Sunday, 30 November 2014

Celebrating the Spanish recovery

Lots of people have been celebrating the Spanish recovery. "From boom to bust to export-led recovery", crowed one Twitter commentator.

This is the reality:
Well, real GDP growth is now positive. I suppose that is a recovery, sort of. Though 0.5% growth is not exactly robust. In the UK we call 0.5% growth "stagnation", not recovery.*

But look at this:

Note the red at the far right. That is deflation. Consumer prices in Spain are falling by about 0.5%, according to the latest figures. To be sure, this is an annual chart: using annual GDP figures, NGDP is about 1%. I don't call that much of a recovery.

And I doubt if the Spanish see it as recovery, either. This is GDP per capita:

Yes, the Spanish are worse off now than they were in 2003. Ouch.

So if the "recovery" is largely due to falling consumer prices flattering real GDP, what about those exports?

Here's the Spanish current account:

This looks like something of a success story. The current account is indeed slightly positive, which might indicate a trade surplus (more on that shortly). More importantly, though, the very large imbalances that built up prior to the 2008 crisis largely due to inflows of capital into Spain's overblown construction industry have unwound. This is a much healthier current account than six years ago. But the cost has been terrible. Spain's construction industry was a major source of employment. This is what happened when the property bubble burst and the construction industry collapsed in 2008:

Spain's unemployment rate is now beginning to fall - though how much of that is due to emigration is unclear. But at 23% for adults and double that for 18-24 year olds, there is an awfully long way to go. Indeed it is by no means certain that unemployment can ever return to pre-2008 levels. The OECD's latest forecast of the sustainable (i.e. non-inflation accelerating) rate of unemployment is 18.9%. This is based upon a Phillips curve relationship which assumes growth returning to something like 3%. But structural unemployment at this level is a considerable drag on both growth and public finances. Putting it bluntly, if Spain is to recover AND put its public finances on to a sustainable path, about a fifth of its current population must leave. 

So for the Spanish people, there really is not much to celebrate, is there? But wait. What about those exports?

Here are Spain's exports:

 And these are imports:

Now, maybe my eyes are deceiving me, but this doesn't look like a story of export success to me. Exports appear simply to have returned to their pre-2008 trend growth rate - in fact if anything the export growth rate appears now to be declining slightly. The real story is the collapse of imports. And that is unquestionably due to the fall in household incomes from benefit cuts, tax increases, wage falls and above all unemployment, coupled with unserviceable debts and an extraordinarily harsh attitude to mortgage defaults. This is no export-led recovery. The current account balance has been achieved almost entirely through a massive fall in the standard of living of Spain's population.

I can't see anything to celebrate.

Related reading:

Structural destruction
Magical thinking at the G20 - Pieria

* This is a chart of quarter-on-quarter percentage RGDP growth. Annual percentage growth is 1.6%.

Saturday, 29 November 2014

Structural destruction

Researchers at the Federal Reserve recently produced a fascinating article in which they argued that severe recessions such as that in 2008-9 leave permanent economic scars.This set of charts shows the effect of the 2008-9 recession on real GDP trend growth for four economic areas - the US, the UK, the Euro area and Canada:

This reminds me of the four-image game on the UK's satirical current affairs show "Have I Got News For You". Spot the odd one out, and explain why.....and no, it isn't the one you think it is.

Actually each chart has a claim to be the odd one out, which just goes to show how the economic effects of the financial crisis varied by country. Or perhaps more accurately, how the response to the crisis by monetary and fiscal authorities varied. These charts show a significant drop in trend RGDP for all four economic areas: Canada, which had neither a property market crash nor a banking crisis, shows the smallest fall. Interestingly - and contrary to popular belief in the States - both the UK and the Euro area appear to have suffered a worse fall in trend RGDP directly attributable to the crisis than the USA did. 

But it is the behaviour of the red lines on these charts that really interests me, since they represent the actual path of RGDP post-crisis. As can be seen, Canada - which did not do QE but maintained fiscal spending (though it recommended austerity for everyone else) - has recovered better than the other three. But even though it didn't get such a kicking as the others, its RGDP is still below the previous trend. The Fed researchers show that even for mild recessions, output remains below previous trend seven years afterwards:

So despite Canada's milder recession, it is still suffering from a hangover. 

