Sunday, 31 August 2014

Fear the fear

"Debt isn't always bad, fearing inflation is stupid and governments should spend far more, suggest top economists", reads a headline in the Guardian. Reporting on proceedings at the Lindau Economics Meeting last week, Philip Inman highlights Christopher Sims's lecture "Inflation, Fear of Inflation and Public Debt", in which Sims argues that fear of both inflation and government debt is driving the developed world into a never-ending slump. As Inman explains, the timing and location of this speech are particularly telling:
Sims was well aware he was speaking in a Germany that fears inflation much as the villagers in the Asterix comic books fear the sky falling on their heads. Without naming Angela Merkel, he said anyone who feels threatened by inflation is stupid.

But actually it is worse than that. Fear of inflation is not just stupid, it is dangerous. And the Germans above all should understand this.

Popular mythology in Germany has it that the Weimar hyperinflation of 1922-23 led directly to the rise of Hitler. This is not true. The Nazi party was formed soon after the end of the First World War, but it struggled to achieve electoral success throughout the 1920s. In the German election of 1928, the Nazi party only managed to win 12 seats in the Reichstag. Four years later, in 1932, it was by far the largest party, winning 230 seats with 37% of the vote. What changed during that time?

Here is an excerpt from a speech given by German Chancellor Heinrich Brüning in 1931, at the height of the Great Depression in Europe (my emphasis):

"I will do my utmost to prevent any inflationary measure of any kind, not only in the spirit of justice, not only to protect the weak, but also because it is my opinion that the honest balance of the German economy has to be recreated, in spite of all bitterness, and that any attempt and any request for inflationary measures only can have the goal in mind to foil this process of establishing a clear balance, to pull another veil over the mistakes over the past. Successes in foreign policy can be achieved all the faster, if we are able to present to the world an honest and clear balance of the German finances and the German economy, for everybody to study.

This is the strongest and most efficient weapon the Reich government had, and to forget this weapon was the task of this administration in its first year. Because of it, public opinion all over the world, without exceptions, now takes a completely different point of view when it comes to the reparations, when compared to years past. Domestically it has to be similarly. Many social and professional tensions would have not become that acute, the political right-wing radicalism would not have gained that much strength, if certain healing processes would have been begun earlier, if the surgeon's knife would have cut earlier and more radically in the private as well as public economy.

Brüning used the memory of the earlier Weimar hyperinflation, together with popular hatred of war reparations, to justify extreme austerity measures. And because the scars left by that hyperinflation are so very painful, he got away with it. When the Reichstag threw out his austerity budget, it was imposed by presidential decree. Among other things, sickness benefits and pensions were cut, unemployment insurance was reduced and workers were required to pay higher contributions. There was also a brutal internal devaluation caused by deliberately tight monetary policy: during the two years of Brüning's chancellorship wages, salaries, rents and prices fell by 20%. The result was similar to the Hoover/Mellon liquidationism in the US: it made what was already a deep recession triggered by a financial crisis far, far worse. By 1932 unemployment was nearly 30%, RGDP was falling by 8% per annum and everyone had had enough. Hitler won the 1932 general election with a landslide. The rest, as they say, is history.

It was fear of inflation, fear of debt and fear of extremism that enabled the Nazi party to come to power.

Related reading:

Germany's hyperinflation-phobia - The Economist

The Greater Depression - Brad Delong (ProSyn)

Wednesday, 27 August 2014


My first Pieria post about matters discussed at the Lindau Economics Meeting looks at the ever-increasing liquidity of financial assets and the consequences for monetary policy:
Several economists at the Lindau meeting were severely critical of central banks' conduct of monetary policy in the light of continuing depression in the US, Japan and much of Europe, and called for greater use of fiscal policy to bring about recovery. Among the most critical was Christopher Sims, who gave a trenchant presentation on “Inflation, Fear of Inflation and Public Debt”.
He started by announcing the death of the quantity theory of money, MV=PY. Due to interest on reserves and near-zero interest rates, “money” can no longer be clearly distinguished from other financial assets....
Read on here.

Sunday, 24 August 2014

Nobel laureates, halo effects and idiosyncratic markets

Chatting to a young Indonesian economist over breakfast this morning, I discovered that his impression of Nobel laureates had been radically changed by the Lindau meeting.

“I used to think that being a Nobel Laureate meant being a world expert in economics”, he said. “Now I know that's not the case. Nobel Laureates are world experts in their own particular area of research. But they aren't experts in economics as a whole.”

The tendency to regard people who are highly qualified and experienced in one area as therefore competent to pronounce upon everything under the sun is a form of what is known as the “halo effect”. And it can have absurd consequences. In a press briefing that I attended, a journalist from a well-known news publication asked the American economist Peter Diamond to comment on the Eurozone. The journalist in question is an EU citizen resident in Frankfurt who has been reporting on European matters for several years. She has far more practical knowledge and experience of the Eurozone than Diamond. But because of his Nobel laureate status, he was presumed to have opinions on the Eurozone that were of more value than hers.

