Tuesday, 28 June 2016

Who is really to blame for Brexit?

Guest post by Tom Streithorst.

Brexit already looks a disaster. Sterling has plunged to the lowest level in thirty years, the FTSE fell more than 12% at the open, global equities lost $2 trillion in value in less than a day, and gold, the traditional safe haven in times of turmoil, has shot up. Uncertainly reigns. Firms are less likely than ever to hire or invest. It is going to get worse.

Who shall we blame?

David Cameron is the obvious villain. He did not need to call this referendum. When he promised a vote three years ago, there was no real call for Britain to exit Europe other than on the fringes of his own party, . Cameron made a purely political decision. He knew Brexit would be bad for his country, and still he promised a referendum merely to shore up support among Eurosceptics who might support UKIP in the general election. For momentary political advantage he gambled the prosperity of the nation. He lost. If history remembers him at all, it may well be as the Prime Minister who destroyed the United Kingdom and replaced it with Little England.

Jeremy Corbyn didn’t do much better. The Leave campaign was led by right-wing Tories, but they won the election with the votes of working-class Labour supporters. Corbyn never was a fan of the EU. He voted against it in 1975, and although he supported Remain this time, he did so neither vociferously nor effectively. Corbyn could have done much more to convince Labour voters that they would be better off in Europe, that austerity not immigration was the source of their pain. That he didn’t do a better job reflects both his own lack of conviction on the subject and his ineffectiveness as an opposition leader.

Boris Johnson, the Donald Trump of Britain, also deserves blame. Born in New York City, educated at the European School of Brussels, it was as the Daily Telegraph reporter covering the EU in the 1990s that he popularised the “unelected Brussels bureaucrat” meme that took over Fleet Street. Before Johnson, the tabloids mostly ignored the EU. After, editors demanded eurosceptic stories from their Brussels reporters. Silly tone-deaf bureaucrats made better copy than economic growth, increased trade, and grants to poorer parts of Britain. Johnson, driven by personal ambition and little else, betrayed his long time friend Cameron by leading the Leave Camp. He may well be rewarded with 10 Downing Street for his perfidy.

It is satisfying to curse our politicians for their selfishness and small-mindedness, but it should not blind us to a deeper failing. The split in votes was largely geographic. London, Manchester, Bristol, Scotland and Northern Ireland voted to stay. It was little England, the suburbs, countryside, and decayed industrial towns that wanted to leave.

Ultimately, I blame us, the educated metropolitan elite that mostly supported Remain. We profited from globalization. The poor outside of the metropolitan areas, not so much. Economic textbooks tell us, quite accurately, that free trade and free movement of people increase economic growth. Not everyone will be a winner, of course, but in the aggregate we all are.  The secret then, the textbooks continue, is to use some of that increased prosperity to relieve the damage done to the losers from globalization. That lesson we ignored.

The great civilizational split of our time isn’t between Islam and Christianity but rather between metropolitan cosmopolitans and the more parochial folk outside the great cities. It is England outside the M25 that voted for Brexit. Experts told them Brexit would make them poorer, but they no longer believe the experts. And why should they? The experts have not been concerned with their wellbeing for quite some time.

In his book The Twilight of the Elites, Chris Hayes asks why meritocracy has brought such a decline in the quality of the people who run things. He answers that first, meritocracy is mostly a sham, that the social class of your parents determines your income much more than meritocrats pretend, but that the myth of meritocracy allows the successful to pretend their prosperity is purely their own doing. This deprives them of any motivation to care about the less fortunate.

The second is that inequality makes everyone, even the affluent, feel insecure. When falling from the top 1% to the top 10% is a substantial drop, members of the elite are more concerned with their own professional advancement than any responsibility towards their country. Noblesse oblige is an aristocratic concept, available only to those who feel their own position is secure. Meritocracy makes none of us feel secure. A good year does not guarantee the next.

Working-class Leave voters are bitter, with good reason. Wages haven’t gone up in ages. Eight years after the financial crisis, the economy remains stagnant. Many naturally blame immigration.

