Tuesday, 30 September 2014

Debt hysteria

I have been reading the Geneva 16 report, which came out yesterday. It's scary stuff. If you thought the world was reducing its debt pile - forget it:

The debt is still growing, but the world's GDP growth is slowing. Indeed as aggregate debt figures are usually quoted versus GDP, the two are connected. The debt pile grows faster as growth slows, simply because the denominator is falling.

The report looks at total debt/GDP - not just sovereign debt. This is refreshing: unrelenting media focus on sovereign debt as the principal problem misses the fact that in many countries the bigger burden is PRIVATE debt. However, it makes the figures even worse. Global debt, it seems, is a terrible problem.

None of this will come as a surprise to anyone, except perhaps the news that the world as a whole is actually accumulating debt rather than deleveraging. The deleveraging efforts by developed countries are being more than offset by the increasing debt of emerging markets, particularly China.

But as I read the report, I found myself wondering why there was no discussion of the other side of all this. Who are the owners of all this debt?

There is a simple answer to this. Households and corporations own this debt. It is the savings of households and the uninvested profits of corporations. Since the financial crisis, developed-country governments also own some of this debt, via their central banks. And in emerging markets, where  governments, corporations and households can be very closely related, exactly who owns the debt can be unclear.

The global debt glut described in this report, and the global saving glut described by Bernanke, are the same thing. The authors note that growth has been slowing in developed countries since 1980. Indeed it has - and during that time capital ownership and indebtedness have been increasing in tandem, as we might expect since they are opposite sides of the same coin. The report cites numerous analyses that show high debt levels - public AND private sector - tending to impede growth as resources that could have been turned to productive investment are spent on debt service. Secular stagnation is as much a consequence of over-indebtedness as it is of excess capital.

The owners of debt think they have saved prudently and accumulated safe financial assets to insure them against an uncertain future. They believe that their savings are PAST income, stored.  Bonds and bank accounts are simply their own money in another form. How very dare anyone suggest that their hard-earned savings should be lost in order to relieve the debt burden on others? Let the profligate debtors sort out their own problems. Prudent savers must be protected from loss.

But debt assets are not stored past income. They are actually claims on the FUTURE income of other people. When you buy bonds, you are spending, not saving. Your money goes to someone else and you have no right to its return. In return, you receive a promise. In a simple vanilla bond, the promise has two parts:
  • the promise that you will at some point in the future recover a nominal sum of money equal to the amount that you paid for the bond (note that this is not protected against inflation)
  • the promise of a stream of coupon payments that may or may not include compensation for expected inflation
There are huge variations on this theme, but they all boil down to the same thing. You spend money in the present in return for a promise of more money in the future.

The price of the bond is the value of that promise, and it depends on the trustworthiness of the borrower. If the borrower is regarded as trustworthy, the price is high. But if the borrower is regarded as untrustworthy - say they have recently failed to honour a payment promise - the price is low.

Similarly, bank accounts are not "your money, stored". They are a loan to the bank. You give the bank your money in return for a promise of future income (interest payments), and possibly other services such as safe storage and payments. You don't have any right to return of that money: what you have is a promise that if you ask for it back, the bank will honour your request if it can. 

Risk of loss due to default is a intrinsic part of lending. When you lend money - whether by buying bonds, putting money in a bank account, or lending directly to someone - you accept the risk that the borrower will fail either to make the promised payments or return your money. Your judgement of someone's creditworthiness governs the amount you will charge them for this risk: the interest rate on an unsecured loan to someone with a good credit history is typically far lower than on a loan to someone with a recent history of payment default. A good credit history is a very valuable intangible asset for a borrower. Destruction of trustworthiness as a result of default amounts to a serious loss of net worth.

You may insure against risk of default by demanding that the borrower pledge some of their assets as surety: this of course what pawnbrokers do, but it is also the foundation of all property lending and most lending in financial markets. A mortgage is a loan on which the lender has the right to seize an associated asset (property) in the event of default. A repurchase agreement (repo) is a loan on which the lender has the right to seize a certain amount of securities in the event of default. Since the financial crisis, secured lending has become far more widespread due to loss of trust. The world runs on pawnbroking.

The problem with this, of course, is that the assets pledged as surety may fall in value, as we saw in the subprime crisis. When this happens, the risk of default may or may not rise, but the risk of losses in the event of default rises. Suddenly the loan or the bond is not worth as much. And insurance policies such as CDS aren't foolproof either: insurers can go bankrupt if there are too many claims, as AIG and the monoline insurers discovered. Nor is deposit insurance wholly trustworthy: Iceland legally defaulted on deposit insurance obligations to overseas customers of its banks. There is no such thing as a completely safe debt asset.

Nevertheless, the world's savings are largely held in the form of the world's debt, and people like to believe that their savings are safe. Because too high a debt burden increases the likelihood of default, many people - including the authors of the Geneva 16 report - think that governments should reduce sovereign debt. There are four principal ways of doing this:
  • by running persistent budget surpluses.
  • by reducing the real value of the debt through inflation
  • by reducing the debt/GDP ratio through higher growth.
  • by outright confiscation of savings (financial repression)
The authors dismiss the third of these as there is no evidence that higher growth can eliminate a persistent debt overhang. Historically, they note, the second (inflation) has most frequently been used to reduce post-war sovereign debt burdens, often in combination with the fourth (financial repression). The first is the preferred choice of governments such as Germany and the UK, but in practice running sustained budget surpluses is extraordinarily difficult to do and arguably pointless if the private sector is also highly indebted.

