Monday, 28 September 2015

Investment is needed everywhere


And particularly in Europe, as this chart shows:


The ratings agency Standard & Poors has called for governments everywhere to increase investment spending. It also says they need to improve the efficiency of the spending they are already doing. 
Private sector investment spending all over the world fell after the 2008 financial crisis. In Europe, where the crisis started earlier, it started falling in 2007. And it has not recovered. Private sector investors remain risk-averse and fearful of losses, chasing safe havens and unwilling to invest long-term in infrastructure, skills and R&D.

When the private sector will not invest, the job falls to government. And immediately after the financial crisis, governments did step up, increasing investment spending as private sector investment fell. Some governments have continued to invest ever since, notably China, which still spends about 8.5% of GDP every year (much of it outside its borders), and India, which is spending about 4.7%. But most governments have cut back investment spending in order to consolidate their budgets. The result is a widespread investment chill that is depressing growth and keeping unemployment elevated in far too many countries......
Read on here.

Related reading:

Making the case for public investment

Sunday, 27 September 2015

The Great Yield Divergence

When a former Bank of England deputy governor gives a presentation entitled "Are Low Interest Rates Natural?" to a extraordinarily high-powered audience of academics and monetary policymakers, you can bet he will come up with some great charts. Charlie Bean's historical analysis of long-term real and nominal yields in the UK is amazing:


It is very evident that for most of the last 200 years, nominal and real consol yields have been pretty much pinned together. Charlie said that the gold standard prevented rates deviating by keeping the price level under control. But I am unconvinced by this.

Firstly, let's look at the historical record. In 1717, Isaac Newton, then Master of the Mint, changed from defining the value of the pound in silver as had traditionally been the case to defining it in gold. At that time, most banknotes were issued by commercial banks: the Bank of England issued notes in return for deposits, but for high denominations only and the amounts were variable. After the Bank Charter Act of 1844, which ended the issuance of banknotes by commercial banks in England and Wales (though not in Scotland or Northern Ireland), the Bank of England gradually moved to issuing notes for fixed amounts and lower denominations. But for much of the century, banknotes were issued in high denominations only and were not widely used, except in Scotland where a £1 note was popular (as it still is today). Most people used coins for everyday transactions, principally small-denomination silver coins. For all practical purposes, therefore, what Britain actually had during this time was bimetallism, rather than a gold standard as we would understand it now.

But no matter. War destroys gold standards, whether bimetallic or paper. Even though the gold standard only really applied to high-denomination bank notes, not the common currency used by the people of Britain, when Britain went to war with France in 1793, gold convertibility came under increased pressure as investors retreated into outright holdings of gold. The Bank of England eventually suspended gold convertibility in 1797 after a series of runs on the Bank threatened to drain its gold reserves. Convertibility was not restored until 1816 after the ending of hostilities with France.

And yet the fact that gold convertibility was abandoned for nearly twenty years barely creates a ripple on Charlie Bean's chart. Both nominal and real rates rose, but in parallel with each other.

It also isn't the case that prices were under control during this period. Inflation was very high - in 1800 it touched 36% - and volatile:


And the price level rose during this period:

(both charts from the Bank of England)

Price level rises are common during and after wars because of supply-side destruction coupled with very high government spending: the price level rise during and after World War I is also very evident on this chart. The price level rise is sufficient to explain rising yields during the French Wars. But it doesn't explain why real and nominal yields didn't diverge during a period of high inflation and suspended gold convertibility. There must have been some strong nominal anchor keeping them pinned together. It certainly wasn't inflation targeting. Anyone hazard a guess as to what it was? I reckon it was a fixed exchange rate, but I could be wrong.

But the real story on this chart is, of course, the Great Divergence of real and nominal yields. Ever since the Great Depression, nominal yields have been persistently above real yields, often by a substantial margin. Even during Bretton Woods, a period of relative financial stability (and a quasi-gold standard), nominal yields were somewhat above real yields. Yet in the previous 200 years, despite periods of fiat currency and high inflation, real and nominal yields didn't diverge. Why do they now?

This is not just an idle question. The yield on consols (interest-bearing government perpetuals) is a proxy for the risk-free rate of interest. If nominal yields are persistently above real yields even in the absence of significant inflation, then something is massively askew in the pricing of risk-free assets. Today, inflation is hovering around zero, but Charlie's chart shows us that nominal yields are about two percentage points above real yields. I thought the post-crisis period was supposed to have euthanised rentiers? This chart suggests that they are doing better than ever.

Perhaps what this divergence tells us is that our expectations of future returns are persistently skewed to the upside. We therefore undervalue safe assets (hence high nominal yields) and overvalue risky ones. As Andy Harless says, safety is a scarce and valuable asset. Arguably, it should be a lot more expensive than it is. Perhaps we don't really think it is necessary - or we don't really think these assets are safe.

But why did everything change in the Depression? I don't buy the gold standard argument. Rather, I think that the cataclysmic shocks of the 20th century have weirdly distorted our view of financial reality. The fact is that a significant proportion of the human race now expect to receive returns on financial assets that are far removed from the real ability of the economy to generate them. I don't know why this is, but in my view we should be looking at things like labour market dynamics, longevity and pension expectations.

And we need to look at them as a matter of urgency. Such divergence between nominal and real rates suggests that there is a continual drain of resources from workers to rentiers, from young to old and from poor to rich. This shows itself as rising indebtedness among the young and poor, and increasing fragility of the global financial system. It cannot possibly be sustainable.

In his presentation, Charlie Bean reviewed an array of measures that might give central banks more control of nominal rates at the zero lower bound,such as raising the inflation target, negative rates and eliminating or charging interest on cash. But he concluded:

"It would be better to find ways of raising the natural rate through structural and fiscal policies."

Indeed, somehow we have to bring nominal and real rates back together. Ideally this would be through raising the natural rate. But I suspect the post-Depression natural (real) rate is lower than we would like it to be, and it's just taken us best part of a century to understand this. If so, then this is not simply a matter of getting fiscal and structural policies right. It raises serious questions about the ordering of society. After all, a large number of people depend on there being significantly positive real returns on essentially risk-free assets. If significantly positive real returns on risk-free assets are a thing of the past, we owe it to those people to stop pretending we can restore their lost returns through "confidence-boosting fiscal adjustment" and "growth-friendly structural reforms". They simply aren't going to be able to live comfortably in their old age on the interest on risk-free savings.

The truth is we do not know when, or if, positive real returns on risk-free assets will return. If the future path for growth in future is low to zero, then they may never return. If this is the case, then the solution to the "Great Divergence" must be for nominal risk-free rates to drop. Permanently.


Related reading: 

Weird is normal - Pieria
No, you can't have your risk-free returns back - Tomas Hirst, FT Alphaville








Thursday, 24 September 2015

Oh dear, Volkswagen.....

That cliff edge feeling.....


Yes, that's Volkswagen's share price. I was amused by the UBS advert. And just to rub salt in the wound, here is Carole King:


Anyway, Volkswagen is in deep, deep brown stuff. Here are links to my posts so far on this. I will add more as I write them.

1. The Car Manufacturers' Libor Scandal. Rigging emission tests will prove extremely expensive for Volkswagen. But I doubt if VW is the only vehicle manufacturer guilty of nefarious practices. I reckon it's an industry-wide disease not unlike the benchmark rate rigging scandals in banking.