To his credit, Diamond refused to answer the journalist's question, saying that his area of research was entirely US-focused. But other American Nobel laureates were not so humble.

Edmund Phelps, in a breakfast briefing for young economists, extolled the virtues of American “opportunity” and criticised European “corporatism”. This was in a panel discussion on innovation sponsored by Mars, whose European representative - sitting on the panel next to Phelps – had much to say on innovation within large enterprises. And a young French economist on the same panel talked about entrepreneurialism in European countries. No matter. To Phelps, America was the source of all innovation, and Europe had a “terrible problem”.

But Phelps actually undermined his entire argument by comparing the US with something called “Europe”. Had he compared the US with, say, Germany, it would have been a fair comparison, although I'm not sure his conclusions were justified. But directly comparing a country, even one with a federal model of governance, with a whole continent is absurd. Europe is astonishingly diverse, and although its residents do generally recognise a common identity called “European”, it does not have the strength of the “American” identity. “Europe” is still a work in progress. 

Phelps's views on America and Europe were directly contradicted the very next day by another American Nobel laureate, Joseph Stiglitz. Here is Stiglitz – soundbite king as ever:
The idea that America is a “land of opportunity” is a myth. It's not so much the American dream as the Danish dream, or perhaps the Scandinavian dream.

I wonder which of these august gentlemen is right? I suspect neither. It is too easy to see America as the source of all innovation and Europe as free-riding on America's inventions. But equally, it is unfair to dismiss America, which remains a vibrant individualistic culture. Such competitive comparisons are unhelpful and unnecessary.

This brings me to the subject of American dominance among economics Nobel laureates. In his presentation on the role of the housing market in the Great Recession, Vernon Smith showed a series of extremely interesting slides. Here are a couple of them:

The whole presentation was excellent and his conclusions important. I shall write about this separately. But there is an important omission in the header of each of these slides. And that omission is telling.

Smith was of course talking exclusively about the American housing market. But nowhere on his slides does he show that. The slides are simply about “the housing market”. This was in a presentation to young economists, business and media representatives from 80 countries.

Smith presented to this international audience as if all housing markets everywhere were like the US and therefore he did not need to define the boundaries of his research. But nothing could be further from the truth. Housing markets are astonishingly diverse, no doubt because housing is a basic survival need and in many countries also a primary source of wealth. The US housing market is one of the most idiosyncratic: it has unique features such as 30-year fixed rate mortgages, warehousing and GSEs; it has more extensive government and near-government support than almost anywhere else; and it is as far as I know the only housing market where the majority of mortgages are securitised. Yet Smith did not see fit to tell his international audience that his research ONLY applied to the US and could not be taken as a model for anywhere else. Indeed he possibly didn't even think of that. The parochialism of American economists is at times staggering.

Nor is it just economists who are ignorant of national idiosyncracies in key markets such as housing. I had an interesting discussion with an American freelance economic journalist about the Bank of England's Funding for Lending scheme (FLS). Under the FLS, banks can temporarily swap illiquid prime loans (mostly mortgages) for highly liquid treasury bills, which they can then use as collateral in repo markets, thus enabling them to obtain market funding more cheaply. I explained this to my American friend, and his response was “I don't think people understand securitisation”. Umm. This scheme is not securitisation, and it would not work in a largely securitised marketplace such as that in the US. It only works when banks have large balance sheets made up mostly of illiquid loans.

In most European housing markets, lenders usually carry mortgage loans on their balance sheets rather than securitising and distributing them, which means that as their mortgage lending increases their balance sheets gradually become larger and more illiquid. To an American knowledgeable about economics and familiar with the operation of his own housing market, this is a very strange way of doing things. Yet to a European, it is the American way of doing mortgage lending that is odd. My American friend is indeed correct that people don't understand securitisation. To Europeans, it's a nasty American practice that nearly blew up the world.

This is not unlike the “accent” problem. I have no accent. Of course I don't. Everyone else has an accent, not me. So when I went to the US on a business trip a few years ago, I walked into my company's New York office, said something and was astonished to hear from the other side of the office, “I LOVE that accent!” It took me some time to realise that the person they were speaking about was me. I have an English accent. Of course I do. We do not see our own idiosyncracies.

The economics profession is dominated by Americans, and by research that focuses on American markets and American ways of doing things. Of 17 Nobel laureates presenting at the Lindau Economics Meeting, nearly all were elderly white middle-class male Americans – so hardly representative even of America - and most of them were doing exclusively American research. There is a terrible dearth of research that looks at other markets, particularly emerging ones: and an even greater scarcity of research that compares idiosyncratic markets, not in the Edmund Phelps compare-to-denigrate mode but in the interests of promoting international understanding of different ways of doing things.