For a government to run a persistent budget surplus requires that it takes in tax more than it spends. In the absence of a trade surplus, this means extracting money from the domestic private sector, which understandably does not want to give it up.* Running a sustained budget surplus when there is a trade deficit amounts to financial repression. But even if there is a trade surplus, a government surplus means lower saving for the private sector than it might desire. The Geneva 16 report points to substantial debt overhangs in the private sector. When the private sector is highly indebted, saving can take the form of paying off debt. If the government runs a surplus, therefore, it impedes deleveraging in the private sector, and may even force some sectors (typically the poor) to increase debt. Reducing the sovereign debt not only reduces saving in the private sector, it comes at the price of continued and possibly rising indebtedness. The report rightly notes that transferring debt from the private to the public sector, as the US has done, isn't deleveraging. But transferring it back again isn't deleveraging either. And as transferring it back again is likely only to be possible with extensive sovereign guarantees (the UK's Help to Buy, for example), whose debt is it really, anyway?

Reports such as this, that look on debt as a problem and ignore the associated savings, fail to address the real issue. The fact is that households, corporations and governments like to have savings and are terrified of loss. Writing down the debt in which people invest their savings means that people must lose their savings. THIS is the real "shock, horror". This is what people fear when they worry about a catastrophic debt default. This is what the world went to great lengths to prevent in 2008. The problem is not the debt, it is the savings.
If we really wish to reduce the global debt pile, we must either accept that the households, corporations and governments that currently own that debt must take losses, or find alternative investment vehicles. The problem, of course, is that potential replacements are either illiquid (property), risky (equities) or volatile (commodities). 

I don't think that trying to find substitutes among existing asset classes in any way solves the problem of "too much debt". Debt is dysfunctional. It places debtors in a one-down position in relation to creditors and creates moral hazard for both - creditors because they can claim their due even at the price of severe hardship for the other, and debtors because they believe creditors will balk at enforcing the terms of the contract. This dilemma is centuries old: in The Merchant of Venice, Shylock's "pound of flesh" was his rightful due when Antonio defaulted on his loan, but enforcing that right would have killed Antonio and made Shylock a murderer. Shakespeare rightly lampooned such a destructive relationship, but four hundred years later nothing has fundamentally changed: we might not murder defaulters, but we certainly make their lives extremely difficult. We need a fundamentally different way of viewing the investments that households, corporations and governments make.

I think the world is inching its way towards a model that replaces most debt with equity. We have already seen debt for equity swaps in distressed banks. Perhaps we need debt for equity swaps for sovereigns, too. Why not replace USTs with shares in USA Inc.? Let's stop calling it "sovereign debt". It's share capital. It's our collective investment in our own futures.**

Debt for equity swaps are also possible for households that have both assets and debt - an over-mortgaged homeowner, for example. Though I wouldn't want to take this too far. Someone whose net worth is less than their debts cannot offer a debt for equity swap. They are insolvent, and their debt needs to be written off, not restructured. We do not want to see a return of debt peonage. But there are other shared-equity models that could replace current debt-based ones: imagine, for example, well-off elderly sponsoring the tertiary education of young people and mentoring them during their studies and in the early part of their careers. Or, for that matter, young people investing in the care of the elderly in return for a share in their housing wealth.

Clearly there are limits to the equity-savings model: there would still be a role for some debt, and some losses will have to be accepted. But equity is (pardon the pun) a far more equitable investment than debt, since issuers and investors are equally responsible for the success of the investment. Yes, an equity investment is ostensibly higher risk than lending: but haven't we yet learned that the safety of debt is an illusion?

Indeed, is it not time we stopped trying to buy the illusion of safety to comfort ourselves at the expense of others? There is a world of opportunity out there. Let's stop cowering in the dark, get out into the sunshine and sow the seeds of the next Golden Age.

Related reading:

Deleveraging, what deleveraging? - Geneva 16 (CEPR)
The deadly quest for safety
Government debt isn't what you think it is
On risk and safety
The other side of debt

* To show this, here is the familiar sectoral balances equation:

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

where S = private sector saving, I = private sector investment, G = government spending, T = tax revenues, X = exports and M = imports. S-I is usually positive because not all saving is invested in the private sector: the residual is private sector holdings of government debt and money ("net financial assets"). At the present time, the excess of S over I is considerable.

Let's assume for the moment that trade is balanced, i.e. X-M = 0. It is easy to see that if the government runs a surplus, i.e. G-T < 0, S-I must decrease. In other words, the private sector's overall saving must reduce. If X-M > 0, then clearly S-I may not actually reduce. However, even with a positive trade balance, the government's surplus means lower saving for the private sector than would have been the case with a deficit. Therefore it is fair to say that the government's surplus is confiscation of the private sector's actual or intended savings - i.e. financial repression.