2. Volkswagen's CEO has resigned, but that doesn't solve its problems. Volkswagen is too big too manage. Actually most global corporations are. And their CEOs are far too keen on avoiding blame. Not many do the decent thing and resign promptly, as VW's Winterkorn did. But was he told to by the Executive Committee?


Wednesday, 23 September 2015

GDP transactions in secondary markets



There is a widespread view that much bank lending is unproductive, i.e. does not raise GDP – or if it does, it does so in an unsustainable way by inflating asset prices or increasing inflation, rather than by increasing production.  Many proposals for bank reform therefore envisage restricting banks to “productive” lending, by which usually seems to be meant business finance and short-term consumer credit. Financial transactions on secondary markets, and the purchase of second-hand property, are regarded as unproductive.

This appears attractive. Banks do indeed lend far more for property purchase than they do for business finance, and most of the properties purchased are second-hand. So, the thinking goes, if we could eliminate unproductive housing finance, banks would lend more to businesses, and that would mean higher GDP in the longer term.

But I’m afraid there is a serious fallacy here. Lending for secondary market purchases does contribute to GDP, and not just in unhealthy asset price inflation. Without secondary markets, primary markets are diminished, and – by extension – so is GDP.

Here is an example. Suppose I buy a brand-new house off plan. Clearly, the building of my new house employs a significant number of people in various trades, who collectively create a “product” – a house - so my purchase is a GDP transaction. The bank that lends me the money to buy my house has therefore lent productively. Few in the UK would disagree with this. But in Spain or Ireland they might see things differently: after all, building houses there became a wholly unproductive activity prior to 2008.

But suppose I buy a listed building with no roof, rotten floors, shattered windows and holes in the walls, which I then restore for subsequent sale?  For the restoration, I employ a significant number of people in various trades, who collectively create a “product” – a refurbished house – that can be sold for a much higher price than the original dilapidated shell. Clearly, this contributes to GDP. It also brings into use a house that previously was not suitable for habitation. Please tell me why the borrowing to finance this should be regarded as “unproductive” when the borrowing to buy a brand-new house is not?

Perhaps, though, this is too obvious an example. Suppose I buy a house owned by an elderly lady who has lived there for 50 years. The house is not in poor condition, but the décor is not to my taste and it needs modernisation. I could do it up gradually, paying for improvements entirely from earned income. But I choose to front-load the upgrade by taking out a Home Improvement Loan. This is consumer credit that I would not have taken out if I had not bought the house. Because I borrow to do up the house, I provide employment to assorted tradesmen, revenue to the suppliers of kitchen & bathroom equipment and income to the staff on the tills at B&Q. And when I have finished decorating, I buy new carpets and furnishings, probably also on consumer credit. None of this would have happened if I had not bought the house. So although buying a house in good condition on the secondary market does not itself contribute to GDP, since the house was built long before I was born, the things I do after buying it to make it a place I like to live in do contribute to GDP. Is financing a secondary market house purchase of this type “unproductive”? I don’t think so.

In fact most people purchasing second-hand houses decorate and refurnish them, and most do so using consumer credit. The second-hand housing market gives considerable impetus to GDP through these consequential transactions.

And there is another side to this. What happens to the money I pay to buy the house?

In my first example, I pay a deposit up front, and my final payment when the house is completed and all snags resolved. The money goes to the builder, who pays down the loan he has taken out to fund the building of the house. So the money I borrow simply refinances the builder’s loan. Is this a contribution to GDP? No. It is the original builder’s loan that contributes to GDP. My subsequent mortgage does not, directly – though without people like me borrowing to buy houses, builders would quickly default on their loans, as Ireland’s banks discovered.

In my second example, I pay for the shell house up-front. The person I buy the shell from, hugely relieved to have got rid of the unproductive millstone round his neck, splashes out some of the money on a much-needed holiday in the Seychelles, and uses the rest to buy a brand new top-of-the range BMW. Does this contribute to GDP? Clearly yes, though the holiday mostly contributes to the GDP of the Seychelles and the BMW to the GDP of Germany. So my shell purchase is productive in more ways than one.

In my third example, the elderly lady is going into residential care, and the money raised from the sale of her house will go towards paying for her care. The sale of her house therefore funds employment in the care sector, which contributes to GDP.

But even if my elderly lady were only buying a retirement flat, the transaction would still contribute to GDP, since my house is worth more than her retirement flat and she can use the difference to top-up her consumption spending.

So secondary market purchases of property DO contribute to GDP, in lots of ways. In fact the refurbishment example is the most GDP-enhancing of these purchases, and the elderly lady example is arguably the most socially useful. Surely the lending to finance these should be regarded as "productive"?

All secondary market transactions are potentially GDP enhancing. This is because of their “pull” effect on primary markets. For example, consider someone who owns a 5-year-old BMW. He wants to buy a brand new car, but he needs to sell his current one in order to afford a new one. So he trades in his car. If there were no secondary market for cars he would be unable to do this: he would drive his BMW until it fell apart, rather than buying a new one every 5 years. True, car manufacturers might respond by cutting the prices of new cars to entice purchases, and they might run a scrappage scheme for cars older than 5 years: but could this really be called “productive”?

As a general rule, when there is no secondary market for long-dated assets, the issue of new assets in that class is limited by the availability of new entrants to the market and the expiry of existing assets. Secondary markets are essential to maintain liquidity: restricting finance for secondary markets actually diminishes, rather than increasing, primary market activity.

So the idea that secondary market purchases are “unproductive” is thus incorrect on many counts. Restricting finance for secondary market purchases, whether cars, houses or financial assets, puts downwards pressure on GDP.

Related reading:

Ann Pettifor, there will be no shortage of money - Positive Money
Quantitative Easing and the Quantity Theory of Credit - Richard Werner
Co-op community marks 30 years of building a better life - Co-Op News

This post was prompted by a discussion on Twitter about what "lending for GDP transactions" really means in practice. It first  appeared as a guest post at RWER


Tuesday, 22 September 2015

The Car Manufacturers' Libor Scandal

We have become used to tales of banks breaking rules, evading regulation, rigging rates and being fined eye-watering amounts of money when caught. But now their ranks have been joined by an automobile manufacturer. The German giant Volkswagen has been caught rigging the results of emission tests on diesel automobiles. 
The emission tests are designed to ensure that new automobiles meet stringent anti-pollution requirements. America’s love affair with automobiles means that air quality can be a problem, particularly in cities. The Environmental Protection Agency therefore places limits on the toxic emissions of automobiles to prevent air quality deteriorating to the point where it threatens human health and the environment. 
But this depends on automobile manufacturers cooperating. And Volkswagen, the largest seller of diesel automobiles in the US, decided that emissions regulations could be optional for its products.....
Read on here (Forbes).