But Canada's headache is nothing like as bad as that suffered by the other three. The US, UK and Euro area have not only failed to recover previous trend growth, they have actually slowed down again since the crisis. The US's recovery slowed from 2011 onwards despite continual QE. It is hard to establish any cause for this other than misguided fiscal policy: the shenanigans over the fiscal cliff and the ridiculous sequester have taken their toll. It's an entirely self-inflicted wound and now, thankfully, over. As Matthew Klein puts it, the US has now at last stopped holding back its recovery

The UK's recovery stalled in 2010, prior to the Euro crisis. It is unclear exactly what the cause of this was: Simon Nixon at the WSJ suggested that it was due to misguided monetary tightening by the Bank of England, and I have argued that it was due to failure by both the fiscal and monetary authorities to offset an oil price shock. However, the fact that the UK elected an austerity-minded government in May 2010 whose first action was to raise VAT might also have something to do with it. When the economy is recovering from a severe demand shock, raising consumption taxes is just about the worst thing you can do. After all, if you need people to spend, taxing their spending is completely counterproductive. (Japan has just expensively discovered this.) Anyway, whatever the cause, the UK clearly experienced another shock which knocked it onto an even lower trend path for RGDP.

But the really shocking chart is that for the Euro area. The terrible consequences of the Euro crisis are all too clear. Like the UK, the Euro area suffered a second demand shock. But the response was very different. I criticise the UK government for inappropriate fiscal tightening, but at least it offset it with monetary easing, and latterly added fiscal easing too in the form of tax cuts and support for the housing market. It is these, in my view, that have generated the current recovery. In contrast, the response from EU fiscal and monetary authorities has been woefully inadequate. Such monetary easing as the ECB has done has failed to offset the severity of the demand shock, while procyclical fiscal tightening has actually amplified the shock. Euro area RGDP is on the floor and showing little sign of recovery. Adult unemployment is currently 11.5% across the whole Euro area, and much higher in some periphery countries: youth unemployment is double that of adults. Contrast this with the US, which has done far more to promote job creation than the Euro area despite unemployment only touching 10% at the height of the 2008-9 recession. If the US had unemployment at Euro area levels, it would be doing fiscal and monetary stimulus on an unprecedented scale. I am frankly astounded at the tolerance of the young people, in particular, whose futures are being systematically wrecked. They will bear the scars for life. Why they are not rioting in the streets is a mystery.

As yet, it is unclear what the new trend path for Euro area RGDP will be: the crisis is by no means over. But one thing is clear. The policies of Euro area fiscal and monetary authorities are doing serious damage to the economy. This is not "structural reform" - it is wholesale destruction of the productive capability of the economy. It's an unmitigated disaster. 

But the really worrying part of the Fed research is this chart:


This chart shows how growth expectations were gradually revised downwards over the years after the initial shock. This chart applies to the US, obviously, but the researchers found a pattern of downward revisions to growth estimates in 62 recessions from 1989 to 2009 in 23 advanced economies. Underestimating the severity of a shock appears to be an industrial bias among economists. Indeed, in my review of FOMC minutes earlier this year, I noted that FOMC members expected growth to return "any day now", even when indicators were negative, while expecting inflation to disappoint on the upside, even when indicators showed expectations were well-anchored. The combination of these two beliefs would lead monetary authorities to underestimate both the depth and length of demand shocks and therefore respond with inadequate monetary stimulus. 

This is bad enough. But these forecasts also affect the decisions of fiscal policy makers. And it is very clear, to me at any rate, that fiscal policy in the US, UK and Euro area was tightened too soon after the shock and by far too much. The driver for these decisions appears to be over-optimistic growth forecasts coupled with worries about high government deficits. There is also a pernicious belief that monetary easing offsets fiscal tightening even in the aftermath of a severe demand shock. It is now abundantly clear that it does not. Fiscal tightening is always contractionary, and particularly so after a demand shock. That is why the Euro area economy is in such a mess. It is being driven into the ground by inappropriate and in some cases frankly vicious fiscal policy. 