** I have to caveat this proposal. Issuing share capital to replace debt is not a solution to the Eurozone crisis. Since sovereign share capital is really only a version of currency, members of the Eurozone do not have the capacity or the authority to issue shares to replace debt. But there is no federal-level institution that could or would do this either. The denial of the right of sovereigns to issue their own share capital is one of the most poisonous aspects of the Euro project.


Monday, 29 September 2014

George Osborne's message to UK business: Pay People More!

Though I'm not sure that's quite what he meant. And I don't think his audience understood it either. But it's the implication of his latest freeze on working-age benefits.......
"The UK's Conservative Party, like its Labour Party and most of the media, is obsessed with deficit and – ultimately – public debt reduction. Never mind dreadful productivity, falling real incomes, high private sector debt burdens, under-employment and inadequate investment: public sector borrowing is THE economic problem of our time. The deficit is TOO HIGH. Public spending MUST BE CUT. And George is the man to do it.

"Osborne informed the Conservative Party Conference that, if re-elected, he would freeze working-age benefits for two years. Assuming inflation remains positive, this means a real-terms cut in benefits not only for the unemployed, but also for those in work who are receiving a range of benefits including earned-income tax credits, housing benefit and child benefit. It's a further squeeze on real incomes for low- to middle-income earners. This went down very well with his predominantly grey-haired, well-heeled audience, the vast majority of whom would not be affected. Austerity is always popular when it affects somebody else......
Enter the hapless John Cridland of the CBI, who (unintentionally) lifted the lid on what this plan would mean for UK businesses. More than his job's worth to say so, though....

Read on at Forbes. Such fun.


The economics of Ed

Ah, but which Ed?

You'll have to read the post to find out.....it's at Pieria.

All I will say here is that whichever Ed it is, the economics are woeful.

Enjoy. (I did!)



(you don't really want to know who is responsible for these photos, do you?)

Saturday, 27 September 2014

Eastern European risks for Austrian banks

Austrian banks have developed extensive lending networks in Central and Eastern Europe since the fall of the Iron Curtain. Most of them face deteriorating loan books and falling profits due to difficult economic conditions in Central and Eastern Europe, exacerbated by the Ukraine crisis. But none is more exposed than Raffeisenbank....

Read about Raffeisenbank's Eastern European woes here. There's an update on Erste Bank's Hungarian problem, too.

Tuesday, 23 September 2014

Delinquent Banks: Barclays and UBS

By "Delinquent Banks", I mean banks that have been fined and/or prosecuted for regulatory breaches and financial crimes.

Today's Delinquent Banks are Barclays. They are is of course seasoned delinquents, having been fined numerous times for various crimes and regulatory misdemeanors. But then so are all banks of any size.

So what exactly have they done this time?

Read on here.

Financial Conduct Authority building, London. Photo credit: FCA

Monday, 22 September 2014

The Scottish independence saga

I've collected here all my posts in various places on Scotland's quest for independence and related issues. It's quite a story - not least because my own views changed during that time. To start with, I was personally uninvolved: I didn't care whether Scotland stayed or went (though I wanted Nat West back). But as time went on, I became more convinced by the emotional arguments for independence - and less convinced by the economic case. In the end, head ruled heart and I came out in favour of "No". But it's not over yet.....

Scotland's currency conundrum
I was one of the first people to look at the currency question in some detail, in January 2012.  I realised that the currency could not be considered in isolation from other matters such as EU membership and even what "independence" really means in our globally interconnected world. All of those are therefore discussed in this post.

Scotland and the Banks
After the UK political parties ruled out a currency union, I looked at Scotland's remaining alternatives and the consequences for the banks. It was clear that Scotland's banks would have to leave Scotland.
Of Course Scotland Can Use The (Scottish) Pound
In this piece I argued that Scotland should convert its existing Scottish pound into a new Scottish currency.

Is an Independent Scotland Economically Viable? An Exchange
My debate with James Meadway of NEF on the economics of Scottish independence. By this time the banks had announced their intention to re-register in England after independence. The economic case fell apart at that point - though in my view the banks were always going to do that, so the economic case was always fatally flawed.

Independence and Union
My angry piece about the behaviour of both sides of the campaign in the run-up to the vote. And my head versus heart dilemma.

Splitting the Bank
Alex Salmond claimed a share of the Bank of England's assets after independence, including its store of gilts due to QE purchases, apparently with the intention of writing off Scotland's share of UK debt against them. In this post I explained why this would be impossible. (Wonkish).

What Scotland Should Have Done (And Still Should Do)
In this post I explain why the economic case for Scottish independence didn't hang together, and what Scotland now needs to do to make independence possible at some time in the future. 

In three posts (so far), I have also considered the consequences for the United Kingdom of the Scottish vote.

In February 2014 I predicted that a "No" vote would have far-reaching consequences for the UK. 

What next for the United Kingdom?
The promises made by the No campaign to win Scottish votes are already causing the UK to drift towards fundamental constitutional change. 

The English question
Towards a new federal model for the UK.....the case for an English parliament.

This isn't over either. Not by any means. I will add more posts here as I write them.