Polemic Paine came to similar conclusions (and even a similar title). And he adds a dimension that I hadn't thought of:
To be honest I don’t care too much if my car burps out more NO2 than declared in a test as long as I am street legal and the low running costs I am enjoying don’t change. But the tax man certainly does. I may decide not to buy a car if it jumps up a car tax band due to emissions but if the taxman has been defrauded out of billions due to cars being declared at a different tax band to where they actually lie then that is as good as fiddling your tax returns. The pollution issue is minor compared to what happens when you defraud a tax authority and this is where people go directly to jail.
"Made in Germany" lies in the gutter, according to the Telegraph:
VW's conspiracy to rig emissions exposes it as the 'Lance Armstrong' of the car industry, once again revealing corrupt reflexes in German boardrooms.
Not that this is likely to be limited to German companies. The fallout could be substantial for car manufacturers in many countries. As Polemic says, now is not a good time to be a large corporation.




Sunday, 20 September 2015

An unjustified rating

Anti-austerity demonstrators in Helsinki, Finland

The ratings agency Fitch has affirmed the AAA rating on Finland's sovereign debt. But on reading Fitch's analysis, the justification for this is very hard to see.

Finland's economic situation is, to say the least, dire.  This is what Fitch has to say about it:
The Finnish economy is adjusting to sector-specific shocks in key industries (electronics, communications and forestry), is already experiencing the impact of an ageing population through a declining labour force, and is exposed to the weakness of Russia's economy (Russia is Finland's second-largest export market). The structural decline of key industries and a shrinking labour force have led to a sharp decline in productivity growth and in estimates of potential growth.
So, a serious fall in productive capacity due to supply-side shocks, unfavourable demographics and a Russian problem. This has significantly weakened Finland's external position:
The loss of competitiveness has led to the current account turning negative in 2011 and net external debt rising to an estimated 35.7% of GDP in 2014 from -3.6% in 2007 - more than three times the 'AAA' median of 10.1%.
 The rise in external debt is evident from this chart:





















UPDATE. Ramanan points out that the chart above is gross external debt. Current net figures are hard to find (completely missing from Eurostat, and Bank of Finland only reports gross figures). Standard & Poors helpfully provides this table from March 2015 showing their gross and net external debt calculations:


The rise in net external debt since 2008 is evident.

I am personally of the opinion that such a large increase in external debt (net and gross) is by itself sufficient justification for downgrade. High external debt seriously raises the likelihood of foreign exchange crisis and external default, particularly for members of fixed exchange rate systems.

But Finland's problems don't end there. It has been in recession since 2012:



 And although the growth forecast for 2015 is now (just) positive, the outlook is hardly bright, according to Fitch:
Economic growth has been weak so far this year. Real GDP was broadly unchanged in 1Q15. In the second quarter of the year, GDP rose 0.2%. Investment and goods export growth have been weak, partly offset by private consumption and services exports. Fitch forecasts that GDP growth this year will be 0.3% - a slight downward revision from the last review. We have also revised our forecast for growth in 2016 to 1% from 1.3%, reflecting some negative impact on growth from the new government's fiscal consolidation plans.
Er, what's that - fiscal consolidation? In a stagnant economy with damaged productive capacity?

Seriously. Finland's government is planning austerity to reduce its budget deficit:
The government's budget proposal includes permanent consolidation measures worth EUR3.5bn (around 1.7% of GDP) to be implemented in this parliamentary term. The consolidation measures are focussed on current spending. The government plans also point to tax reforms and increased investments of EUR1.6bn over 2016-2018.
Well, the investment is welcome. But spending cuts, with unemployment at 9.7% and rising? No wonder there have been protests.

According to the BBC, the Finnish government says that the spending cuts are necessary to revive the economy:
Last week, Finnish Prime Minister Juha Sipila announced plans aimed at reviving the eurozone member's economy after three years of recession. 
The plans included cutting back holidays, reducing pensioners' housing allowances, and reductions in employees' overtime and Sunday pay.
How on earth reducing pensioners' housing allowances and squeezing people's incomes is supposed to revive the economy is beyond me. But wait - this isn't actually to do with reviving the economy:
"The Finnish state has contracted debt at a rate of almost a million euros (£730,000) per hour for seven years, day and night, every day of the week. We cannot continue like this," Mr Sipila said.
 So it's all about debt, not growth. Yet growth is definitely Finland's biggest challenge. So why the focus on debt?

I noted in a previous post that the insane Eurocrats have decided that despite Finland's dire economic situation, the top priority for its government must be to reduce the budget deficit (currently just over 3% of GDP) and get debt/GDP under control. To ensure compliance, they have put Finland into the "excessive deficit procedure". As a Euro member, Finland has no choice but to do as they say or face fines and sanctions. That's where these austerity measures have come from - though the Finnish government, traditionally hardline, probably would have tightened the budget even without EU pressure.

It is not surprising that the Finnish government has opted for fiscal consolidation at the expense of growth and employment. What is surprising, and disappointing, is that the analysts at Fitch apparently think this is a good thing. Despite substantial evidence - including, now, from other Eurozone countries - that consolidation in a slump makes the fiscal position worse, not better, Fitch produces some optimistic forecasts for deficit/GDP:
The consolidation effort outlined in the budget proposals should lead to the deficit shrinking to 2.8% in 2016, and 2.7% in 2017.
I sometimes wonder if economic analysts have any understanding of multiplier effects. When the economy is on the floor, the fall in GDP from fiscal consolidation is likely to be considerably larger than the nominal cut in the government budget. Fitch trimmed its growth estimate for 2016 by a measly 0.3% to allow for this consolidation. That is nowhere near enough, and the growth estimate was already over-optimistic anyway. If the government goes ahead with these measures, in my view Finland can expect to be back in recession by 2017.

This will make Fitch's debt/GDP forecasts over-optimistic too:
We expect the debt ratio to reach 62.2% this year, and to 66.2% by end-2017. In the baseline case of our debt sensitivity analysis, we project that the government debt ratio will peak at 69% in 2020.
Of course, if instead of embarking on austerity measures, the government concentrated on restoring growth, the figures might look a lot better. It's amazing what raising the denominator does to a ratio.

None of this adds up to the sort of profile that we would expect to see from an AAA-rated sovereign. To be sure, Fitch says the outlook is negative. But surely Finland's current situation is bad enough to justify a downgrade?

Well, there is this:
The general government sector had a net asset position of around 59% of GDP in 1Q15 due to the strong financial position of statutory pension plans. Finland is among only seven OECD countries to enjoy a government net asset position. 
Right. So if all else failed, Finland could raid statutory pension plans to pay creditors.

So Fitch justifies Finland's AAA rating on the basis of unrealistic estimates for growth, unemployment and budget balance, and an (unstated) expectation that Finland's government would as a last resort steal money from its own pensioners to pay creditors.

Fitch is every bit as insane as the Eurocrats.

Related reading:

A Finnish cautionary tale
The insane Eurocrats
Stiglitz to Finnish PM: "Think about growth, not government debt"


Image courtesy of the BBC. 