And the consequences are terrible. The OECD's latest forecast of the "non-inflation accelerating rate of unemployment" (NAIRU) for Greece was 17.275%: for Spain, it was 18.9%*. This means that the supply-side of the economy now cannot create enough jobs for the adult population without inflationary consequences. For Spain, nearly a fifth of the workforce must remain unemployed, apparently. If ever there were evidence of the damage done to the supply side of Euro area periphery economies by the combination of severe shocks and misguided policies, this is it. To add insult to injury, having failed to prevent or repair this damage, EU authorities now present the people of these countries with a choice: leave your home and migrate to a foreign land where you do not speak the language (and where you are becoming increasingly unwelcome), or be thrown on the scrap heap. 

The EU authorities continue to talk about the need to do something about unemployment, and in particular youth unemployment. Now and then they even come up with initiatives, usually involving spending very little money relative to the scale of the problem. But while fiscal harshness and lack of monetary support remain the order of the day, there can be no real improvement. 

Eventually, I suppose, the Euro area will recover, because economies always do. But by then an entire generation of Europeans will have been sacrificed to appease the gods of ordoliberalism and hard money. The Euro area depression will be officially the longest and deepest in recorded history. And the rest of the world will be stagnating due to the deflationary impact of the European disaster. 

The "Great Recession" is no longer an adequate name for the time we are living through. As Brad DeLong said, it should now be known as the Greater Depression.

Related reading;

* Earlier version of this post had OECD forecasts from November 2013. Now updated.

Monday, 17 November 2014

Reflections on Rochester and Strood

In the post this morning: three communications from UKIP, two from the Conservatives, one from Labour. This is a pretty typical day. Every day brings more confetti through the letterbox, most of it from UKIP and the Conservatives. All of it goes straight in the bin.

I also get emails from the Conservatives, phone calls from the Conservatives, visits from the Conservatives.....I told an opinion pollster who rang recently (yes, I get lots of those too) that the Conservatives look desperate to me. I'm utterly sick of their flood tactics.  But now UKIP have adopted the same tactics. Spam, spam, spam. They are nearly as bad as the PPI leeches.

Spamming my letterbox, mailbox and voicemail merely annoys me. I don't need more information. I know what all of the main candidates are offering. Heaven knows, they've told me enough times.

I've read Kelly Tolhurst's six-point plan, headed up by the biggest non-issue of this by-election - immigration. I've read Mark Reckless's insane claim that a party that has no plan for reducing the deficit is somehow more likely to achieve it than one that has spelled it out in gory detail. I've also read Naushabah Khan's sensible local plans which have been unfortunately hijacked by her party's insistence that she must fight the other parties on their own ground.

I'm much less clear about what the other parties are offering. I think during this campaign I have had one leaflet from the Lib Dems, occasional leaflets from independent candidates and none at all from the Greens. Maybe it's because of where I live - the outskirts of Strood are not where the main battle lies. Or maybe it is just that the other parties have all given up prematurely. Whatever. I'm bored with it all anyway. Roll on Thursday.

Oddly enough, given it is only three days until the vote, the media have gone a bit quiet this week. Maybe they are bored with it too. A week ago, the BBC was busy promoting the idea that this by-election was all about immigration. Here is Louise Stewart, in an article promisingly named "Issues Beyond Immigration":
Perhaps the Rochester and Strood by-election campaign could also be summed up in three words - Immigration, Immigration, Immigration.
It was always going to be a big issue, given this vote was triggered by the local MP's defection from the Conservatives to UKIP.
And the headline for BBC South East's televised "Rochester and Strood Debate" announced that although local issues did feature, the debate "really heated up" when immigration was discussed. Apparently this "proved" that this by-election is about immigration, really.