And so it begins. Update, 10th May 2015. 

The SNP has thrown the Smith Commission report in the bin and demanded "full fiscal autonomy", or "full fiscal responsibility", or "devo-max", or whatever you want to call it. The IFS has produced figures showing that full fiscal autonomy for Scotland at the moment would have horrible effects on its fiscal position. And what about the Barnett formula? Alex Salmond has a way out of the condundrum, of course. 

Richard Murphy proposes that the Bank of England should monetise bonds issued by a UK government agency to support infrastructure, housing and green energy development in Scotland. By agreement with Westminster, of course. Which is now predominantly Conservative. Yes, that'll work, won't it?

It is not possible for Scotland to have "full" fiscal autonomy while it remains in the UK's currency union. Attempting to introduce it would reduce the UK to a miniature version of the Eurozone.

There will be more posts in due course.

Sunday, 21 September 2014

The English question

I've just been listening with increasing annoyance to Angela Eagle, deputy leader of the Labour Party, speaking on devolution. She wants to drive down devolution "to the regions and to our major cities". This would of course only apply to England. Scotland already has its own Parliament and Wales and Northern Ireland have Assemblies: further devolution would give these country-level governments more power to manage their own affairs. But if the Labour Party get their way, England will be denied this. England, the largest country in the "group of four" that is the United Kingdom, would be the only country with no government of its own.

England is not just a name, and it certainly isn't just a "collection of regions". I get a little tired of people (mostly Americans, or Celts with chips on their shoulders) telling me that England has no culture and no history except an inglorious one as a failed colonial power. England has well over a thousand years of history as a unified nation: it is one of the most ancient nations of Europe, far older than Germany or Italy. We were all taught at school how Alfred the Great, in the eighth century CE, unified the warring Saxon clans. And although England was subsequently divided after the invasion of the Danes, that split was short-lived and England was reunified even before the invasion of the Normans in 1066 and the establishment of the Plantagenet dynasty. There were some nasty civil wars after that - the standoff between Empress Matilda and King Stephen, and the Plantagenet family dispute known as the "Wars of the Roses". But these never challenged the existence of a country called "England". The argument was always over who should run it.

Yet now, it seems, the Labour party wants to eliminate England. This is understandable: as this map shows, England is overwhelmingly Conservative, and the Labour party would struggle to gain any presence at all in an English parliament:

(map h/t @MarcherLord)

 But the Conservatives have similar problems in Scotland and Wales: they struggle to win any Westminster seats in either country and are in a tiny minority in both the Scottish parliament and the Welsh assembly. Is this a reason for breaking these countries up? Surely not. Neither, therefore, are the Labour party's problems in England a reason to break up an ancient nation.

Calls for England to be regionalised along the lines of historic kingdoms such as Cornwall and Northumbria, or the old Saxon/Viking territories of Wessex, Mercia and so on, are understandable, as is the call for great cities such as London and Manchester to run their own affairs. I don't have a problem with any of this. Devolution to regional and city level WITHIN England is sensible, though it could go too far: regionalising the NHS, for example, would be bonkers, since it would be bound to result in very variable standards of care across the country - already the case to some extent because of the budgetary problems of some NHS Trusts.  But I don't see  regional/city devolution within England as an alternative to the creation of an English parliament. I see it as a decision that an English parliament should be empowered to make. Westminster's job is to create and empower the English parliament, not meddle with the governance of English regions. 

The main objection to an English parliament seems to be the dominance of England at Westminster. This is of course an existing problem, which would become even worse with further devolution to Scotland and Wales. Some people want England regionalised so that there is parity of population among areas represented in what is inevitably going to become a federal parliament. But this is absurd. Scotland has twice the population of Wales, and both have higher populations than Northern Ireland: is anyone suggesting these, too, should be broken up so that Northern Ireland is adequately represented? No, they are not. The integrity of all three of these national governments is to be preserved despite the population imbalances. So it should be with England, too.

It is not England that should be broken up to create a UK federal model of governance. It is Westminster. I think the UK should become a federation of four nations, each with their own elected government, with a separate directly elected federal government. Westminster must undergo radical surgery: the number of MPs must be slashed, and it must become properly representative of the people of the UK. Reforming Westminster would involve regionalisation of the whole UK - not just England - along similar lines to the EU parliament. But the principal of subsidiarity should also apply: Westminster's powers should be limited to those matters that the four countries agree are best handled at federal level.

But I fear the changes to Westminster that this would involve are so great that political vested interests will ensure it never happens. The Labour party's stance is determined only by its worries about losing the 2015 election, while the Conservatives are clearly seeing the "English question" as an opportunity to shaft Labour and get back at the SNP. It's shabby, frankly.

The people of the UK deserve better. We need a proper debate about how we wish to be governed, rather than a package of ill-thought-out measures rushed through ahead of a general election.

Wednesday, 17 September 2014

Splitting the Bank

Faisal Islam reports that Alex Salmond has demanded “Scotland's share” of the assets of the Bank of England, namely its gold, FX reserves and its holdings of UK debt built up through two rounds of QE:
Salmond didn't mention the liabilities, which is unfortunate since if you take a share of an institution you must take both the assets and the liabilities. The liabilities of the Bank of England are the monetary base of the United Kingdom – sterling notes & coins and sterling bank reserves.