Saturday, 19 September 2015

The Fed's IOER policy is not "paying banks not to lend"



Mainstream media get this wrong all the time. The latest to go down the "paying banks not to lend" rabbit hole is Binyamin Appelbaum in the New York Times. Because he didn't understand how IOER works, he didn't understand the Fed's strategy, and wrote a post that gets it quite seriously wrong. So I've written a Forbes post attempting to set things straight. Here's a taster:
The FOMC has decided not to raise interest rates – for now. But it’s still widely expected that rate rises will come soon, possibly by the end of the year. Some people think that QE should be unwound first, but the Fed’s plan is to raise rates first. The Fed will unwind QE gradually as the securities it has purchased mature. 
This creates a problem. Because of QE, the banking system is awash with reserves. Banks have more cash on deposit at the Fed than they need to settle customer deposit withdrawals (payments), and they therefore don’t need to borrow funds from each other as they would in normal times. Because of this, the Fed Funds rate – the rate at which banks borrow from each other – no longer influences bank behaviour. It has fallen to zero. 
Well, nearly zero. Actually the Fed Funds rate hovers somewhere between zero and 0.25%. This is because the Fed is paying interest at 0.25% on excess reserves (IOER). Paying IOER prevents the Fed Funds rate from falling to zero.

And I go on to explain how rate normalization will work, including the roles of IOER and reverse repos.

Read on here.

Related reading:

Floors and ceilings
Understanding the permanent floor - Scott Fullwiler
Interest rate control during normalization - Simon Potter, Federal Reserve

Image: Industrial magnet, from magneticattraction.wikispaces.com

Friday, 18 September 2015

All QE is ""people's QE" - just not the right people


There is a widespread belief that the Bank of England’s QE only benefited banks. Promoters of Jeremy Corbyn’s “People’s QE” use the strapline “QE for the people, not for banks”, and describe conventional QE as “bankers’ QE”.
So is this true? Did QE primarily benefit banks?
The Bank of England’s QE programme did not purchase gilts directly from banks, but from non-banks – pension funds, insurance companies, asset managers, high net worth individuals. However, because the Bank of England does not deal directly with non-banks, banks intermediated QE purchases. Banks bought gilts from investors, and sold those gilts to the Bank of England. Customer deposits increased as a consequence of the banks’ gilt purchases: bank reserves increased as a consequence of the banks’ gilt sales. The end result was a vast increase in both base money M0 (bank reserves) and broad money M1 (customer deposits).
Because QE has vastly increased bank reserves, many people are angry that banks have cut back lending severely since the 2008 financial crisis. What is the point of giving banks all this money if they don’t lend it out? But banks don’t lend out reserves. They don’t lend out customer deposits, either. Throwing money at banks doesn’t make them lend. The extra money that landed on bank balance sheets left them with far more reserves than they needed to settle payments, but made no difference to lending.
The Bank of England pays interest on reserves at base rate ("bank rate"), currently 0.5%. Some people say that this is in effect paying banks not to lend, and blame this payment for the fall in bank lending. But this is mistaken. Banks collectively have no choice but to hold the extra reserves created by the Bank of England through QE. When investors spend the proceeds of QE on other assets, such as corporate bonds, equities and commodities, the money simply moves from one bank to another. QE money does not leave the banking system unless it is converted into physical notes & coins.
But do banks benefit from interest on reserves? Slightly, since they pay less than 0.5% on demand deposits. But against this should be set the opportunity cost. If they did not hold so many reserves, what would they hold instead?
Banks must hold sufficient safe liquid assets to meet liquidity buffer requirements, which have increased considerably since 2008. The safest and most liquid assets are reserves, but there are substitutes such as Treasury bills and gilts. Banks' holdings of gilts have actually risen since 2008. 
But for banks to earn money, they must do riskier lending. A few basis points spread between customer deposits and reserves or T-bills isn’t going to satisfy their shareholders. Far from discouraging risky lending, therefore, the presence of excess low-earning assets on bank balance sheets should encourage it. If banks aren’t lending, therefore, other factors are at play – such as depressed consumer demand and a very large private sector debt overhang.
The main effects of QE are to support asset prices and depress longer- term interest rates. So banks with balance sheets stuffed full of poorly-performing loans collateralised by risky assets undoubtedly benefited from QE, because it prevented wholesale destruction of their balance sheets through sharply falling asset prices and swathes of household and corporate bankruptcies. But although QE helped keep banks alive, it has made it far more difficult for them to return to profit. When interest rates are close to zero and yield curves are flat, banks can’t make money.
All in all, it is hard to see that QE could fairly be described as “QE for banks”. But if banks were not the main beneficiaries, who were? In 2013, the Bank of England admitted that the principal beneficiaries were asset holders, particularly those in the top 5% of the income distribution:
By pushing up a range of asset prices, asset purchases have boosted the value of households’ financial wealth held outside pension funds, but holdings are heavily skewed with the top 5% of households holding 40% of these assets.
Rich people, in other words. So conventional QE is QE “for the people”. Just not the people that Jeremy Corbyn would like to help.
Of course the Bank of England argued that conventional QE actually benefited everyone:
Without the Bank’s asset purchases, most people in the United Kingdom would have been worse off. Economic growth would have been lower. Unemployment would have been higher. Many more companies would have gone out of business. This would have had a significant detrimental impact on savers and pensioners along with every other group in our society. All assessments of the effect of asset purchases must be seen in that light.
Those who suffered years of unemployment, under-employment and depressed real incomes might regard this as cold comfort. Would direct reflation of the economy through a modern Debt Jubilee, “helicopter money”, and/or a money-financed investment programme have worked better? I am one of many who think that it would. When asset prices are in freefall and the economy is collapsing, conventional QE works: but when the problem is lack of demand due to damaged bank and household balance sheets, conventional QE is inadequate.
We have relied far too much on conventional QE. Whether it has helped restore the UK’s fortunes we do not know. But we do know that further reflation of the economy is not at present needed: the debate at the moment is when to raise interest rates, not whether to do more QE. We need investment, yes, but while interest rates remain low we can have this through conventional bond financing at little cost. To my mind the attention of the new Labour leadership should be elsewhere.

For too long we have turned a blind eye to QE's regressive nature. Surely the top priority now must be to address the inequality that "QE for the rich" has helped to cause.
This post first appeared on The Exchange at the FT. Image from secretsofthefed.com

Sunday, 13 September 2015

The insane Eurocrats

In July 2008, the European Commission decided that the UK had an "excessive deficit" under the terms  of Article 104 of the Maastricht Treaty. Estimating that Government budgetary plans for 2008-9 would result in a deficit of 3.5% of GDP, the Commission said
The excess over the 3 % of GDP reference value is not exceptional in the sense of Article 104(2) of the Treaty. In particular, it does not result from an unusual event outside the control of the United Kingdom authorities, nor is it the result of a severe economic downturn. The Commission services' spring 2008 forecast projects UK growth to slow in 2008 and 2009 to annual rates below potential. Nevertheless, GDP growth is expected to reach 1,7 % in 2008 and 1,6 % in 2009. The excess over the 3 % of GDP reference value is also considered not temporary, with the Commission services forecasting, on the basis of unchanged policies, a deficit ratio in 2009/10 still higher than 3 % (at 3,3 %). This indicates that the Treaty requirement concerning the deficit criterion is not fulfilled.
And it told the UK government to sort itself out pronto:
- The United Kingdom authorities should put an end to the excessive deficit situation as soon as possible and by financial year 2009/10 at the latest, in accordance with Article 3(4) of Council Regulation (EC) No 1467/97, by bringing the general government deficit below 3% of GDP in a credible and sustainable manner. 
- To this end, on the basis of the Commission services' spring 2008 forecast, the authorities should ensure a structural improvement of at least 0.5% of GDP in 2009/10. 
The Council establishes the deadline of 8 January 2009 for the United Kingdom authorities to take effective action to this end.
Now, we all know what happened next, don't we?