All economies have unique features, that grow from deep historical and cultural roots: all have common features too. The problem is disinguishing between those characteristics that are common to all economies, and those that are nationally or regionally idiosyncratic. When one nation is dominant in the field of economics, a research model that narrowly focuses on the economic features of that nation runs the risk of being interpreted as applying to all economies, especially if that model is developed by a Nobel laureate. Halo effects lead to “generalisation from the particular”, and a failure to recognise and promote understanding of economic diversity. There is no one right way of doing things, and the American way – or any other nation's way, for that matter – is neither universally applicable nor even necessarily the best.

Monday, 18 August 2014

The Bulgarian Banking Disaster

Another in the Bulgarian banking series at Forbes. Two months on, CorpBank is still closed and there is no end in sight. Depositors are angry, bondholders are nervous after the bank's recent default, and the Bulgarian authorities are making increasingly desperate attempts to find the money to reimburse depositors and - perhaps - recapitalize the bank so it can be reopened. Meanwhile, Tsvetan Vassilev, the bank's majority owner, is in hiding after an international arrest warrant for him was issued on charges of embezzlement. And Delyan Peevski's power base becomes ever larger....

Read the article here.

Depositors protesting about CorpBank's closure. Picture credit: Novinite

Sunday, 17 August 2014

Oil, Angola, and corruption

From Forbes:
The US oil company Cobalt International Energy Inc. has been issued with a Wells Notice by the U.S. Securities and Exchange Commission in relation to its operations in Angola. The Wells Notice formally warns Cobalt that it may face enforcement action for breaches of “certain federal securities laws”:
In connection with such investigation, on the evening of August 4, 2014, the Company received a “Wells Notice” from the Staff of the SEC stating that the Staff has made a preliminary determination to recommend that the SEC institute an enforcement action against the Company, alleging violations of certain federal securities laws. In connection with the contemplated action, the Staff may recommend that the SEC seek remedies that could include an injunction, a cease-and-desist order, disgorgement, pre-judgment interest and civil money penalties. The Wells Notice is neither a formal allegation nor a finding of wrongdoing. It allows the Company the opportunity to provide its reasons of law, policy or fact as to why the proposed enforcement action should not be filed and to address the issues raised by the Staff before any decision is made by the SEC on whether to authorize the commencement of an enforcement proceeding. The Company intends to respond to the Wells Notice in the form of a “Wells Submission” in due course.
It is thought that the laws breached include the Foreign_Corrupt_Practices_Act" (FCPA).....
Bribery and corruption, eh? Well, it is Angola....

Read the whole of this unsavoury tale here.

Thursday, 14 August 2014

The ECB is not doing its job. Again.

At the risk of sounding like a broken record, I'm going to say it again. The ECB is not doing its job. It is sitting on its hands and muttering about inflation while the Eurozone sinks further into depression. Even the mighty Germany's economy is shrinking, France is on the floor, Italy is in a slump and Spain's once-promising recovery looks set to be curtailed as consumer prices slide. What is the ECB doing about it? This:

The targeted longer-term refinancing operations (TLTROs) that are to take place over the coming months will enhance the accommodative monetary policy stance. These operations will provide long-term funding at attractive terms and conditions over a period of up to four years for all banks that meet certain benchmarks applicable to their lending to the real economy. This should help to ease funding conditions further and stimulate credit provision to the real economy.

In other words - nothing. Apart from lending money to banks in the hope they will lend it out, as if this hadn't been tried before and failed dismally. When will monetary authorities learn that throwing money at banks does not make them lend? The much-promised SME ABS programme, which might actually make a difference, is still only being talked about.

The ECB justifies its inaction by arguing that inflation - currently well below target at 0.4% for the Eurozone - is set to rise to near its 2% target over the medium term. It claims that monetary developments in the Euro area support this view. Really? Here's the key table from the June 2014 release of "Monetary Developments in the Eurozone":

There is nothing whatsoever here to indicate that inflation is going to head in any direction other than downwards. The M3 lending figures are still dire. Adjusted June figures are slightly better than those for April and May, but the fact is that lending to the private sector is still falling. The table doesn't show this, but lending to the public sector is also falling as fiscal authorities tighten their budgets. That is concurrent deleveraging by both the public and private sector at the same time, with no monetary easing by the ECB to offset it.

I'm frankly astonished by the ECB's inaction. M3 is not only subdued, but according to the ECB what little growth there is, is driven mainly by investors from outside the Eurozone:

"The increase in the MFI net external asset position, reflecting in part the continued interest of international investors in euro area assets, remained an important factor supporting annual M3 growth."

If international investors pull their money - which if the Eurozone goes deeper into depression, or geopolitical risks centred on Ukraine worsen, they may well do - the whole thing could collapse. It seems the ECB prefers to rely on external investors to do its monetary easing for it, despite the fragility that such cross-border dependence creates for the financial system. I thought the ECB had a responsibility to ensure financial stability?