There is a very good reason why Salmond didn't mention the liabilities. He wants to use Scotland's share of the Bank of England's assets to write off Scotland's share of UK debt, leaving Scotland with a debt-free balance sheet at independence:
Neil Wilson, in a good though flawed post, explains how this would work:
On a population proportion of 8.38%, Scotland owns/owes £186bn of HM Treasury's balance sheet, and so the question is how best to deal with that.
The TL;DR version is that £186bn of the shortest dated Gilts from the Asset Purchase Facility are uplifted to HM Treasury and written out there - reducing both the Gilts outstanding and the Taxpayer Equity figure by £186bn and creating an asset adjustment at the Bank of England.
That then settles the Scottish share of the UK National Debt, and the Scottish claim over the Bank of England in one neat accounting journal. Scotland's government owes nothing in GBP, and the UK has no outside entity with any claim over its central bank.
I should explain that the Asset Purchase Facility is the off-balance sheet vehicle actually used for QE purchases. It is a wholly-owned subsidiary of the Bank of England, so any adjustments to its balance sheet will consolidate into the balance sheet of the Bank of England. Wilson has a neat chart, which I've borrowed to show here:

What Wilson is suggesting is that £186bn of the gilts at the APF, representing Scotland's share of the UK national debt, should be written off. If this were done as a balance sheet writeoff, that would mean an immediate reduction in the sterling monetary base of £186bn, wiping out nearly half of the QE expansion at a stroke. As the monetary base is made up mainly of bank reserves, it would be bank balance sheets that took the hit. Done in this way, the price of writing off Scotland's debt would be either instant insolvency for the UK's banks or an undignified scrabble for whatever gilts remained in circulation. Clearly this is a non-starter (though it would reduce gilt yields to something nicely negative).

But that isn't what Wilson is suggesting. What he has done is rather cleverer. In his model, the gilts are written off against something called “Taxpayers' Equity” on HM Treasury's books, which is actually expected future tax revenues (and therefore sits on the asset side of the balance sheet). The monetary base remains untouched. In effect he has written off part of the asset side of the Bank of England's balance sheet, rendering it technically insolvent, then recapitalised it with an asset transfer from HM Treasury's balance sheet. 

Writing off QE gilts in this way would mean that nearly half of the QE expansion of monetary base could not be unwound through normal open market operations, since it would no longer have tradeable assets backing it. In effect, the UK would have monetised Scotland's share of its debt.

The trouble is, this makes Wilson's proposal legally impossible. The UK is a signatory to the Lisbon Treaty which forbids monetisation of government debt. Scotland would not have monetised anything, since it would simply have written off gilts on both sides of its balance sheet with no monetary expansion involved. But the UK would have broken Article 123.

Monetising Scotland's share of the UK debt also raises serious questions regarding the conduct of UK monetary and fiscal policy post-independence. In the integrated central bank/government model that Wilson uses, tax revenues sterilise monetary expansion (government spending): government spends money into the economy, and money is recycled back to government in the form of taxes. The sale or loan of gilts to the private sector by the Bank of England acts like a windfall tax, since it drains money from the private sector: this is how normal monetary operations work. In the absence of gilts to sell or lend back into the market (open market operations), the only way of draining reserves would be to raise taxes: this might be dressed up as interest rate rises (to preserve the fiction of central bank independence), but it would amount to the same thing. 

Wilson concludes that because “Taxpayers' equity” is the net savings of the private sector, there would be no cost to the UK taxpayer from monetising Scotland's debt. If the monetary base expansion were both permanent and non-inflationary, this would be true. But books have to balance. Considering the central bank and government as an integrated unit, if the monetary base (liability) shrinks, so must taxpayers' equity (asset). QE was only ever supposed to be a temporary expansion of the monetary base: at some point, the plan is to unwind it. If half the gilts purchased under QE were written off in settlement of Scotland's share of UK debt, unwinding QE would inevitably mean tax increases (or equivalent interest rate rises) – which would fall wholly on the reduced UK population, since post-independence Scotland's population is not going to contribute taxes to HM Government.

Salmond would no doubt argue that as Scotland intends to continue to use sterling, there would be no need to reduce the monetary base to reflect the smaller size of the UK economy. But as the only fiscal backing for the UK's monetary base comes from the UK government, the Bank of England would be irresponsible if it considered Scotland's needs when determining an appropriate size for the monetary base post-independence. The size of the monetary base should be appropriate to the size of the UK economy: it would not be unreasonable for the Bank of England to conclude that it must shrink. To be sure, there are other gilts that could be sold to drain the reserves: this model wipes out less than half of the Bank of England's holding. But it would make it impossible to return to pre-2008 monetary policy in the long run without somehow obtaining higher tax revenues.

Of course none of this would be remotely appropriate in Salmond's preferred option, a currency union. If the UK were to enter into a currency union with an independent Scotland, HM Treasury would issue Scotland with shares in the Bank of England. If Scotland repudiated them in favour of its share of Bank of England assets, it would de facto have rejected the currency union. It cannot have both a currency union AND a share of Bank of England assets. Currency union means sharing the institution, not stripping its assets.