By the time of the January 2009 deadline the UK was in recession. European Commission staff forecasts at that time envisaged a GDP fall of 2.3% in 2009, though they still thought growth in 2008 would be slightly positive. You would think that the European Commission would decide that fiscal consolidation should be postponed, wouldn't you? Not a bit of it. In April 2009 the Commission reviewed the UK's progress against the targets for deficit reduction set in July 2008, and concluded that:
The United Kingdom has not taken action in response to the Council Recommendation of 8 July 2008 within the period laid down in that Recommendation. 
And despite acknowledging that the exceptional measures taken by the UK government in response to the financial crisis were in line with the European Economic Recovery Plan agreed in December 2008, the insane Eurocrats simply extended the deadline for the fiscal adjustment by six months:
On 27 April 2009, acting upon a recommendation by the Commission that took into account the Commission services’ January 2009 interim forecast, the Council decided that the UK had not taken action in response to the Council recommendation of 8 July 2008. In accordance with Article 104(7) and on a recommendation by the Commission, it addressed new recommendations to the United Kingdom with a view to bringing an end to the excessive government deficit situation by 2013/14. In its recommendations, the Council established the deadline of 27 October 2009 for the UK government to take effective action. 
Needless to say, the UK failed to comply with this deadline too. The European Commission's economic forecasts proved wildly optimistic: the UK economy collapsed by 4% in the fourth quarter of 2008 and shrank by nearly 6% in 2009.

The GDP fall itself increased the deficit in relation to GDP. Automatic stabilisers and a serious fall in tax receipts further increased it, and the fiscal stimulus under the EERP also added to it. By the time of the second deadline, far from reducing, the projected deficit for 2009-10 had increased to 13% of GDP.

So what did the Eurocrats do? They did at least acknowledge that the UK government's failure to meet its targets was due to "exceptional circumstances". But then they insisted on fiscal consolidation starting in 2010, with a view to eliminating the "excessive deficit" by 2014-15:
The United Kingdom authorities should bring the general government deficit below 3% of GDP in a credible and sustainable manner by taking action in a medium-term framework. Specifically, to this end, the United Kingdom authorities should:  
(a) implement the fiscal measures in 2009/10 as planned in the 2009 Budget, avoiding further measures contributing to the deterioration of public finances, and start consolidation in 2010/11 in order to bring the deficit below the reference value by 2014/15; 
(b) to this end ensure an average annual structural budgetary adjustment of 1¾% of GDP between 2010/11 and 2014/15, which should also contribute to bringing the government gross debt ratio back on a declining path that approaches the reference value at a satisfactory pace by restoring an adequate level of the primary surplus; 
(c) further specify the additional measures that are necessary to achieve the correction of the excessive deficit by 2014/15 cyclical conditions permitting and accelerate the reduction of the deficit if economic or budgetary conditions turn out better than currently expected 
This casts the austerity measures implemented by the Coalition government on coming to power in May 2010 in a different light, doesn't it?

The Coalition's austerity measures met with the approval of the Eurocrats:
On current information it appears that the United Kingdom has taken action representing adequate progress towards the correction of the excessive deficit within the time limits set by the Council. In particular, the measures announced in the June 2010 Emergency Budget will further increase the size of fiscal consolidation in 2010/11 and also significantly strengthen the planned pace of deficit reduction over the medium-term. 
And on that basis, they decided no further action to force persuade the UK to deal with its deficit was needed. Kudos to Osborne for getting Brussels off his back, yes?

Not quite. The story doesn't end there. Fast forward to May 2015 - yes, the month of the UK's latest General Election, in which the Conservatives won outright. The UK was supposed to have brought its budget deficit below 3% of GDP by then, so the European Commission reviewed the UK's progress against this target. This is their conclusion:
Despite the fiscal consolidation programme set out and being implemented, the United Kingdom did not put an end to its excessive deficit by 2014-15. Furthermore, the United Kingdom did not adhere to the average fiscal effort of 1¾% recommended by the Council on 2 December 2009. Overall, the response by the United Kingdom to the Council recommendation according to Article 126(7) TFEU of 2 December 2009 has not been sufficient, 
Oops.

And their latest recommendation follows on, of course:
(1) The United Kingdom should put an end to the present excessive deficit situation by 2016-17 at the latest. 
(2) The United Kingdom should reach a headline deficit of 4.1% of GDP in 2015-16 and 2.7% of GDP in 2016-17, which should be consistent with delivering an EN 5 EN improvement in the structural balance of 0.5% of GDP in 2015-16 and 1.1% of GDP in 2016-17, based on the updated Commission 2015 spring forecast. 
(3) The United Kingdom should fully implement the consolidation measures incorporated into all budgets and Autumn Statements up to and including the 2015 budget to achieve the recommended structural effort, with any modifications being fiscally-neutral in relation to the current plans. The United Kingdom should further detail the expenditure cuts in the upcoming Spending Review. These are necessary to ensure the correction of the excessive deficit by 2016-17. 
(4) The United Kingdom should accelerate the reduction of the headline deficit in 2015- 16 and 2016-17 if economic, financial or budgetary conditions turn out better than currently expected. Budgetary consolidation measures should secure a lasting improvement in the general government structural balance in a growth-friendly manner. In particular, further cuts in capital expenditure should be avoided. 
(5) The Council establishes the deadline of [15 October] 2015 for the United Kingdom to take effective action and, in accordance with Article 3(4a) of Council Regulation (EC) No. 1467/97, to report in detail the consolidation strategy that is envisaged to achieve the targets. 
And for good measure, it adds a requirement for the UK to commit to "comprehensive structural reforms", which is code for "take 5,000 lines and a detention". Teacher is not pleased.

But actually this whole saga is hilarious. The European Commission has no power whatsoever to force the UK to implement its austerityfest. The original European Council "excessive deficit" recommendation from 2008 somewhat shamefacedly admits this (my emphasis):
Pursuant to point 5 of the Protocol on certain provisions relating to the United Kingdom of Great Britain and Northern Ireland, the obligation in Article 104(1) of the Treaty to avoid excessive general government deficits does not apply to the United Kingdom unless it moves to the third stage of economic and monetary union.  While in the second stage of economic and monetary union, the United Kingdom is required to endeavour to avoid excessive deficits, pursuant to Article 116(4) of the Treaty.
And the UK government robustly reinforced this in its response to the 2015 European Commission review (my emphasis):
The UK is not a member of the single currency and cannot face sanctions under the EU’s SGP. The UK’s obligation under the SGP is to “endeavour to avoid an excessive government deficit” as a result of its Protocol to the EU Treaties (Protocol 15).
Nonetheless, the European Commission undoubtedly is pressuring the UK government over deficit reduction. After all, it is trying desperately to whip a set of recalcitrant Eurozone members into shape, including - most importantly - France, which is resisting every step of the way. How on earth can the European Commission coerce France into "fiscal responsibility" when its neighbour across the Channel is blithely ignoring the Stability and Growth Pact?