The ECB's forecast of rising inflation over the medium-term seems critically to depend on banks. The thinking seems to be that the reason why lending figures are so awful is that banks are in a mess, so once banks have cleaned themselves up in order to pass the forthcoming stress tests they will start lending again, growth will return and inflation will start to rise. I fear this is magical thinking. The sort of lending that banks would need to do to restore growth across the whole Eurozone would soon put their balance sheets back in unacceptably risky territory. Are regulators really going to allow them to do this? Indeed, do we really want them to?

The damage that is being done to the supply-side in many Eurozone countries in the name of "reform" raises credit risk and discourages lending. Repairing banks is not going to offset this. The fact is that companies in depressed countries are more likely to go bankrupt than companies in countries experiencing vibrant growth. Even a cleaned-up bank is not going to expand SME lending in a seemingly endless recession. They will lend in other countries that are doing better.

And nor will reducing fiscal deficits and implementing "structural reforms" make banks any more willing to lend to risky enterprises in depressed economies. But nonetheless the ECB breathes fire at fiscal authorities:
As regards fiscal policies, comprehensive fiscal consolidation in recent years has contributed to reducing budgetary imbalances. Important structural reforms have increased competitiveness and the adjustment capacity of countries’ labour and product markets. These efforts now need to gain momentum to enhance the euro area’s growth potential. Structural reforms should focus on fostering private investment and job creation. To restore sound public finances, euro area countries should proceed in line with the Stability and Growth Pact and should not unravel the progress made with fiscal consolidation. Fiscal consolidation should be designed in a growth-friendly way. A full and consistent implementation of the euro area’s existing fiscal and macroeconomic surveillance framework is key to bringing down high public debt ratios, to raising potential growth and to increasing the euro area’s resilience to shocks.
Let's spell this out. Fiscal authorities are NOT RESPONSIBLE for the depression in the Eurozone. This is what is really going on:

See the fall in the solid black line from mid-2012 onwards? That's monetary tightening. There has been a whopping monetary contraction in the Eurozone for the last two years. No wonder it is not recovering. In fact, no wonder the depression is now widening out to engulf the core as well as the periphery. Far from offsetting the effect of painful fiscal consolidations imposed on Eurozone countries, the ECB's excessively tight monetary policy has made their suffering worse and delayed or prevented their return to growth.

As market monetarists know, I am not a wholehearted believer in monetary offset, because I think monetary and fiscal policies have different distributional effects. In my view the Eurozone would still be suffering even if the ECB were doing monetary easing as other central banks have done. But making no attempt whatsoever to offset fiscal consolidation with monetary easing is simply disastrous. Hard-money ideology is driving the Eurozone into what Ambrose describes as "the most serious depression in Europe for 170 years" - far worse than the European Great Depression that led to the rise of Hitler. The only astonishing thing is that so far there has been so little public unrest. How on earth have the people of Europe become so docile?

The ECB is not even achieving its mandate of price stability. It is a disaster.

Broken record:

 So what exactly can the ECB do, anyway?
Why negative rates won't work in the Eurozone - Forbes
Spain, the ECB and the power of talk - Forbes
Why the ECB won't do QE
The Eurozone credit crunch
Deflation and the ECB
The ECB is irrelevant and the Euro is a failure - Pieria
It's the Euro, stupid - Forbes
About that ECB interest rate cut
A central bank crisis
Draghi's debt trap
It's the currency, stupid

Tuesday, 12 August 2014

South Africa Has Bailed Out A Predatory Lender

An incendiary post at Forbes about South Africa's rescue of African Bank, which was lending far too much money at exorbitant interest rates to poor people who were otherwise shut out of the financial system. How on earth is this a justifiable use of public funds?

Read the whole article here, and weep.

Related reading:

African Bank has not learned its lesson - SABC

Monday, 11 August 2014

Of course Scotland can use the (Scottish) pound

The Scottish currency question is in the news again as Alex Salmond insists that an independent Scotland would use the pound "come what may". At Forbes, Tim Worstall and I both look at what this might mean in practice. But we have slightly different views....
"My colleague Tim Worstall argues correctly that an independent Scotland would still be able to use the pound if it chose. Just as the US has no power to prevent Panama, Ecuador and even Zimbabwe using the US dollar as their currency, so the remainder of the UK would have no power to prevent an independent Scotland using the pound. But equally, independent Scotland using the UK pound as its currency without any form of monetary union with the UK would have no control whatsoever over monetary policy. In Zimbabwe this is a good thing, since the last thing anyone wants is the government to have any control of monetary policy. But Scotland is not Zimbabwe: the whole point of the independence campaign is that Scotland should be able to manage its own economy. Using another country’s currency is dependence, not independence. 
"But Tim has missed something....." 
Read on here.