And I'm not convinced that using the gilts at the Bank of England to write down Scotland's share of debt is sensible anyway. After independence Scotland would be cut off from Bank of England currency issuance. If it continued to use sterling without a currency union or used its own currency backed by sterling it would need substantial sterling reserves. Scotland would do better to keep the gilts as sterling reserves - they wouldn't be enough, but they would be better than nothing.

Alternatively, Scotland could claim the value of its share of the Bank of England's assets in the form of physical cash, in which case we would presumably give them Giants and Titans to the value of their claim on Bank of England assets. The accounting for this would be different from Wilson's model, of course: since the Bank of England is the issuer, these would remain on the Bank of England's balance sheet as a liability, and the gilt holdings would be untouched. 

But in fact Scotland cannot eliminate its share of UK debt by writing it down against the value of its share of Bank of England assets anyway. The market value of Scotland's share of the assets of the Bank of England is less than the market value of its share of UK debt. Wilson assumes that Scotland's debt would be entirely monetised from Bank of England holdings of gilts. But this is a larger share of the Bank of England's assets than Scotland should have, whether judged on population or GDP. If a “fair share” of Bank of England gilt holdings were written down against Scotland's share of national debt, there would still be debt left over. I fail to see why the UK should monetise the whole of Scotland's debt simply because the Bank of England is wholly owned by HM Treasury.

And all of this will be immaterial if the Scots vote “No”, anyway. For a few years, at least. 

Related reading:

Salmond's QE grab - Long & Variable (good post by Tony Yates)

Tuesday, 16 September 2014

Independence and union

I have been very reluctant to write more about the Scottish independence question. Earlier this year I wrote a couple of pieces about the currency question, and one about the implications for the rest of the UK. But since then I have become very aware of how painful this is for many people, including me. This piece is not easy for me to write: I have strong personal and family ties to Scotland, and have always seen my Scottish friends as part of my British "family". My own identity is more British than English, and I am deeply hurt by people who say "the United Kingdom is not a country" or "there is no such thing as British". That may be how they feel, but it is not how I see myself. For me, I am British first.

I am also concerned that anything I write now would be inevitably seen as taking a political stance. The economics of what is being called "independence" are horrible, at least in the short term: but if I write a piece explaining that, it will be seen as "anti-independent" and feed into the SNP's "Project Fear" rhetoric. But nor do I want to contribute to Yes campaign euphoria. The economics are horrible for the people of Scotland. They are not being told the truth.

I do not like the way in which the facts are being skewed, changed or omitted to suit the political stance. And I should emphasise that BOTH sides are guilty of this.

There have been actual lies from the SNP, such as Salmond's false claim that a Scottish government would be unable to prevent the Scottish NHS suffering spending cuts if Scotland remained in the union. The Scottish government already has full control of SNHS spending, so any cuts would be its own decision, Nor does the argument that SNHS spending would have to be cut due to reductions in the Barnett formula stack up: Scotland's receipts under the Barnett formula have actually risen by 3% under the Coalition government and it now receives more in fiscal support than any other region of the UK.

The SNP has also made many claims that cannot be substantiated. It continues to state that Scotland would remain part of the EU, despite clear statements from EU member states and officials that Scotland would have to apply for membership and meet Maastricht criteria. It also continues to insist that the UK government will eventually agree to a currency union which would be highly detrimental to both sides and probably would not survive anyway. And the SNP conceals important facts, such as that leaving the UK could mean temporarily losing EU support for Scottish farmers. .

Telling the Scottish people things that are untrue, making claims that have been rejected by the other parties concerned and concealing facts is unfair. The people of Scotland cannot make an informed decision if they are not being told the truth about what leaving the UK would mean. I call upon the SNP to come clean about what leaving the UK would mean for Scotland in the first few years. There would be a deep recession, possibly a currency crisis, and a substantial loss of capital and trade. It would be grim.

But in its way the approach taken by Better Together is more poisonous. Better Together's approach has been to paint a completely negative picture of an independent Scotland in order to frighten people into voting "No". This is just wrong. Scotland is perfectly capable of surviving as an independent country. It would suffer serious hardship for some years, but independence would enable it to rebalance its economy away from risky financial services and declining oil, and become a well-diversified, successful market economy. I have no doubt that the determination of the Scots, and their ability to endure difficulties for the sake of the future, would enable them to do this. They have every right to manage their own affairs and are more than capable of doing so.

And that brings me to the real problem at the heart of this debate. When I looked at the ballot paper for the vote on Thursday, I was surprised by the wording:

"Should Scotland be an independent country?"

My immediate response was "Yes of course it should!". Why would anyone want to be a citizen of a country that was not independent? If this were a vote about English independence, I would be very tempted to vote Yes and damn the economics. But that would cause me a problem. I said at the start of this post that I am British first, English second. Why should my desire to see England independent mean that I have to give up my British identity? Similarly, for those Scots who also see themselves as British - and there are many of them - why should they have to give up part of their identity in order to achieve independence for Scotland?