So Osborne, having successfully got the Eurocrats off his back in 2010, has tried the same trick again. He has produced plans that actually exceed the latest fiscal targets. Though from the tone of the Commission's report, it does not seem that they will be quite so relaxed about progress monitoring this time round. But they won't want to rock the boat ahead of Britain's EU referendum.

Or - will they? I'm not so sure. After all, they are insane.






Everything's under control, China edition



Daiwa Securities has forecast Armageddon. They say that over-investment in China in recent years has created a debt bubble so great that Chinese authorities would not able to manage its collapse, resulting in a debt deflationary spiral which would make 2008 look like a walk in the park. Such a meltdown would, in their words, "send the global economy into a tailspin".

But they also outline another scenario, in which China's economy undergoes a nasty, possibly prolonged recession, from which it will emerge with lower growth.

Which of these scenarios will play out? Well, as I discuss in my latest Forbes post, it really depends what Chinese authorities do. They insist that "everything is under control". But are they actually in the wrong trousers?

Read my analysis and conclusions here.

Related reading:

Never mind Greece, look at China
Lessons for China from Japan
China's economy: no collapse, but it's serious and so are the politics - George Magnus
If we don't understand both sides of China's balance sheet we understand neither - Michael Pettis

Other Forbes posts on China:
Quantitative tightening is a myth (but that doesn't mean there isn't a problem)
China's interest rate cuts will not solve its real problem
China's Black Monday signals the end of its growth cycle
China joins the global devaluation party

Friday, 11 September 2015

Rethinking government debt



There is a huge amount of hysteria about government debt and deficits, not just in the UK but throughout much of the world. As I write, Brazil has been downgraded by Standard & Poors because of concerns about rising government debt and weakening commitment to primary fiscal surpluses in a context of political uncertainty and deepening recession. It is the latest in a long line of downgrades and investor flight over the last few years. The global economy is a very stormy place.

The UK, which has halved its fiscal deficit in relation to gdp in the last five years, is embarking on another round of fiscal tightening, with the aim not only of completely eliminating the deficit but running an absolute surplus by 2020 in order to, in the words of the Chancellor, "bear down on debt". The Chancellor's plan enjoys considerable popular support due to a widespread belief that if we do not eliminate the deficit and start paying down debt, we will end up like Greece. "Dealing with the deficit" has become synonymous with good economic management.

But others argue that further austerity to eliminate the deficit and pay down debt is unnecessary and harmful, especially if it means further cuts to investment spending. A growing number of voices call for the UK to increase investment spending even if it means a rise in headline debt/gdp in the short term, because improved growth from the extra investment would result in debt/gdp falling in the longer term. For many of these people (and I admit I am one), deficit phobia is economically illiterate and failing to invest when interest rates are on the floor is irresponsible management of the economy.

Still others say that government debt is unnecessary: a monetarily sovereign government can fund spending through central bank money creation. Jeremy Corbyn's People's QE gives a nod in this direction.

So who is right? How much debt should the UK have? What is the purpose of government debt?

To discuss the purpose of government debt, we must first consider the relationship between debt and money. Ever since the abandonment of the gold standard in 1971, governments have issued their own currencies. A government bond issued by a currency-issuing sovereign is simply a promise to issue an agreed amount of sovereign money at defined points in the future. The only new money issued is the interest: the principal payment at maturity simply re-issues the money withdrawn from circulation when the bond is sold. Thus, buying a government bond is exactly the same as placing money in a government-insured time deposit account in a bank. We should really regard government bonds as certificates of deposit. They are simply money, in another form.

Debt issued by a monetarily sovereign government in its own currency is the safest of safe assets. A monetarily sovereign government cannot be forced into default on debt issued in its own currency, and it does not have to tolerate inflation either. Default is a political decision. So is inflation.

But the power to issue money does not of itself confer monetary sovereignty. Many governments that are not monetarily sovereign issue money. What then do we mean by "monetary sovereignty"?

Monetary sovereignty means that the government  has full control over both the amount and the value of money in circulation, in all its forms (including government debt). Note that fixing a value is not the same as controlling it. We generally say that a government is monetarily sovereign if the following are true:
  • it issues its own currency 
  • it has a freely-floating exchange rate
  • it has an open capital account
But this would also be monetary sovereignty:
  • it issues its own currency
  • it has a fixed exchange rate or the currency is not traded
  • it has strict capital controls
Note that the definition of "monetarily sovereign" would include some failed states. Monetary sovereignty is not a guarantee of responsible economic management. Sovereign governments can trash their economies if they choose.

There are five principal ways in which governments can lose or relinquish sovereignty.

1. Any country in which the currency used to settle debts ((legal tender) and pay taxes is not issued by the government is not monetarily sovereign. So, for example:
  • Ecuador (uses US$)
  • Panama (ditto)
  • Kosovo (uses Euro)
  • San Marino (ditto)
  • Zimbabwe (anything goes except the Zimbabwean dollar)
This category also includes all Eurozone eountries except Germany.

2. Any country which fixes the value of its currency in relation to one or more other currencies does not have monetary sovereignty UNLESS it also has strict capital controls. So, for example:
  • Bulgaria (currency board to Euro)
  • China (floating peg to a basket of currencies: leaky capital controls)
  • Denmark (ERM II peg to Euro)
Switzerland regained monetary sovereignty when it released its Euro peg earlier this year,  to the consternation of the financial markets.

3. Any country whose currency's value is explicitly or implicitly determined by the value of a commodity does not have monetary sovereignty.

The most obvious example of this is the inter-war gold standard, whose inflexibility prevented countries such as the US from reflating their economies and thus turned a recession into a Depression. But oil exporters such as  Russia and Kazakhstan also fall into this category. They have now floated their currencies, but their currencies track the oil price.

4. Any country that borrows mainly in another currency does not have monetary sovereignty even if it issues its own currency. This includes high levels of foreign-denominated external debt arising from a large trade deficit. Most hyperinflations involve countries which issue their own currencies but have very high external debt: this was certainly true of the archetypal hyperinflation, that of the Weimar republic.

5. Any country which is largely dependent on trade links to a more dominant country does not have monetary sovereignty. This is perhaps the least obvious category, but it is crucially important. The small economies of South East Asia are dependent on trade ties with China. As the external value of a currency is largely determined by trade, their currencies therefore fall or rise with the yuan even without explicit pegs.

The five categories listed above cover the majority of countries in the world, including some of the largest economies. Monetary sovereignty is a very rare breed indeed. The vast majority of governments cannot issue either money or debt without limit. For most of the world, deficits (including external ones) and debt DO matter. Though perhaps fiscal rules don't have to be quite as strict as those imposed in the ridiculously-named EU "Stability and Growth Pact", which are slowly squeezing all growth out of the Eurozone and creating social and political instability.

But there seems to be a select group of countries which do have monetary sovereignty. The most prominent of these is the US, but it also includes Japan, Germany (because it is the Eurozone hegemon and the Euro is really a renamed Deutschmark), Switzerland (now), the UK, Canada and possibly Australia. Oddly, all of these violate one or more of the categories above - but they are nonetheless trusted by investors. Why this is, is a mystery. The key criteria appear to be the following:
  • a history of sound economic management and few defaults (ok, so why is Germany in the list?)
  • a dominant economic position (ok, so why isn't China in the list?)
  • a credible independent central bank
  • reserve currency status
  • long-dated government debt stocks mainly owned by own citizens
  • stable government and low political risk
These countries enjoy privileges that other countries do not. Although they have very low interest rates on government debt, they do not need to fund government spending with debt: they can simply issue money to meet commitments, relying on taxation and monetary policy to maintain purchasing power. They even have unlimited access to each other's currencies through central bank swap lines, thus in effect eliminating their external debt liabilities. But these extraordinary privileges do not mean that their own-currency debt has no purpose. On the contrary, they make it more vital than ever - and there is not enough of it.