The real problem is austerity. Britain is able to borrow at microscopic rates. We could have invested in our future, created jobs, and make our present more prosperous. But we didn’t. And now we will all be poorer.

Monday, 27 June 2016

The snake oil sellers

The fallout from Britain’s historic decision to leave the European Union continues. Domestically, there are regrets, recriminations and accusations. Young people,particularly those aged 16-17 who did not have a vote, complain that the vote did not take their interests into account  A petition for a second referendum reached over 3m votes in a few days, although it was subsequently found to have been hacked: the true number is uncertain. The media have spent the weekend tracking down people who voted to Leave and now regret it, and publishing increasingly desperate schemes for avoiding Brexit. There is a sense of denial. If only we could turn back time....

But it's too late. The UK is now persona non grata in the EU, and EU foreign ministers are pushing for formal exit procedure to be triggered as soon as possible. The political meltdown in both main parties currently makes this impossible, but chaos can't continue forever. Eventually, Article 50 will have to be triggered, and the UK will leave the EU, never to return.

The lies that made Brexit

There is now clear evidence that the Leave campaign deliberately misled the British people in order to achieve victory. Within hours of the vote, Leave campaigners were backtracking on the two principal promises of the Leave campaign - immigration control, and £350m per week funding for the NHS.

In an interview with the BBC's Ewan Davies, Dan Hannan said that regaining control of immigration didn't necessarily mean reducing it: "We never said there was going to be some radical decline," he said. "We want a measure of control.” Davies was flabbergasted. "Come on, that's completely at odds with what the public think they have just voted for!" he cried.

Denying that they had ever made the promises seems to be a strategy. "I never said that", said Iain Duncan Smith about the £350m NHS funding. "I just stood in front of buses and posters". And he went on to say that the Leave campaign had never promised the money anyway. A furious Chris Giles of the FT didn't mince his words:

He was right to be angry. Duncan Smith's words were mealy-mouthed. The Leave campaign's advertising explicitly promised £350m would go to the NHS:

The man on the right in this picture, Liam Fox, now admits that the £350m figure itself is fiction. This had been pointed out prior to the vote both by the IFS and by the head of the UK's statistics service, Sir Andrew Dilnot, who reprimanded the Leave campaign for using the figure:

I conclude that there is a lack of clarity in the way the official statistics have been drawn on in the statements I have considered. In particular, I note the use of the £350 million figure, which appears to be a gross figure which does not take into account the rebate or other flows from the EU to the UK public sector (or flows to non-public sector bodies), alongside the suggestion that this could be spent elsewhere. Without further explanation I consider these statements to be potentially misleading. Given the high level of public interest in this debate it is important that official statistics are used accurately, with important limitations or caveats clearly explained.
The Leave campaign ignored Sir Andrew and continued to present £350m as funding that would be available to the NHS. And Nigel Farage undermined the IFS's credibility by claiming that EU funding for some of its work made it untrustworthy - a claim robustly denied by the IFS. At least Fox now admits that the experts were right. I suppose we should be thankful.

But the lies continue. Boris Johnson, in an op-ed in the Telegraph, describes negative prognostications as "wildly overdone", and insists that nothing will really change:

British people will still be able to go and work in the EU; to live; to travel; to study; to buy homes and to settle down. As the German equivalent of the CBI – the BDI – has very sensibly reminded us, there will continue to be free trade, and access to the single market. Britain is and always will be a great European power, offering top-table opinions and giving leadership on everything from foreign policy to defence to counter-terrorism and intelligence-sharing – all the things we need to do together to make our world safer.
Though the freedom of movement Johnson promises British people would not be available to citizens of EU countries:

Yes, the Government will be able to take back democratic control of immigration policy, with a balanced and humane points-based system to suit the needs of business and industry.
So Britain can give bad deals to others while retaining all its existing rights and privileges? No way. This is not remotely credible. None of it is. It is cloud cuckoo land. 