I was in the audience for that debate (if you want to watch it, the iPlayer link is here). Immigration was indeed discussed, and there was a heated debate between Kelly Tolhurst and Naushabah Khan about the Coalition's record on controlling immigration. But as they were arguing, the audience went quiet. I looked around. They were mostly disengaged. The energy from the audience had dissipated. Suddenly what had been a lively discussion of local issues had become a national media circus.

I thought maybe it was just the impression I gained at the time, so I watched the broadcast as well. The same impression remained. Politicians were arguing about the issues their head offices had told them to discuss (and the media liked) while local voters looked on, disengaged and unimpressed.

A few days later I discussed the programme with one of my students who had been in the row behind me in the debate. 

"Was it just me, or was the audience really bored during the discussion of immigration?" I asked.

"Not bored, exactly," said my student. "It just seemed pointless. It's not what we are interested in".

Other people I spoke to echoed this. And the lady who asked the question in the broadcast itself summed it up:

"I don't think immigration is the big issue it is being made out to be", she said. "And I think the real concerns of local people are not being heard".

Indeed they are not. Recent reports on the by-election have focused entirely on how awful it will be for David Cameron if UKIP wins. The Telegraph wrote a piece called "Rochester and Strood by-election explained" which completely omitted any mention of local concerns in Rochester and Strood. And a nice piece in the Guardian about a local shop's straw (or rather sweet) poll degenerated into party politics. No wonder people in Rochester and Strood are cross.

To her credit, Louise Stewart did say that her own impression was that immigration wasn't the main issue:
And it's not a scientific poll, but when I've spoken to voters on the streets of Rochester and Strood the crisis which has engulfed the Medway Maritime Hospital (which was taken into special measures over a year ago) seems to be the area of most concern for residents.

Slightly further out residents in Hoo are worried about plans to build 5,000 homes at Lodge Hill - on a Site of Special Scientific Interest - and the Green Party and Liberal Democrats have made fighting it one of their key policies.
The other big bugbear seems to be traffic management - businesses say they're suffering due to the long-standing traffic hold-ups on Medway's biggest trading estate, worsened by what they describe as "incompetent" highways management of roadworks nearby.
Yup, that's more like it. Medway Hospital, the Lodge Hill development and traffic jams. Had this by-election been six months earlier, the list would have included the Estuary Airport proposal, which was - and remains - unbelievably unpopular with local people. It's not about immigration. Really, it isn't. It's about this area being a dumping ground for all sorts of political pet projects that can't go anywhere else because of the insane London greenbelt. It's about stupid political ideology that deprives schools and hospitals of resources, squeezes people's incomes and hurts the poor. It's about failure to reform the banks, failure to mend the roads, failure to fix the health service. It is, in short, about the everyday things that affect the lives of ordinary people.

Although I'm not going to vote for him, I have to say that Mark Reckless actually addresses these local concerns well. And if he wins it will be more because of this than the ridiculous UKIP policies. As a Westminster politician he has been something of a joke, but he has been a good constituency MP. He has more personal support than perhaps the media appreciate.

But one thing that came across clearly in the BBC debate was how close Tolhurst and Reckless are. As far as policies are concerned, they are almost indistinguishable. And the Labour candidate wants to play them at their own game. Three parties, all offering pretty much the same menu. Do we vote for posh Mark, chavvy Kelly or clever Naushabah, or waste our votes on a fringe party?

In the end it all comes down to this.We, the voters of Rochester and Strood, are being drowned out by the noise from the media circus and the political Punch and Judy show. If we kick the main parties by re-electing Mark Reckless, it will not be because we are a bunch of racist, sexist xenophobes. It will be because we are angry that what really concerns us is apparently of so little importance to the Westminster elite. They should take note.

 Related reading:

Rochester and Strood: it's not about UKIP

The land of the setting sun

"So tief im Abendrot, wie sind wir wandermü das etwa der Tod?"
- R. Strauss, Four Last Songs, no. 4 "Im Abendrot"

Japan  is in recession. Will it ever escape from its deflationary trap? Indeed, should it even try to? Or would it be better for it simply to accept that its future is gentle decline into a comfortable (and highly automated) old age? Is it becoming the land of the setting sun?

My thoughts on this are at Pieria.