The debt of this "Premier League" countries has four main uses in the modern global economy:
  • A safe savings vehicle for  their own citizens (particularly vital in those that have poor demographics, such as Japan)
  • A safe haven for foreign investors fleeing from trouble elsewhere
  • An anchor for investment portfolios
  • An essential lubricant in financial markets
Strictly speaking, only the first of these is "necessary" as far as those governments are concerned. Their primary responsibility is to their own citizens. Enabling those citizens to save safely AND invest productively is a part of that responsibility. For that reason alone, these governments should issue enough debt to meet the saving propensity of the domestic private sector, though they might choose to lean against the pro-cyclicality of saving preferences by issuing money instead of debt in recessions and debt instead of money in booms.

But the other three are also essential, from a global economy perspective. The financial system needs safe assets. The fallout when private sector "safe assets" are exposed as the risky assets they really are is terrible. So too is the fallout when sovereign debt issued by governments that do not have monetary sovereignty is exposed as the risky asset it really is. We have seen both in recent years: the 2008 crisis was a failure of private sector safe assets, and the Eurozone crisis was a failure of government safe assets. We are still paying for the consequences of these failures. To pretend that the financial system can manage without safe assets is folly.

This explains the clampdown on government debt and deficits in "Premier League" countries. There is a terrible fear among financial sector actors that these countries will pursue reckless economic policies that destroy the purchasing power of their currencies and the value of their government debt. This fear has been deliberately communicated to the general public in those countries by captive politicians and media, in order to ensure wide acceptance of the austerity policies that much of the financial sector believes is necessary to maintain the value of safe assets. It is perhaps understandable, but it is economically unjustified. The truth is this:
  • Running a primary fiscal surplus in a recession makes the recession worse, raising debt/gdp and increasing the risk of sovereign default
  • Running a primary fiscal surplus when growth is poor and the private sector highly indebted is likely to cause a recession
  • Running a sustained absolute surplus robs the private sector of its savings
  • Paying off government debt deprives the private sector of a safe store of value
  • Increased growth and prosperity arising from productive investment outweighs the cost to future generations
Sadly such basic economics is lost on credit ratings agencies and investors, who see only rising deficit and debt/gdp and start to panic about getting their money back.

It is indeed necessary that the government debt of the world's "premier" countries should remain "safe". But draining their economies by forcing austerity policies upon them is not the way to keep it safe. On the contrary, it is likely to make it LESS safe. Safety is ensured through investment in the physical and human capital of the country to secure growth and prosperity for the future.

Clearly, even governments of "Premier League" countries can't do entirely as they please. There is bound to be a tipping point at which trust is lost and the country is relegated to the second division. We don't know exactly what that tipping point is. But the message from today's low interest rates is that we are nowhere near that point. For the sake of both their own citizens and the global economy, these countries can, and should, invest.

Related reading:

When governments become banks
On the new purpose of government debt - FT Alphaville
Government debt isn't what you think it is






Thursday, 3 September 2015

"Quantitative Tightening" is a myth

(But that doesn't mean we don't have a problem).

Deutsche Bank has frightened everyone by warning that if China sold substantial quantities of US Treasuries (USTs) to support the yuan, this would amount to a substantial tightening of US monetary policy.

The reason why China accumulated USTs in the first place was because of its trade surplus:


The excess of exports over import sucked dollars into China, where the People’s Bank of China (PBoC) exchanged them for domestic currency (yuan). The PBoC therefore acquired large amounts of dollars, which it stored in the form of USTs. By doing so, it took USTs out of circulation and returned to the world economy the dollars that had been sucked into China. This can be regarded as a form of dollar quantitative easing (QE). Therefore, Deutsche Bank argues, if PBoC sells its USTs, this amounts to undoing QE.

But it’s not that simple.....

To read the rest of this Forbes post, click here.

Wednesday, 2 September 2015

The real purpose of central banks



One of the things that has emerged from the PQE debate is a suggestion that it is time to consider ending the Bank of England's inflation-targeting mandate. Unfortunately this got mixed up with calls for ending the operational independence of the Bank of England (Richard Murphy), or abolishing central banks (Bill Mitchell, stated in response to a question at Reframing the Progressive Agenda).

What we might call the "twin peaks" approach to macroeconomic policy-setting has been adopted the world over. Separation of fiscal and monetary policy, and independence of the central bank, have become the hallmarks of good practice. Many countries have also adopted inflation targeting, though not all have: a good many developing countries still target exchange rates, and are currently learning (painfully) that exchange-rate targeting doesn't work when everyone's currencies are depreciating madly due to commodity price falls.

But the status of the central bank and the primacy of inflation control in macroeconomic policy setting are not really related to each other. To illustrate this, here's a thought experiment.

Suppose that we did what Bill wants, and abolished the central bank. Government would become its own central bank: it would spend directly into the economy by crediting private sector bank accounts, and would drain excess money through a programme of differentiated taxes. I've noted before that taxes and interest rates are essentially the same thing but with different distributional effects. Both control the amount of money in circulation. But interest rate changes indirectly influence private sector saving and borrowing, whereas tax changes directly affect private sector spending. We might expect, therefore, that tax changes would be both more powerful and more immediate in their effects than interest rate rises - though strangely, the mainstream economic community seems to think the reverse is the case.

In theory, therefore, this could work. Inflation control would be exercised by means of tax rate changes, particularly the poorly-named "indirect" taxes (VAT, sales tax, sin taxes). Indirect tax changes have direct, immediate and powerful effects on the economy: not long ago a promising recovery was derailed in Japan by an ill-considered increase in sales tax, and in the UK the VAT increase immediately after the Coalition government came to power in 2010 probably contributed to the slackening of growth later that year.*

So we do not need a separate central bank to control inflation. Government can do that itself. But why do we want to control inflation? Indeed, can we control it? We fear it, so we want it controlled, but it is by no means clear that we have effective control of it. Central banks the world over are failing to meet inflation targets. Western economies have inflation far below the standard 2% target. Why is this?

There are all manner of theories to do with commodity price falls, weak currencies and low demand. Some combination of all of these is no doubt partly to blame. But in Europe, where low inflation is firmly entrenched despite very high unemployment, the principal reason is that the inflation target has effectively been abandoned.

The ECB has price stability as its single mandate. But the primary macroeconomic targets are not set by the ECB. They are set by the member state governments and enforced by the European Commission with (increasingly reluctant) support from the ECB. The primary macroeconomic targets in the Eurozone, and to a lesser extent the EU, are the Maastricht Treaty limits on government debt and deficit. It is slavish adherence to these that makes it impossible for the ECB to meet its inflation target.