Related reading:

Scotland and the banks
Scotland's currency conundrum
Scotland's currency options - NIESR
Scotland's future: your guide to an independent Scotland - Scottish Government

Sunday, 10 August 2014

Banco Espirito Santo: The Angolan Story

If you thought what I described in my recent pieces on Bulgaria was corruption, just read makes Bulgaria look like the Garden of Eden. Honestly, I was shocked. What was supposed to be a post about the failure of the Angolan arm of BES turned into a post about the systematic looting of Angola by its corrupt political elite. And I've only scratched the surface, really. Horrifying.

I am grateful to Nicholas Shaxson for pointing me in the direction of this piece of analysis.

Related reading

The BES story so far:

Banco Espirito Santo: a Portuguese disaster, not a European crisis
How to rip off a bank, Espirito Santo style
How to rip off a country, Espirito Santo style

Plus, for comparison purposes, the Bulgaria sequence:

What on earth is going on in Bulgaria?
The curious case of the Bulgarian bank runs
The Bulgarian Game of Thrones
The EU should beware of Russian interest in Balkan banks

Oh, and if' you'd like some more Angolan and Portuguese horror, here's David Malone from 2012. Different bank, same people. Plus the media dimension, which I didn't even touch on. Enjoy, if you can.


Ricardo Espirito Santo Salgado, CEO of BES, meets Eduardo dos Santos, Angolan President.
October 2013. Photo credit: Angop

Saturday, 9 August 2014

Marginally confusing

When the efficacy of (unconventional) monetary policy is discussed, the point that is often raised is that QE is ineffective because it directs money to the rich, who have a lower marginal propensity to consume than the poor. People argue that if only we could direct money to the poor - perhaps by throwing money out of helicopters into deprived areas - monetary stimulus would be far more effective.

The same argument appears in debates about the effect of inequality on growth. Consumption drives growth (well, it's not quite that simple, but bear with me); inequality concentrates income in the hands of a few at the expense of the many; the rich few have a lower marginal propensity to consume than the (relatively) poor many, so spending is less than it would be if inequality were lower. Therefore rising inequality impedes growth.

But here is John Cochrane:
"Didn't Milton Friedman demolish the whole concept of "marginal propensity to consume" 70 years ago?"
Well, did he? This is serious. If the concept of "marginal propensity to consume" is as dead as the dodo, how come people keep relying on it to support arguments that inequality reduces growth and monetary stimulus is ineffective?

In his Permanent Income Hypothesis, Friedman argued that rational agents would use saving and borrowing to smooth their consumption over their lifespans, eliminating income shocks and enabling them to maintain a stable level of consumption. Transitory changes in income would not affect people's long-term consumption path. The marginal propensity to consume is consequently zero.

Friedman assumed no liquidity constraints: agents are always free to borrow. He also implicitly assumed that employment and income is stable over the long-term. But people have no ability whatsoever to plan for the long-term when they are unable even to secure their income in the short-term. They may have dreams, but dreams are not rational expectations.

Before I unpick this any further, though, I need to distinguish between the marginal propensity to consume and the average propensity to consume. They are quite different concepts that are frequently confused. The average propensity to consume is the proportion of long-run average income that goes to consumption spending: the marginal propensity to consume is the proportion of any INCREASE in income that will go to consumption spending. So for example, if my expected long-run average monthly income is £1000 and my expected long-run average monthly consumption spending is £600, my average propensity to consume is 600/1000 = 0.6. If I receive a bonus of £100, and I spend £50 of that on a new pair of shoes that I would not otherwise have bought, my marginal propensity to consume is 0.5. Note this is a one-off (i.e. transitory) income increase. This is important: a permanent income increase changes the average propensity to consume. I shall return to this when considering the inequality question.

To illustrate this, consider two individuals. One is CEO of a bank, earning a telephone-digit salary, mega-bonuses and stock options. The other is a labourer on the minimum wage.

The CEO is able to meet all his everyday expenses comfortably from his income. Indeed, he can meet all exceptional needs and wants from his income too, without borrowing. He may like to have a bigger bonus, but he doesn't need it, and receiving a bigger bonus will make absolutely no difference to his spending patterns. Because of this, as his income rises his average propensity to consume decreases. And his marginal propensity to consume is zero, since no income increase will make him spend any more.

So it is not that the rich choose to save more of their income when it rises. It is just that increasing their income makes absolutely no difference to their spending, and therefore they save a higher proportion of their enlarged income. I hope this is clear.

Now let's consider our minimum-wage labourer. Let's suppose that he is able to meet his everyday living expenses from his wages. But he can't cover exceptional items. So he has two choices: he either saves routinely from his wages, or he borrows to meet unexpected expenses. Or possibly both, since unexpected expenses like the washing machine breaking down occur at random and therefore may or may not be covered by the savings built up through routine saving. If he is always able to borrow to meet spending needs, then under Friedman's hypothesis, his marginal propensity to consume is also zero, and his average propensity to consume falls as either his income or his debt rises (since debt must be serviced and therefore the proportion of income that goes on consumption in the future must fall).