Tuesday, 11 November 2014

The central bank of Russia is regaining control - but for how long?

At Forbes, more on Russia's currency problems:
After the Central Bank of Russia (CBR) established free float with the condition that it would intervene to protect domestic financial stability, the ruble immediately rallied, but then fell again. Many people forecast dire consequences. I admit I was a little worried, but I thought the ruble would stabilize once markets became used to the lack of routine intervention from the CBR. After all, the whole point of allowing a free float is to enable the currency to find its own level – and more importantly, restore control of monetary policy to the central bank.
When a country operates a fixed exchange rate system, it de facto adopts the monetary policy of whichever country issues the currency to which it pegs its own currency. In the case of the ruble, that is the United States. And as I have noted before, because China has large US$ reserves and a currency peg to the US$, the Fed’s policy is to a degree determined by the People’s Bank of China (PBOC). After all, a currency peg has two sides. It is unusual for the pegging country to influence the monetary policy of the country to which it pegs: usually a smaller, weaker country pegs its currency to a the currency of a larger, stronger country, and the larger country simply ignores the smaller one. But the US and China are now sufficiently close in size and strength to influence each other. Both also influence the oil price, and as Russia is an oil exporter, that has significant effects on the Russian economy. In effect, Russia’s monetary policy has until now been jointly determined by the Fed and the PBOC.

This means that the CBR has never really been in control of either the ruble or monetary policy.....
So how is it regaining control - and what might make it lose it again? Read on here.

The foolishness of the old

Older people tend to want their pensions and benefits protected and the burden of cuts to be borne by the young. Of course, this is only natural:
Most people want government to spend more money on them than on anyone else. This applies regardless of their tax contributions (those who don’t pay tax often demand more than those who do). And it is completely understandable. After all, charity begins (and when times are hard, ends) at home.
But it is also foolish. In my latest post at Pieria, I explain why older people should be demanding that governments invest in the young. 

Sunday, 9 November 2014

A Strange Memorial

Poppies, at the Tower of London, turning the moat blood-red. A wonderful memorial to the British and Commonwealth servicemen who died in the First World War. 

One of them was my great-uncle, Henry Dodson Noon. We've always referred to him as "Uncle Dodson", so Dodson is the name I shall use in this post.

Dodson was born in 1894 in Eastwood, Nottinghamshire, the son of George Henry Noon and his wife Mary Catherine Noon, my great-grandparents, who were farmers. In 1911, at the age of 17, he emigrated to Australia. My mother always said it was "because there was no money in farming in Britain". Indeed, farming was at that time in long-term decline: Dodson was not the only farmer's son to emigrate. Nonetheless, he doesn't seem to have become a farmer in Australia either. His Australian Army papers show his occupation as "butcher".

In 1914 he joined the 16th Battalion AIF. After training near Perth and Melbourne, he embarked with the rest of the 4th Australian Infantry Brigade to join the Anzac force in Egypt. He fought and was wounded at the battle of Gallipoli in 1915, receiving a bullet through the nose. The wound became infected and he was invalided home to England.
He later returned to his battalion. At some point he was promoted, since his embarkation papers for Egypt show his rank as "Private", but his war grave records show his rank as "Sergeant". He fought at Mouquet Farm on the Somme, where he disappeared and was listed as "missing" on August 31st 1916. After extensive enquiries on behalf of his mother and the Rector of Eastwood, his death was finally confirmed six months later. The exact circumstances were not established until May 1917, when Sergeant-Major Blimman in the 16th Battalion wrote this:
Sgt. Noon was killed on the night of 29th-30th August 1916. He was not buried in a soldier's cemetery. His body could not be found, but it was buried by shell fire in a German trench. I knew Sgt. Noon well and I think I was the last person to speak to him before his death. Dodson's body was never found, he is remembered both on the Australian war memorial at Villiers-Bretonneux in France, and on the Northumberland Road war memorial in his home village of Eastwood, where he is listed as "H. Dodson Noon" (third from the bottom).