The reality is that the UK will be smaller, poorer and less significant because of Brexit. I grieve for the lost opportunity to put the UK at the heart of Europe, leading the non-Euro bloc and forcing through necessary reforms. And I am furious that a bunch of sleazy, power-grabbing chancers - on both sides - have played fast and loose with the lives and the hopes of the people of the UK. It is an utter disgrace.

The negative consequences of Brexit

It is already clear that the short-term consequences of the Brexit decision will be negative. Sterling fell sharply on the announcement and is continuing to fall, bank and corporate shares crashed and there was high volatility on stock markets around the world. Capital is leaving the UK, and will continue to do so while the present uncertainty continues. And there are no guarantees that it will return.

The sharp fall in sterling, trumpeted as "good for exporters" by the economically illiterate Nigel Farage, may give little benefit to businesses: it is worth remembering that sterling devalued by 25% in 2009 to no avail. This is because the UK is a major importer of intermediate goods, the prices of which rise when the currency falls, increasing input costs for business. Consumers will also be hurt: the summer holiday plans of Brexit-voting Daily Express readers have already been disrupted because the pound in their pocket doesn't buy so much furrin currency. Tragic.

Fiscally, increased borrowing costs as government debt faces downgrade will eventually feed through into spending cuts and tax rises. And for consumers, the effect is likely to be higher prices for some goods, particularly fuel and energy. Daily Mail readers, your SUVs are about to become a lot more expensive to run. And so are your tasteless Christmas lights, your wasteful patio heaters and your flights to Ibiza. Pity the Daily Mail didn't warn you about that.

All of this will eventually feed through into lower growth, lower real incomes and higher unemployment. And there will be a negative impact elsewhere, too. 
In a fascinating blogpost, David Beckworth describes the Brexit decision as a global monetary shock comparable with the fall of Lehman. His argument is twofold. The rapidly strengthening dollar tightens monetary conditions in emerging market economies which peg to the dollar, and puts pressure on governments and corporations with high levels of dollar-denominated debt: 
So between tightening monetary conditions for the  dollar bloc countries and increasing real debt burdens for all the non-resident issuers of dollar debt, the global economy has been hit with a large dollar shock. Put more crudely, the strong dollar noose that has been choking emerging economies since mid-2014 has now been complemented by the opening of  trap door on the gallows via Brexit. This makes the strangulation of global economy complete.
Beckworth adds that the flight to safety, which is causing yields on USTs, bunds and JGBs to crash, will eventually result in a fall in output as the global economy hits the effective lower bound on interest rates. If he is right, then the world is facing recession.

And that would have not only short-term, but long-term consequences for the UK. The Brexit argument is that freed from the EU, the UK can increase trade with the rest of the world. But the rest of the world might be in no shape to cooperate.

So Leave campaigner Andrea Leadsom's claim that Brexit would have "no economic impact" was wildly wrong. The IFS, the Bank of England, the IMF and other reputable institutions that warned about the negative consequences of Brexit were right. In fact if anything their warnings were understated. But they were not believed.

Why weren't the experts believed?

"I think the people of this country have had enough of experts", said Michael Gove. His words resonated. People had indeed had enough of experts. The Remain camp's reliance on "expert witnesses" backfired badly. It failed to capture the public imagination, and - worse - it undermined the credibility of the experts themselves. They were no longer seen as neutral.

Negative forecasts about the effects of Brexit were dismissed on the grounds that all experts except those that supported the Brexit cause were biased towards Remain. Patrick Minford was credible: ten Nobel prize winning economists were not. The Institute of Economic Affairs was credible: the IFS was not. The Leave campaign came up with all manner of reasons why respected institutions could not be trusted, and although the institutions fought back, they were not believed. "They would say that, wouldn't they?" was the response. They couldn't win.

That the Leave campaign systematically undermined the credibility of experts is understandable. If people believed the experts, the foundation of the entire campaign would be shown as the deceit we now know it to be.