I have two issues with this. Firstly, I question whether a rise in income and a rise in debt can realistically be regarded as equivalent. Debt involves incurring a future cost in order to meet consumption needs now, whereas a higher income means that consumption needs can be met now without future cost. Another way of looking at this is as a difference in price: goods bought with debt are more expensive than goods bought from income. When credit is widely used to substitute for income, there is actually consumer price inflation because goods and services are purchased with an additional debt interest charge*. This doesn't show up in any measure of consumer price inflation. Perhaps it should.

If debt and income are not equivalent, it is not reasonable to assume that someone on a low income, such as our labourer, is indifferent to how his consumption is financed. When ordinary people doing TV quiz shows are asked what they will do with the winnings, invariably they say "I will have a holiday". That is a holiday that otherwise they would have borrowed to afford (thereby paying more for it), or saved up for (thereby cutting other spending), or not taken at all. Their marginal propensity to consume is not zero. It is actually positive (if they have more income, they will spend some or all of it).

And there is another problem, too. Friedman's assumption that a labourer on a low wage can always borrow is very evidently false. People on very low incomes often can't borrow at all, or only at cripplingly high rates. And even people on higher incomes may have limits on how much they can borrow. When the limit is an affordability constraint (debt service as a proportion of income), lowering interest rates may encourage people to borrow. But then so would raising wages. Borrowing is not necessarily a response to low income - it may be a response to rising income, or expectation of rising income in the future.

So our labourer not only doesn't really want to borrow (he'd rather have a pay rise), he may not be able to. Either way, his marginal propensity to consume is positive. Give him more money, he will spend it, mostly.

There are however a couple of special cases where the marginal propensity to consume is generally zero for people on low wages. The first of these is people near retirement and anyone else who faces a sharp drop in income in the near future. Friedman argues that people plan their saving and consumption patterns over their lifetimes to ensure that they don't face a cliff edge at retirement. At the time that Friedman was writing, this was quite possibly true: people generally stayed in the same job all their lives and were therefore able to predict with reasonable certainty how their income would fluctuate over their lifespan. This sort of stability encourages both borrowing for consumption smoothing and long-term saving. But that is not how people live now. In our quest for flexibility in labour markets, we have destroyed the job security and income stability that enabled people to plan for the future in this way. Few people now stay with the same company for long, and an increasing number - particularly among those on low wages - are doing temporary, casual and insecure work. The result is a much more short-term outlook. This may seem perverse: if people don't know how long they will have their current job, we might expect them to increase precautionary saving. And some people do. But for many, chronic insecurity seems to have the opposite effect: they spend the money while they have it, and rely on state safety nets and/or debt to see them through the difficult times.

The second special case is people who are close to insolvency. These people are likely to spend any additional money they get on paying down debt (economically, this is equivalent to saving). Their marginal propensity to consume may therefore be close to zero, and their average propensity to consume falls as their income rises until they have reduced debt to a less scary level. Again, this may seem perverse, since rising income makes debt more affordable. But highly indebted people have severe liquidity constraints: being unable to borrow because you are already very highly leveraged means that you have no way of smoothing consumption, and the cost of debt service may make it impossible to save on a regular basis. Easing the liquidity constraint is most easily done by reducing debt and restoring creditworthiness. And debt is not called a "burden" for nothing: very high debt feels like a millstone round the neck. No wonder people want to get rid of it if they possibly can.

But Friedman - and Cochrane - was of course looking not at these microeconomic cases, but at the macroeconomic aggregates. So can it be true that ignoring distributional factors, overall the marginal propensity to consume is zero? I would have to say "it depends".

When there is full employment and job security, and incomes are high enough for debt to be used only to cover unexpected expenses and not to compensate for chronic funding shortfalls, then I could believe that the aggregate marginal propensity to consume would indeed be at or close to zero. And this was generally true, I think, at the time at which Friedman was writing.

But it is not true now. A large number of people are in unstable employment, and real incomes** for the majority of people have been falling for six years and, in the US, stagnating for two decades. The value of qualifications is debased, and certain skill sets are becoming obsolete, making it hard for people to predict their future employment path. Debt levels are generally far higher than they were in Friedman's time, and credit availability is more restricted than it was six years ago. A lot of people therefore face liquidity constraints. As I discussed above, when there are liquidity constraints the marginal propensity to consume is usually positive. It seems highly unlikely that the combination of the rich, those close to retirement and those close to bankruptcy would be sufficient to reduce this to zero in aggregate.

And this of course explains why people still rely on the "marginal propensity to consume" to explain the negative effects of rising inequality on growth and the ineffectiveness of monetary policy that benefits the rich. It works.

Well, it works for monetary policy, anyway. Helicopter drops or fiscal easing that targeted the poor would be a more effective stimulus than QE. Even if people used the money to pay off debt it would STILL be a more effective stimulus than putting yet more money in the hands of those who already have more than they know what to do with. I refuse to accept that distributional matters are of no consequence.