Dodson was George & Mary Catherine Noon's only son, and with his death the name Noon died out in Eastwood. But in a strange way, it lives on - and not just on war memorials or in the memories of his family. For this, we have to thank Eastwood's most famous son - the writer D.H. Lawrence.

D.H. Lawrence knew the Noons. Indeed there seems to have been some animosity between them. Family legend has it that when they were children, my great-aunt Maggie (Dodson's older sister) was not allowed to play with Lawrence because her mother thought he was a "nasty little boy".

In 1920-1, D.H. Lawrence wrote a short story called "Mr. Noon", which was published posthumously in 1934. But his work on "Mr. Noon" didn't end there: he gradually developed the story into a novel, though he never completed it. The unfinished novel was eventually published in 1984 in a critical edition compiled by Lindeth Vasey. The chief protagonist of Lawrence's story is Gilbert Noon, a twenty-six year old mathematics teacher with musical talent. On the basis of the initials G.N. and the character's behaviour, Vasey concluded that Gilbert Noon was modelled on Lawrence's friend George Neville. And indeed there are obvious similarities, although in many ways Gilbert Noon is also Lawrence's own alter ego. "Mr. Noon" is widely recognised as Lawrence's most autobiographical work.

But Vasey seems to have made no attempt to identify the provenance of the name Noon. For me, this is a grave omission. G.N. are the initials not just of George Neville, but also of Dodson's father, George Noon. George Noon, as an independent farmer, was a small businessman with money - like Gilbert Noon's father. And Dodson, had he lived, would have been twenty-six in 1920, the year Lawrence started work on "Mr. Noon". The Noons were a musically talented family: we do not know if Dodson had musical talent, but his sister Maggie was a professional pianist and other girls in the family sang and played the piano to a high standard. Indeed, I owe my own musical talent to my Noon ancestry. 

So despite the untimely death of Henry Dodson Noon, the name lives on - in literature. Lawrence's unfinished autobiographical work is perhaps my great-uncle's strangest memorial.


A tangled web of fraud

Bulgaria's Corporate Commercial Bank. Again. Oh dear.

There is some good news:

The Bulgaria National Bank (BNB) has now – belatedly – revoked the banking license of the failed Corporate Commercial Bank (KTB) and commenced bankruptcy proceedings. This will come as a huge relief to insured depositors, who will get their money back in time for Christmas. It also means that the attempt by a consortium of investors to rescue the bank has failed.
But what a mess has been left behind:
The BNB’s disclosures about KTB reveal the desperate measures that were taken to preserve the illusion of solvency in the months before its failure. This statement from the BNB’s website explains how the bank self-funded its own Tier2 capital with a complex web of circular lending transactions involving an investment company called TC-IME and a host of smaller intermediary companies. The ownership of the components of this tangled web requires some explanation.
Indeed it does. Read on here.

Related reading:

Bulgarian Stalemate
The Bulgarian Banking Disaster
The Bulgarian Game of Thrones
The curious case of the Bulgarian bank runs
What on earth is going on in Bulgaria?

Russia's desperate defence of the ruble

Two pieces (so far) at Forbes on the Russian central bank's desperate defence of the ruble. Well, it appears desperate, anyway. But is it, really?

Firstly, I explain why the Russian central bank can't defend the ruble and shouldn't try to:
When a currency is rising in value due to capital inflows, the central bank can cap its rise by buying assets and foreign currency. This is what the Swiss central bank has been doing for a few years now. Its purchases of Euros amount to possibly the largest QE program in the world relative to the size of its economy. Since it can create infinite amounts of Swiss francs, it is unquestionably the most powerful player in the Swiss franc market, and no market participant will oppose it. Instead, market participants will happily co-operate with it by selling Euros at the price that it sets.
Similarly, when a currency is falling sharply in value, the central bank can support it by selling assets, including foreign currencies. But in this case it does not have infinite quantities of assets. Central banks can create their own currencies at will, but they can’t create foreign currencies or assets. So the ability of a central bank to prevent sharp devaluation of its currency is limited by its asset and foreign exchange holdings. It is not all-powerful – and markets know it.
So what should central banks do? Read the post to find out.