As I noted before, changes in taxation (including government spending, which can be regarded as negative taxation) are equivalent to interest rate changes. So contractionary fiscal policy across the entire Eurozone acts like very high interest rates, sucking demand out of the economy. Also, the ECB is struggling with "zero lower bound" constraints that limit the effectiveness of monetary policy in very demand-deficient economies, Consequently, the ECB simply does not have the power to offset the depressing effect of continual fiscal austerity as countries try to comply with the too-tight fiscal restraints of the Stability and Growth Pact. It cannot get anywhere near its 2% inflation target.

I would suggest that ANY country that is attempting to hit particular targets for government debt and/or deficit has de facto abandoned its inflation target. That includes the UK, whose Chancellor is targeting zero deficit by 2018 and fiscal surplus by 2020. The Bank of England still has an inflation target, but it has no more chance of hitting it than it would have if the Chancellor were "going for growth" with a highly expansionary fiscal policy. "Monetary dominance" is a myth.

Ending the Bank of England's inflation-targeting mandate would make little difference as long as the government remained firmly wedded to balancing the books. Indeed it might make matters worse: if the Bank no longer had a target to try to meet, popular pressure might make large interest rate rises hard to resist. It should be obvious by now that interest rate rises combined with fiscal austerity would be severely contractionary, possibly disastrously so. The Bank of England's inflation target is therefore serving a protective function. There are powerful voices calling for interest rates to rise back to "historic" levels. Targeting inflation silences them.

So we might need an independent central bank to provide some protection from politicians (or fiscal councils) setting insanely tight fiscal targets. However, the Eurosystem, with its one-size-fits-all monetary policy, is not able to protect individual countries from the awful consequences of severe fiscal austerity. So if it can't hit its inflation target because of over-tight fiscal policy, and it can't offset the effect on  real economic activity of over-tight fiscal policy, does the Eurosystem serve any useful purpose at all?

It certainly isn't needed to create money. The right to create money is conferred on central banks (base money) and private banks (broad money) by government, and the value of money thus created arises entirely from the trust that people have in government. In the hydra-like Eurosystem, the authority of  the ECB and national central banks to create money comes from the governments of its 19 member states.

Even in the Eurozone, it would in theory be possible for private banks to be provided with reserves directly by Treasury departments: conversely it would in theory be possible for member state governments to be the only banks. These are extreme positions and I am not suggesting either. I merely point out that both are logically coherent. Central banks and private banks are not essential for fiat money creation.

Occasionally we find cases where the central bank is more trusted than the government, but these are unlikely to be associated with genuine fiat currency systems. For example, Bulgaria has a Euro currency board, which means that its monetary policy and to a large extent its fiscal policy too are in practice dictated by the ECB. And the people like it that way. They haven't forgotten 1996, when Bulgaria experienced hyperinflation. They don't trust their government, and they only trust their central bank because it doesn't really have control of the currency.

It is false to claim, as some do, that the Euro has broken the link between government and currency. Nothing could be further from the truth. Successive crises have shown us that the stability of the Euro crucially depends on the credibility of its member governments. There was even hyperinflation in the Eurozone in the run-up to the closure of Greek banks, when Greek citizens dumped Euro deposits in Greek banks as fast as they could due to fears of confiscation and/or redenomination (value destruction). At that moment, as Greek broad money approached worthlessness, the Euro was fragmented. The loss of credibility of the Greek government threatened its integrity. The Euro is as dependent on trust in government as any other fiat currency.

So we do not need a central bank to control inflation. Even more importantly, we do not need a central bank to create money. All we need is a trusted government. This is the reason for Bill's call for central banks to be abolished. He thinks they serve no useful purpose.

Of course we might want to have a central bank for other purposes, like acting as lender of last resort for the banking system (though as we saw in 2008, the burden of rescuing a collapsing banking system eventually falls on government). It can be convenient to separate the support of the banking system from the support of the real economy. But in the Eurozone, it is hard to see what other useful purpose the central banks serve.

However, there is another reason for having an operationally independent central bank in a democracy. In democracies - even those that have a "fiscal council" or balanced-budget laws - fiscal policy is set by politicians. Politicians disagree on fiscal policy: indeed political parties' pitch to voters is mostly about how bad the fiscal policy of the other side is. For the party in office, the temptation to set fiscal policy to their own electoral advantage is very great: while for parties aiming to dislodge the party in office, the temptation to make headline promises to reverse existing fiscal policies is equally great. So we should expect fiscal policy settings to be significantly determined by the electoral cycle.

An independent central bank can dampen the swings in fiscal policy caused by changes in government. It can't offset them fully, especially when interest rates are close to the zero lower bound, but it can mitigate their effect. It acts, in effect, as an automatic stabiliser, anchored by its mandate: it doesn't much matter what the mandate is as long as there is one. The high inflation of the 1970s was in my view at least partly due to the loss of the Bretton Woods anchor, which resulted in ten years of confusion before a new anchor (inflation targeting) was adopted.

So it is public choice theory, not inflation control, that makes an independent central bank necessary. This, I'm afraid, fatally undermines Richard Murphy's call for the ending of the operational independence of the central bank. The last thing we need is a central bank that is ALSO driven by the electoral cycle. No central bank at all is probably better than this.

And this raises another issue. Those who think central bank governors should be directly elected should perhaps consider whether elected governors might themselves be driven by a desire to remain in office. The prospect of fiscal and monetary policy being driven by two different electoral cycles that are out of phase with each other is  too awful to contemplate.

But if the real purpose of central banks is to protect economies from the whims of politicians (including those in other countries - fiscal policy effects spill over to other economies) - and thereby help to maintain trust in government even when it doesn't deserve it - there must be serious questions about the purpose of the Eurosystem, since it is manifestly unable to dampen fiscal policy swings. There could definitely be a case for abolishing the ECB and returning responsibility for monetary policy to national central banks.

Of course, an independent central bank dampening swings in fiscal policy is smoke and mirrors. The central bank is a political institution. Its mandate is set by politicians and it is only as independent as politicians allow it to be.

There is a widespread view that inflation targeting by independent central bank prevents irresponsible management of the economy by politicians. But I would argue that the reverse is the case. The "twin peaks" model, in supposedly protecting the economy from the whims of politicians, enables politicians to be irresponsible while blaming  the central bank for the consequences of their irresponsibility. This is what is happening all over Europe. Politicians are irresponsibly driving economies into stagnation or depression through a misguided belief that debt is bad and government must "live within its means". And central banks are being held responsible for the resulting lowflation, lack of growth and high unemployment.

It is a dysfunctional model. But until there is greater understanding of macroeconomics among politicians and voters, I can't think of a better one.

_______________________________________________________________________________

Related reading:

PQE, inflation and the problem of voter power
Krugman, Bowman and the monetary financing of government
Inflation is always and everywhere a political phenomenon - Pieria

*If this is correct, then we should expect that the enormous VAT increase in Greece imposed with immediate effect under the terms of the recent bailout should have a serious negative impact on growth, since it is equivalent to a whopping interest rate hike. It's worth remembering that the Russian central bank's political decision to raise interest rates to 17.50% in November last year knocked the stuffing out of an already recessionary economy. Greece's general VAT rate has been raised to 23%, which for most industries is a rise of at least 10%. I await the Q3 and Q4 GDP figures for Greece with academic interest and personal foreboding.