However, I have to agree with Cochrane that the marginal propensity to consume is not relevant in the inequality debate. Inequality is not a short-term problem: it cannot be fixed by transitory stimulus. It is therefore the average, not the marginal, propensity to consume that matters. And the reality is that the rich save a far higher proportion of their incomes than the poor do. Indeed at the bottom end of the income distribution, the entire income may go on consumption spending - not luxuries, just basic needs. Life is a considerable struggle for many people.

But this isn't fundamentally a problem of inequality, although inequality may be an aggravating factor. The real problem is still as it has been for thousands of years: poor people have too little money. If ALL people had the means to live, how much money the rich had would be much less important. I wonder if the present focus on inequality is a distraction from the real issue, which is the slow descent into poverty facing all too many people in the Western world.

Related reading:

The Permanent Income Hypothesis - Milton Friedman
Sacred cows and the demand for money
Capital in the 21st Century - Thomas Piketty (book)

* If the rate of interest on consumer lending were the risk-free rate, then the present value of the debt plus all future interest payments would be the same as the current price of the good or service. A risk-free borrower should therefore be indifferent as to whether purchases are financed from income or debt, although there may be tax advantages from debt financing. But for most borrowers, interest rates are far higher than the risk-free rate - the riskier the borrower and the longer-term the loan, the higher the rate. The present value of the debt plus all future interest payments is therefore considerably more than the current price of the good or service.

** I'm aware that I have only discussed income effects in this piece: wealth effects matter too, but for wealth to influence consumption significantly there must be some way of converting wealth into income. Borrowing against assets is the usual way of doing this for most people.

Thursday, 7 August 2014

When darkness falls

Photo credit: Getty Images

At Pieria, I reflect on the centenary of the outbreak of war in 1914. It is not enough to remember World War I. We must learn from it.
On Monday August 4th 2014, the British people remembered the words of Edward Grey:
The lamps are going out all over Europe; we shall not see them lit again in our lifetime.”
And at 11 pm, the time at which World War I started on this day a century ago, they turned out all but one of their lights.....
Read on here

Tuesday, 5 August 2014

The Austrian savings banks are on their own as government withdraws support for the banking system

My latest at Forbes looks at the implications of Moody's downgrade of Oesterreichische Volksbanken AG:
The Austrian government’s recent decision to overturn the guarantee provided by the State of Carinthia to holders of Hype Alpe Adria’s subordinated debt has come back to haunt it. Citing reduced government support, inadequate capital and poor performance, the ratings agency Moody's has downgraded Oesterreichische Volksbanken AG (VBAG) and its senior debt to Ba3 with a negative outlook. 
This downgrade follows on from Moody’s recent announcement that the Austrian government’s decision with regard to HAA would be “credit negative” for the Austrian banking system and possibly also for the sovereign....
 But this downgrade has much wider implications. Read the whole article here.

(photo credit: Financial Times)

Sunday, 3 August 2014

How to rip off a country, Espirito Santo style

In my latest post at Pieria, I took a hard look at the half-year results of Portugal's distressed Banco Espirito Santo. They are pretty grim reading. No, they are worse than that. They read like an instruction manual for how to rip off a bank. It's no surprise that the losses are appalling.

But now it seems that Banco Espirito Santo is to be bailed out by the Portuguese government. The rescue plan was announced by the Bank of Portugal late in the evening of 3rd August, and the European Commission confirmed that it complied with existing state aid rules.

The Bank of Portugal's statement describes the dramatic events that led to the decision to rescue BES (my emphasis):
On July 30, Banco Espírito Santo, SA announced losses which greatly exceeded those anticipated from the information previously provided by Banco Espírito Santo, SA and its external auditors. Results released on July 30 reflect management acts seriously prejudicial to the interests of Banco Espírito Santo, SA and infringement of Bank of Portugal decisions forbidding increased exposure to other entities of the Espírito Santo Group. These events took place during the tenure of the previous administration of Banco Espírito Santo, SA. Management acts at a time when the replacement of the previous administration had already been announced translated into an additional loss of the order of €1.5 billion compared to that expected from the statement of Banco Espírito Santo, SA to the market on July 10 . This had several consequences:

 i) placed Banco Espírito Santo, SA in a position of non-compliance with minimum solvency ratios in force (Common Equity Tier 1 ratio of 5 percent, three percentage points below the regulatory minimum);

ii) determined a decision to suspend access by Banco Espírito Santo, SA to monetary policy operations and therefore, the liquidity of the Eurosystem;
iii) generated a growing pressure on the Treasury of Banco Espírito Santo, SA;
iv) worsened the public perception of Banco Espírito Santo, SA, as evidenced by the strongly negative performance of the respective titles, injurious situation for the confidence of depositors. This negative public perception led to the suspension of transactions on the afternoon of Friday, August 1, at the risk of infecting the perception relation to other institutions of the Portuguese banking system; 
 v) worsened the uncertainty about the balance of Banco Espírito Santo, SA, invalidating a privately funded solution in a short time.
This framework created continuity problems for Banco Espírito Santo, SA activities. Given the importance of the institution in the whole banking system and the financing of the economy, these problems jeopardized the stability of the payment system and the national financial system.