Shortly after I wrote that post, the Russian central bank abandoned any attempt to maintain the ruble within its trading bands:

The Central Bank of Russia (CBR) seems to have decided that it can’t beat the markets. On Wednesday November 5th, it announced an end to unlimited currency support interventions. It said it would spend a maximum $350m per day smoothing out fluctuations as the ruble approached the edge of a trading band. Once that limit was reached, the ruble would be allowed to fall out of the band. The final sentence of the CBR’s press release spells it out:
As a result of the implementation of this decision, the ruble exchange rate will be determined predominantly by the market factors.
Game, set and match to the markets, apparently.
Or is it? Perhaps not. As I explain in this post, it looks more like "game on" to me.

As this game plays out, I shall write more posts about it.

Related reading:

Russia is facing a full-blown currency crisis - Tomas Hirst, Business Insider
Plunging rouble raises spectre of fresh financial crisis for Russia - FT
Rouble rebounds as central bank says it could take action - BBC
Has the Japanese central bank started another round of central bank wargames? - Forbes

Has the Bank of Japan started another round of central bank wargames?

Never pick a fight with a central bank. The only one who gets hurt is you. Unless, of course, you are another central bank.
Central banks routinely intervene in the markets to influence the prices of assets, commodities and currencies. That’s the way monetary policy is conducted. It’s the principle behind QE.
Generally, everyone co-operates.....
Have you ever wondered why they do? In this piece at Forbes I use a game theory explanation for the ability of central banks to manipulate markets, and apply it specifically to the Bank of Japan's exorbitant QE commitments. 

A terrible stability

My Pieria post on EU unemployment and inflation:
One of the things that struck me about the EU's stress tests was the high levels of unemployment in the baseline conditions for the tests. Levels were elevated across not only the Eurozone, but the entire EU: the aggregate baseline unemployment level for the Eurozone was 12%, largely because of very high unemployment in some Eurozone periphery countries, but that for the entire EU was not far behind at 10.7%.
The baseline conditions did assume that unemployment would reduce. But the forecast was for a drop of less than one percentage point in three years: in the Eurozone it would drop to 11.3% and in the EU to 10.4%. If these baselines are at all realistic, then unemployment is a HUGE problem in the EU.
But inflation, or rather disinflation, is also a problem. In fact the two combine to create a terrible stability. Read about it here

Saturday, 8 November 2014

Lessons for China from Japan

The Economist has an interesting graphic. Here are the world's 10 biggest banks year by year since 2004, apparently:

Umm, not quite. This graphic actually shows the banks with the largest amount of shareholders' equity (Tier1 capital) in US$. It says nothing at all about the absolute size of these banks in assets, and since the Tier1 capital is expressed in dollars rather than as a percentage of assets, it says absolutely nothing about the safety of these banks either.

Cross-checking the figures for 2013 against other metrics gives interesting results. Relbank reports that by assets, Britain's HSBC is the second largest bank in the world, but The Economist's list has HSBC in fifth place by Tier 1 capital. So it appears that its capital is deficient relative to China Construction Bank, JP Morgan and Bank of America. But the accounting treatment affects the definition of assets. In particular, there are significant differences between US GAAP and IFRS regarding the treatment of derivatives. The result is that US banks using US GAAP appear to have smaller asset bases than HSBC (and other European banks) that use IFRS. HSBC is apparently larger than JP Morgan - and has lower capital - because of differences in accounting treatment.Would that difference disappear if both banks were using the same accounting treatment? We don't know.

There are also differences in definition of Tier 1 capital. America's definition of capital is not the same as the UK's, and who knows how China defines "shareholders' equity". The treatment of preferred stock is particularly controversial.

So The Economist's chart should be treated with some care. Nonetheless, it shows how much the Tier 1 capital of the global banking system has increased in the last 10 years. The size of the circle indicates the size of the capital base of the bank concerned. In 2007 the largest bank in the world by capital was the British bank RBS, which was also at the time the largest bank in the world by assets. But the banks that have replaced it are much larger. The RBS of 2007 wouldn't feature on the list at all now. Indeed, European banks generally feature highly in the earlier years of the chart: French banks, and even Spanish banks, were in the top 10 banks in the world by Tier 1 capital. All have now disappeared from the list.