This is the dilemma that has been created for Scots by the way in which this vote has been framed. It was reiterated by David Cameron yesterday: he said Scotland has to decide whether it wants to remain in the union.  But that is not the question the Scots are being asked! Scots are being asked whether Scotland should be independent, not whether it should leave the Union. Independence and membership of a successful supranational union are not mutually exclusive.

The SNP leadership do seem to grasp this, which is more than can be said for Better Together. But they explain it extraordinarily badly. They call for "a share" of UK institutions and insist that there must continue to be a currency union. This won't do: all it does is annoy the other side, who then close ranks and refuse to co-operate at all. It would be far better if the SNP explained clearly that although they want Scotland to be an independent country they do not wish to leave the Union: they want to reinterpret the Union in a way that works for them. They want, in short, to be treated as equals. Welsh nationalists have much in common with this view. And so do I.

I would like to see the UK recognise its constituent parts as independent countries in their own right, united in a federal model. I would like to see the anomalies of the Westminster system, such as the West Lothian question, resolved once and for all by creating a system of governance for the United Kingdom that truly recognises that its citizens really have dual nationality - they are British, but they are also Scottish, English, Welsh and Northern Irish.

I wouldn't like anyone to interpret this piece as endorsing a "Yes" vote. I fear that the intransigence of the UK side is such that a "Yes" vote would indeed mean, as Cameron put it, a "messy divorce" - a divorce which, as far as I can see, neither side really wants. I actually have a problem with both "Yes" and "No" votes: "Yes" because it could result in a costly and unnecessary breakup, and "No" because it could entrench existing governance and lead to an even more painful separation further down the road.

We do not have to sleepwalk into this. Both sides must change their stance before it is too late.

I called above for the SNP to come clean about the costs of this potential divorce for the people of Scotland. Now I call upon the Better Together side to state plainly that a "No" vote would not be a vote for the status quo but would be followed by real changes to the way the Union is constituted, recognising the legitimate demands of the constituent countries of the UK for self-determination and self-government.

Sunday, 14 September 2014

The Co-Op story: a tale of two banks

Over at Pieria, I've posted the text and some of the images from the presentation I gave at the UK Society of Co-operatives conference on September 7th 2014 at the University of Essex. It's the full story of the decline and fall of the Co-Op Bank. Well, not just the Co-Op Bank.....we often forget that there were two banks involved in the Co-Op disaster. One of them was a mutual, but perhaps not the one that you might expect.

The post can be found here.

Monday, 8 September 2014

United Queendom

Oh, this is fun. Bob Denham of EconFilms has turned the economics of Scottish independence (and, let's be honest, the politics too) into what he describes as a "romantic comedy". Cue Rachmaninoff, please...

The mini-series ‘United Queendom’ tells the story of a gay couple on the verge of separation. The couple argue over oils (for the bath), who controls the credit card, membership of ‘The Club’ and whether they should aspire to be like their neighbour, the Scandinavian Model.

With 10 days to go to the referendum and polls showing it will go to the wire, the series is an attempt to get more people engaged in the debate – particularly those who can’t vote but are affected, such as people in the rest of the UK.

Here's what Bob has to say about it:
‘The more people can relate to the debate, the better – and nowhere is that more true than on the economics of a possible break up.’  
He adds:
‘This series is universal. I want everyone in the world to be able to watch and take part.'
I should add that this is not the first time Bob has lampooned a Very Serious Subject. His last online comedy: 'A Very European Break Up' on the European debt crisis has received over 300,000 views and featured in national and international press in countries such as Germany, Greece, the Netherlands and Spain.

The trailer for 'United Queendom' can be found here:

If you'd rather jump in at the deep end, the whole mini-series is here

Enjoy. (I did...)

Thursday, 4 September 2014

Don't pin all your hopes on SME asset-backed securities

Here's a neat chart from JP Morgan (h/t @debtnerd)

(larger version here)

What it says, essentially, is that although the total amount of Euro SME loans currently in issue looks sizeable, by the time you have removed all the loans that would be ineligible for securitisation and purchase by the ECB for one reason or another, there is not much left. Securitising and purchasing 10.3bn Euros worth of SME loans is not going to make a great deal of difference to the distressed periphery.

So the idea must be that the presence of the ECB in the SME ABS market would spur loan issuance. To make a significant difference to credit conditions in the periphery and repair the broken monetary policy transmission mechanism, that loan issuance would have to be simply huge and concentrated in periphery countries. There are several problems with this, to my mind.

Firstly,it makes a huge assumption about the scale of potential demand for credit in the periphery from creditworthy SMEs. Is discouraged demand really that huge - or is there actually a problem with the creditworthiness of potential borrowers, because of the widespread destruction of physical and human capital in the periphery? Distressed corporate loans in the periphery are far higher than in the core. That's why spreads are so high. Why would an SME ABS programme improve the creditworthiness of borrowers?