So when BES's eyewatering losses were declared, which forced it into regulatory insolvency, it was denied access to Eurosystem liquidity and trading in its shares and bonds was suspended. The Bank of Portugal's strong language in this statement echoes that from the new Board of BES: neither seems in any doubt that the activities that directly caused BES's collapse were illegal. As I noted in my Pieria post, the Board's statement amounted to an allegation of fraud. The Bank of Portugal's statement in effect alleges embezzlement, non-compliance with regulatory decisions and failure of fiduciary duty to shareholders. Wow.

BES is to be wound up. The "good" assets of BES are to be placed into a new credit institution, along with ordinary deposits and senior bonds: the remaining assets, along with shareholders' funds and subordinated debt, will remain in BES and be run down over time. No haircut is to be applied to senior unsecured debt. Bondholders and large depositors are no doubt breathing a huge sigh of relief: eighteen months later and they would have been facing losses. The Cyprus solution - haircuts on large deposits and senior bonds to protect the sovereign balance sheet - will become law across the whole EU from January 2016.

But there is something of a puzzle here. The Bank of Portugal calls the new "good bank" Banco Novo, or "New Bank", and seems to expect it to remain intact for the foreseeable future. But the European Commission calls it the Bridge Bank, and describes it as a "temporary credit institution". The reason appears to be the different objectives of the two institutions: the Bank of Portugal is primarily concerned with preserving financial stability and ensuring that BES customers suffer as little disruption as possible, whereas the European Commission is primarily concerned with minimising the impact of this bailout on the fragile finances of the Portuguese state.

The problem is the approach to funding the "good bank". Banco Novo (or Bridge Bank) is to be provided with capital to the tune of E4.9bn from the Bank Resolution Fund. But the Resolution Fund actually doesn't have this money or anything like it. So the Portuguese state will lend it E4.4bn from funds already earmarked for bank recapitalisation - that's around 2/3 of the earmarked funds. Earmarked it may be, but it is still public debt: unless it can be refinanced with private sector money VERY fast, the Bank of Portugal's statement that capitalising the new bank "does not entail cost to the public purse" is not remotely realistic.

The Bank of Portugal describes this loan as "temporary and replaceable with bank loans". I would like to know how long is "temporary" and which banks would replace the loans. But the European Commission has a different view of the means by which the loan will be repaid:
Portugal's Resolution Fund will provide EUR 4,9 billion as capital to the Bridge Bank. To this end, the Resolution Fund will receive a EUR 4.4 billion loan from the Portuguese State. This loan will be primarily reimbursed by the proceeds of the sale of assets of the Bridge Bank.
It seems that the Commission expects the "good bank" to be broken up and sold piecemeal. Oh dear. Clearly there will have to be some negotiation about this.

But the funding of the "good bank", confused though it is, at least should be adequate to allow the new bank to operate. And if a buyer could be found for the whole thing, or a successful flotation achieved, then the loan could be paid off without breaking up the bank. This has to be the best solution for BES's customers. So the fact that the Commission has not recommended this just shows how narrow its focus is. Never mind the people affected, worry about state finances. Hmm.

To my mind the bigger problem is the inadequate funding of the "bad bank". Both the Bank of Portugal and the European Commission assume that once the good assets and senior debt have been removed to the new bank, the remaining shareholders' funds and subordinated debt will be sufficient to enable BES to be wound up without further funding. I'm afraid this is a very dangerous assumption. The Board of BES made it clear in the half year results that the extent of BES's exposure to ES Group liabilities is unknown and considerable risks remain: it seems likely that there will be more losses, possibly very large ones. The final bill could be far higher than the combined shareholders' funds and subordinated debt. But neither the Bank of Portugal nor the European Commission has considered the effect on Portuguese state finances of the "bad bank" BES incurring losses in excess of the value of shareholders' funds and subordinated debt. Protecting senior creditors could turn out to be a very bad decision.

And the decision to rescue BES fails to address the problem I raised in my previous posts about BES (see reading list below), namely the moral hazard that setting such a precedent creates for non-bank conglomerates with embedded banks. Yes, those responsible for the failure of BES may face litigation at some point. But from the record of the last few years, I am not hopeful that it will succeed. And even if it does, I doubt if the amounts recovered will in any way offset the losses suffered - ultimately, I suspect, by Portuguese taxpayers. I stand by what I said in my most recent Pieria post. Those who brought down BES will walk away with the proceeds, and ordinary people will pay.

Related reading:

Banco Espirito Santo: a Portuguese disaster, not a European crisis

Espirito Santo: complexity, opacity and moral hazard

How to rip off a bank, Espirito Santo style