What has replaced them? Chinese banks. In 2004, Chinese banks were nowhere to be seen. Now, four of the largest banks in the world both by Tier 1 capital and by assets are Chinese. In fact of the largest 50 banks in the world, 17 are Chinese.

On Twitter, The Economist's chart was accompanied by a tweet that asked "How long before all the top 10 are Chinese?" It seems a reasonable question. After all, the Chinese economy will soon be the largest in the world, so it should have the largest banks - shouldn't it?

But we have played this scene before. Roll back the years to 1989, and we find this from the Chicago Tribune:
For the first time, the 10 largest banks in the world are all Japanese as Citicorp, the biggest U.S. bank, has fallen out of the top ranks, according to American Banker. Dai-Ichi Kangyo Bank Ltd. is Japan`s and the world`s biggest banking company, with assets of $387 billion at the end of March.
The remarkable growth of Dai-Ichi Kangyo Bank (DKB) came from increasingly risky real estate and construction loans made on the assumption that land prices would continue to rise. Yet by 1989, land prices were already falling in Tokyo - a sign of trouble to come. When the Japanese real estate bubble burst in 1991, DKB found itself with high levels of non-performing loans. Nor was it alone. Almost all of the large Japanese banks ended up with disastrously high levels of non-performing loans, mostly real estate, after the 1991 crash. They limped along until 1997, hiding the true state of their balance sheets, until the Asian crisis hit in 1997. That was enough to cause the failure of the most vulnerable banks, notably Hokkaido Tagushoku Bank, Long Term Capital Bank, and Nippon Credit, along with securities companies Sanyo Securities and Yamaichi Securities and a number of smaller institutions. The rest, including DKB, were forcibly restructured by the Japanese authorities. DKB eventually merged with Fuji Bank and Industrial Bank of Japan to form Mizuho Banking Corporation.

There are other disturbing similarities between the Japan of the late 1980s and China today. The Japan of the 1970s and 80s was an export powerhouse, with a large trade surplus which the US claimed was due to artificial repression of the yen. Sound familiar? The Plaza Accord of 1985 forced the yen to appreciate against the dollar. But although that caused a short recession in Japan, it didn't end its trade dominance. The US's trade deficit remained stubbornly high and Japan continued to "fund the US deficit" by buying USTs - just as China does today. In fact Japan's purchases of USTs were an inevitable consequence of its trade surplus, just as China's are today. Neither country is remotely interested in funding the US's fiscal deficit - but they do like to have plentiful dollar liquidity.

As a young MBA student, I remember being told that Japanese businesses were going to take over the world. Western businesses would have to become more like Japanese businesses in order to survive. So we were taught "Japanese business". We went on trips to Japan to learn how Japanese businesses work and to gain an understanding of Japanese culture. Some of us even learned Japanese.

But Japan's growth came to an abrupt end with the bursting of the asset bubble in 1991 and the collapse of its banking system in 1997. Now, after more than two decades of stagnation, no-one is interested in learning about Japanese business. China is the new powerhouse. Chinese businesses are taking over the world. MBA students are taught about Chinese business. Some of them even learn Mandarin. Hmm.

Size, in banking, is not an indicator of health. We know that the growth of Chinese banks is being driven by property and construction lending - just as the growth of the Japanese banks was. And like the Japanese banks, they are rapidly becoming the largest in the world. To be sure, this is partly because of the retrenchment of banks in Europe. But to me, the Chinese banks look uncomfortably like the pre-1991 Japanese banks. Property prices are falling as the economy slows, undermining the value of collateral, and bad loans are rising rapidly. Yes, they claim to be well capitalised - but so did the Japanese banks

What makes us think this time will be different?

Related reading:

What happened to Japanese banks? -  Takeo Hoshi
The financial crisis in Japan in the 1990s - Hiroshi Nakaso, BIS
The Japanese banking crisis of the 1990s - IMF