But why did Leave's lies appeal to the public? Christine Lagarde, the head of the IMF, asked this question in Aspen yesterday:
Why is it that the populist voices, sometimes based on so-called truth that they now have to retract—why is it that those voices carried a lot more, and a lot further, than the voices of ‘experts’ who were largely unanimous about the outcome and consequences of the decision?”
Partly, it was because populist campaigners such as Nigel Farage promoted Brexit as the fight of "the people" against "the establishment". The vote to Leave was above all a massive kick to the "establishment", both in the EU and the UK. And the experts were seen as part of that establishment.

But it was also because Leave's lies resonated with what people want. People want immigration seriously reduced: so Leave encouraged them to think "taking control" would mean much lower immigration. People want the NHS's funding problems to be solved: so Leave conjured up a fictional source of NHS funding. 

And the deceit still continues. People want to be able to live and work wherever they want, while denying that right to others - so that is what Johnson promises them in today's op-ed. They want an “independent Britain” to dictate the terms under which it will trade with other countries, to their benefit - so he promises them that, too. They want Britain to be a great power - so he gives them that impression. Johnson's op-ed is a tissue of lies that play to people's deeply held beliefs, their hopes and their fears. It is evil beyond belief.

But there is a wider issue here. Populist movements arise from a huge disconnect between people's dreams and the reality of their lives. People dream of prosperity, but they have poverty. They dream of being important, but they are insignificant. They dream of fulfilling, enjoyable work, but they have drudgery. They dream - but they have no hope. Populist movements sell them hope.

Deceit is the stock in trade of such movements, since to convince people to support them they must deny reality. So experts who might reveal their dishonesty must be undermined. It is the very honesty of experts that leaves them vulnerable. If experts see no hope, they say so. And that is not what people want to hear.

When people have no hope, the sellers of snake oil become rich.

Related reading:

Brexit reveals a deeply divided Britain - Forbes
When the world turns dark
Who pulled the switch?
A Latin American tragedy

Image from itv.com.

Tuesday, 21 June 2016


I have reluctantly decided that there will be no more posts on Coppola Comment until after the referendum.

Since I have declared my support for Remain, anything I write about the UK and the EU is now inevitably seen as biased, and anything I write about any other subject is - equally inevitably - seen as avoiding the issue. I cannot, for example, write a balanced analysis of the likely effects on financial services of a vote in either direction, though that is my specialism. Nor can I cross-post the sensible, well researched article on immigration that I was sent earlier today. It is a measure of how toxic this campaign has become that stating my personal views has effectively silenced me.

This is the most unpleasant political campaign I have ever seen in the UK.  Both sides have behaved appallingly. Both have blatantly lied and misused statistics. Both have tried to frighten people into voting for them - the Remain side with scare stories about economic meltdown, the Leave side with warnings about floods of migrants and cultural Armageddon. The real issue, which is whether or not membership of the EU is best for the UK, has been totally buried underneath a stinking pile of disinformation and scaremongering.

I am ashamed of the narrow-minded xenophobia displayed by sections of the Leave campaign, and horrified by the echoes of past extremism in some of its publicity. Where are the British values of fair play, tolerance and open-mindedness? Whatever happened to our historic commitment to welcoming those facing persecution and violence in their own countries?

But even though I support Remain, I am also ashamed of the tactics adopted by some Remain campaigners. Not all Leave supporters are xenophobes by any means, but that is how they have been portrayed. Reasoned debate has given way to mudslinging, and fair play is absent.

Both sides sought to profit from the death of Jo Cox. Remain used her murder to emphasise the involvement of far-right elements in the Leave campaign. And Leave conducted a sustained campaign in the media alleging that Remain was exploiting grief and shock at her death to swing the vote their way. The untimely passing of an honest campaigner and politician sparked underhand and sleazy campaigning tactics by both sides. It was a truly disgusting spectacle, and dishonouring to the memory of a great woman.