If the underlying problem is borrower creditworthiness, then it is difficult to see how the SME ABS programme could generate the huge additional loan issuance required to kickstart growth, even with ECB purchases. Unless.....we saw in the US that demand for ABS could encourage lenders with no "skin in the game" to reduce lending standards and even indulge in outright fraud to increase the volume of loans for securitisation. Although the ECB says it is planning to limit purchases to the highest quality SME loans, how would it ensure that this was the case in practice, especially if there turned out to be not very many high-quality SME borrowers in the periphery? I'm sure Blackrock, which is advising the ECB on the design of this scheme, won't have forgotten about the problems in the US - but is it familiar enough with the very different European marketplace to avoid creating opportunities for fraud and sharp practice?

It's also worth remembering that mortgage-backed securities in the US were first created by the GSEs (the first was issued by Ginnie Mae) and were originally designed to be packages of prime mortgages only. Including subprime in the mix was a later development intended to raise returns on junior tranches. If the Eurozone's SME ABS are to be tranched, presumably the ECB would only buy senior tranches - in which wouldn't there potentially be a similar temptation to include poorer-quality loans in the mix to improve the returns to private sector investors?

And what about the regulators? The Eurozone does not have full banking union: supervision particularly of smaller lenders remains at national level. One of the problems in the US was the fragmentation of the regulatory infrastructure - and a fragmented regulatory infrastructure is exactly what there is in the Eurozone, too. National regulators could be under pressure to cut corners from governments anxious to kickstart growth, and from lenders and securitisers anxious to prove they are doing their bit (and improving profitability). Tight regulations are useless if the institutions are too weak or too captive to enforce them. The flawed institutional design of the Eurozone is itself a serious risk to this programme.

So as far as I can see, the SME ABS programme is either going to be too small to make much difference, or is likely to encounter serious problems with loan quality at some point, putting the ECB's balance sheet at risk. I'm particularly worried by the way in which SME ABS purchases by the ECB is being promoted in some quarters as the primary means of "fixing" the periphery (though Draghi himself does not make this mistake). If only we can get credit flowing to periphery SMEs, the thinking goes, all our troubles will be over. This is simply not true. SME ABS purchases cannot substitute for flawed institutions and inadequate fiscal and monetary support. And even more importantly, they cannot compensate for a lack of creditworthy borrowers.

Central support for hard-pressed SMEs in the periphery would probably help to repair those economies. But the ABS issuance and purchase programme alone will not be enough. In the absence of other measures, reliance on such a programme would simply create moral hazard for lenders, securitisers and regulators.

Without German support, QE in the Eurozone remains a distant dream

Q. What further monetary easing measures do I expect the ECB to announce?

A. Maybe a few basis points off interest rates.

Q. Will they announce QE?

A. No.

Q. Why not?

A. Because the ECB needs the Germans to co-operate, and at the moment they aren't co-operating.

There's a fuller explanation at Forbes here.

And the deeper story behind Draghi's Jackson Hole speech at Pieria here.


Wednesday, 3 September 2014

Draghi's Jackson Hole speech has been misunderstood.

At Pieria, I dissect what Draghi actually said at Jackson Hole on 22nd August, and conclude that he has not called for short-term monetary and fiscal stimulus to kickstart growth, as some have argued:
"Some analysts have claimed that this speech was Draghi's “Abenomics” moment. Nouriel Roubini argues that Draghi has outlined a similar “three arrows” approach:
  • structural reforms in periphery countries
  • fiscal easing focused on investment and on demand stimulus in the core
  • quantitative and credit easing
But Roubini, like others, ignores the context of this speech. It is not fundamentally about restoring growth in the short term. Nor is it about the balance of monetary and fiscal policy, or about the responsibilities of core versus periphery. In fact it is not about short-run economic policy at all. It is about unemployment."
Specifically, it's about cyclical unemployment becoming structural, and the prospect of permanently elevated unemployment, a lower participation rate and lower trend growth. A whole generation thrown on the scrap heap.....

Draghi's proposals for addressing this are radical. Read more here.

Monday, 1 September 2014

Fiscal pessimism

At Pieria, I discuss the inadequacy of monetary policy and the implications of the Fiscal Theory of the Price Level for the conduct of government policy. There needs to be a greater role for fiscal policy, and an end to the fear of debt and inflation that is preventing governments from taking the actions required to restore growth. But this means reversing the prevailing direction of economic thought for the last 30 years:
"In the present situation - what Sims calls “fiscal pessimism” - FTPL predicts disinflation. Fiscal pessimism means that people look with horror at rising government debt burdens and future fiscal commitments such as those arising from an ageing population, and think “how on earth are we going to afford this”? They expect much higher taxes in the future and/or serious cuts to spending programmes. If this is also combined with very low interest rates, so they make little or nothing on their growing holdings of government debt, they feel poorer even though their nominal wealth is actually increasing. They may therefore cut discretionary spending and increase precautionary saving in compensation, causing a disinflationary trend....
"It is all very well observing that hope seems to have departed and people appear to have resigned themselves to a depressing, and depressed, future. But why are people so pessimistic? What – or who - has convinced people that government debt levels are unsustainable and there is significant pain to come? In a word, economists."
Read the whole post here.

This is the second of several posts at Pieria covering topics discussed at the recent Lindau Meeting for Economic Sciences. The first post can be found here