomes continue to rise, saving naturally increases. This is because people with high incomes spend a lower proportion of their incomes than poorer people do. Since saving = investment, that saving must be invested somewhere. It can be invested in assets such as property, gold, fine art and metals. Or it can be lent out, either as direct lending (perhaps via an intermediary) or in the form of securities purchases**. The balance between lending and real assets in a portfolio tends to depend on the investor's attitude to risk: a more risk-averse investor is likely to have more real assets and fewer financial ones, and the financial assets are likely to be less risky ones - perhaps good quality corporate and government bonds rather than junk bonds and equities. Investors tend to be less risk-averse in boom times and more risk-averse in downturns. During the years before the financial crisis, therefore, investors - including the earners of top incomes - tended to lend out their savings rather than buying real assets.

So far so good. We have explained why US inequality rose during this period: top incomes rose while the rest stagnated, and as high earners have a lower marginal propensity to consume, that increase translated into higher saving and therefore into rising wealth for those people. The corporate sector also ran a structural surplus during this period. There should have been a rising saving ratio.

But there wasn't. In fact the saving ratio actually fell. And this was because, as Piketty notes, the low-to-middle income earners whose wages were stagnating were borrowing heavily. Why were they doing this?

Piketty suggests that it was because of aggressive lending practices by banks. This is probably true. But actually it is beside the point. There had to be high borrowing somewhere in the US economy. With the corporate sector in surplus, either the household sector or the government - or both - was forced to borrow.

To explain this, we need to look beyond the borders of the US. At the time of the crisis the US was running a large and growing trade deficit. This was matched by large trade surpluses in other countries, principally China, Germany and Japan. As I explained in the post linked in the first line of this post, countries that run trade surpluses are net exporters of capital, and countries that run trade deficits are net importers of capital. The relationships are not necessarily bilateral: for example, country A may run a trade surplus with country B (which therefore has a trade deficit), and export capital to country C whose banks lend it on to country B to fund its imports from country A. Whatever the actual flows, however, the effect is the same: country A is a net exporter of capital because of its trade surplus, and country B is a net importer of capital because of its trade deficit. To simplify things, we can regard country A as lending to country B to finance its exports.

Germany, China and Japan can therefore be regarded as lending directly or indirectly to the US. This lending takes several forms: purchases of US Treasuries, purchases of US businesses and real estate, cross-border lending directly into the US economy, and purchases of securities. This last form was particularly important in the years before the financial crisis: German banks had substantial investments in US mortgage-backed securities and their derivatives.

German, Japanese and - above all - Chinese lending to the US is the so-called "savings glut" that is widely blamed for creating the financial instability that led to the financial crisis. But Piketty argues that this source of capital is tiny compared to that generated by rising inequality WITHIN the US (my emphasis):
"...this internal transfer between social groups (on the order of fifteen points of USnational income) is nearly four times larger than the impressive trade deficit the United States ran in the 2000s (of the order of four points of national income). The comparison is interesting because the enormous trade deficit, which has its counterpart in Chinese, Japanese, and German trade surpluses, has often been described as one of the key contributors to the “global imbalances” that destabilized the US and global financial system in the years leading up to the crisis of 2008. That is quite possible, but it is important to be aware of the fact that the United States’ internal imbalances are four times larger than its global imbalances."
So the total amount of capital available for investment in the US at this time was far larger than the imported "savings glut" caused by its trade deficit. And because the US was importing capital, all of that capital had to be invested WITHIN the US***. As I've noted already, the corporate sector was (and is) running a structural surplus. That leaves the household sector and the government sector to absorb the capital. No wonder lenders aggressively targeted those households most in need of money. They had to put that capital somewhere****, and poor households were both the easiest to lend to (because they needed the money) and gave the best returns (because they were the highest risk).  Financial innovation enabled far more of this capital than usual to find its way to poorer households: the concentration of risk that would normally have limited individual lenders' exposure to poorer quality borrowers was dispersed across the globe through securitisation and amplified with derivatives.

And no wonder government encouraged lending to poorer households and riskier borrowers. The alternative was far higher government borrowing and lower tax revenues. But this was a short-sighted policy: when the whole system crashed, unsustainable household debt was replaced with government debt, while the recession clobbered tax revenues and raised fiscal deficits. Now, government is trying to push the debt it was forced to take on in the crisis back to the household sector again by means of fiscal austerity. And the effect of fiscal austerity when the corporate sector is in surplus and the household sector is damaged is to force down the trade deficit. No bad thing, you might argue - but reducing the trade deficit entirely by means of squashing domestic demand is beggar-my-neighbour economics. If everyone tries to reduce their trade deficit by this means, no-one can.

So we can now understand the story that Piketty's paragraph is telling. During the years before the financial crisis, as top incomes continued to rise while low-to-middle incomes stagnated, capital available for investment grew. Imports of capital from countries with trade surpluses added to the capital pile, though they were not its main source. Lenders faced with trying to generate decent returns from this capital glut offered cheap money and easy lending terms to increasingly risky borrowers, who lapped it up to fund consumer spending. Consumer spending added to corporate and high net worth returns and expanded the surpluses of exporting countries, increasing the capital pile still more, encouraging lenders to lend even more on even easier terms and creating a whole new industry dedicated to finding new ways of dumping risk on the unsuspecting. It is easy to see how this became a toxic feedback loop that eventually imploded in a disastrous crash.

And it is now easy to see why Piketty argues that US inequality contributed to the financial instability that led to Lehman. You may disagree - but it is a compelling argument.

Related reading:

Capital in the 21st century - Piketty
Picking apart Piketty - Money Illusion

* I'll use Godley & Lavoie's sectoral balance equations to explain this if you really want me to. But I warn you I usually get them wrong.

** For the purposes of this post I am including equity investment in a general "lending" category, although strictly speaking equity investment is a purchase not a loan.

*** This is of course net investment. The US could, and did, invest overseas as well. But its net overseas investment position was negative because of the large inflows of capital from trade surplus countries. Therefore we can regard all US domestically-generated capital, together with the net capital inflow from abroad, as invested entirely within the US.

**** I'm aware that I'm departing slightly from endogenous money theory here. But from a macroeconomic standpoint it actually doesn't matter. All saving must be invested: all investment becomes saving. It doesn't matter whether you express this as saving preceding investment, or investment preceding saving. It comes to the same thing in the end.