This campaign has rolled back stones that perhaps should have been let lie: what has crawled out from underneath them is something I neither wished nor expected to see again. I thought the insular, unfriendly "little England" mentality that I remember from my youth had long since died. The Britain I know and love is a vibrant, cosmopolitan place that leads the world not only in law and finance, but in performing and creative arts - the subjects that above all hold my heart. It is a wonderful mix of people from many nations, cultures and faiths. It is this diversity that makes us great. Yet it is this very diversity that is threatened. If "putting the Great back in Britain" means resurrecting "little England", then I want no part in it.

So I draw the blinds, and turn out the lights, and enter the silence. I will see you on the other side, wherever that may be.

Image from Claire Droppert Photography.

Sunday, 12 June 2016

The EU's greatest achievement


"The EU's greatest achievement is the Euro", said Michael Portillo on the BBC's This Week programme last Thursday.

No, Michael, it isn't. It is the EU's worst mistake.

As Yanis Varoufakis entertainingly explains in an interesting lecture published in the Australian Journal of Political Economy, the creation of the Euro led inexorably to the buildup of unsustainable debt - both private and public - in the Eurozone periphery countries:
The problem is that creating a monetary union is a little bit like invading Russia. At first, there is rapid progress, as the French troops, Napoleon or the Wehrmacht found when they stormed the country, taking large tracts of land without much resistance. Then slowly, as the heavy winter sets in, the Cossacks and the Russian partisans start blowing up your convoys. Eventually you end up with blood on the snow and a hasty retreat. Recall the 1920s – after the Great War the Gold standard had created ‘the Roaring 20s’. Similarly, when Mexico and Argentina pegged their currency one to one on the US dollar, there was a flood of capital coming from the major surplus country - the United States - into Mexico and Argentina, creating the feeling of triumph, growth and investment. It was exactly the same in the Eurozone.
Every one of the examples Varoufakis gives ended in disaster. Blood on the snow, and a hasty retreat. A debt deflationary collapse, and a protracted depression. A sudden stop, followed by debt default and painful restructuring. The European dimension of the 2007-8 financial crisis and the Eurozone sovereign debt crisis (which are the same crisis, really), followed by the Great European Depression.

The inevitable response of the European elite to the problems caused by the Euro is to force economic convergence by fair means or foul, and to call for "deeper integration". But as the Eurozone contracts down in an attempt to heal its wounds, causing suffering across the periphery and rising anger among austerity-hit populations, it becomes ever more inward-looking and defensive. And the growing dominance of the Eurozone in EU policymaking - inevitable, because the focus of European elites is on repairing the damage caused by the Euro crisis - alienates countries that are not members of the Euro. The largest of these, by far, is the United Kingdom.

I don't think the European elites realise how hurt and angry many people in the UK feel about their behaviour. But I have become aware of it in the debate preceding the UK referendum on EU membership. There is a shortage of rational discussion, and many of the comments are personal and nasty. Emotion, not sense, is ruling the roost.

But why are people so angry, and so despairing? There are many reasons, but a common theme appears to be the feeling that Britain is losing control of its own affairs. "Take Control" is the slogan of the Leave campaign. It resonates with many.

My own father has been a lifelong supporter of the European Community. In 1975 he campaigned for the UK to remain in what was then known as the European Economic Community (EEC). But now, he intends to vote to leave.

I asked him why. "It's the Euro," he said. "Britain will never join the Euro. But unless we do, we will be sidelined in European policymaking. Our voice will not be heard, because the Eurozone will dominate. We will inevitably have policies imposed on us that we do not want. We have no choice but to leave if we wish to retain any real control of our own affairs."

I have heard this now from many people. A belief that democratic policymaking - flawed though it is - is being slowly replaced with decisions by an unelected, bureaucratic elite which is only interested in furthering the creation of a United States of Europe against the wishes of the common people. And a growing sense that the UK's voice in Europe is fading as the Eurozone becomes ever more important.

And yet, when I attended the European Summit last week, this was not what I heard. Much of the conversation at the summit was about Brexit, of course. The participants seemed genuinely bemused by it, and distressed that the UK might choose to leave.

Kristalina Georgieva of Bulgaria observed that the UK's voice was - and still is - extremely significant. The UK has often been crucial in forcing through necessary reforms. If it leaves, the UK will be sorely missed.

But of course, she would say that. The UK was instrumental in obtaining the commitment to EU enlargement that enabled her country to join. And not just her country, but others - including the Czech Republic, which hosted the European Summit.

Prague, the capital of the Czech Republic, is a wonderful place. It is, in many respects, the historic heart of Europe. And it is a lively, modern, cosmopolitan European city. Yet when I was young, the Czech Republic was behind the monstrosity known as the Iron Curtain, a pariah country uncomfortably allied to the Cold War "enemy" - the USSR. Even after the dissolution of the USSR in 1991, the Czech Republic, like other former Iron Curtain countries, stayed out in the cold. It separated bloodlessly from Slovakia in 1993 and suffered economic distress in the Russian crisis of 1998. It did not join the EU until 2004. It could not, because the EU did not until then agree to admit the former Iron Curtain countries.

After the creation of the Euro in 1999, many in Western Europe wanted deeper integration of the existing members around the single currency, rather than widening of the EU to admit (among others) former Iron Curtain countries. The UK at that time was under considerable pressure to join the Euro. But the UK never wanted a deeply integrated EU, and it did not want to join the Euro. So it fought for widening, not deepening, of the union.

Eventually, the EU agreed. Ten countries, most of them former Iron Curtain countries, joined the EU in 2004. Two more - Bulgaria and Romania - followed in 2007. The EU today encompasses almost the whole of Europe from the Atlantic Ocean to the border of the old Russian empire.* Even some countries (Ukraine, Moldova) that were historically part of the Russian empire have asked to join.

This, not the Euro, is the EU's greatest achievement. Admitting the former Iron Curtain countries to the EU has brought together the sundered parts of Europe and helped to heal the deep wounds left by the Cold War. The UK should be proud of its part in this remarkable example of cooperation for a far-reaching common good.

But sadly, many in the UK have forgotten about this. Enlargement of the EU resulted in large migration flows from East to West, flows for which the EU, with its open borders and commitment to unrestricted movement of people, was ill-prepared. And the years of stagnation and austerity since the financial crisis have caused growing worry about immigration. Migrants from the EU are blamed for falling wages, insufficient school places, failures in the health service, choked transport systems, shortage of housing. Most of this is unfair - the evidence is that migrants have little adverse effect on any of these, and their contribution is a net benefit to the UK. But it is easier to blame "them" than admit that the real problem is the UK government's history of under-investment and its determination to impose on its population the cost of the banking crisis.

More recently, terrorist threats and the EU's abject failure to deal adequately with massive flows of refugees from the turmoil in the Middle East have increased the fear factor. Now, there is a loud clamour for the borders to be closed and immigration severely restricted.

Few would disagree that large unstable flows of people are a considerable problem. The Schengen agreement which ensures open borders is already effectively suspended in many EU countries due to intolerable pressure on domestic resources from refugees and migrants. The UK, which is not a signatory to Schengen, wants to be able to restrict the right of people from other EU countries to come to its country to live and work. One of the "four freedoms" of the EU, freedom of movement of people, is under attack.

Another of the "four freedoms", the free movement of capital, is also under attack. Large uncontrolled flows of capital are like floods. They sweep away everything in their path, leaving disaster in their wake. The EU was just as unprepared for the enormous capital movements arising from the creation of the Euro and the financial crisis as it was for the enormous migration flows arising from EU enlargement and the refugee crisis. Two countries in the EU and one in EFTA have had to impose outright capital controls to stop capital flight. More subtly, macroprudential measures imposed on banks since the financial crisis amount to a type of capital control, discouraging cross-border lending funded by short-term cross-border wholesale borrowing. Balkanisation of the banking system has made it safer, but it has also made it less effective. The protracted depression in part of the Eurozone is to a considerable extent due to severe restriction of bank lending.

Restriction of capital flows and the migration of people both have consequences for trade. For there to be trade at all, capital must flow: capital controls severely interfere with cross-border trade, as Iceland could tell you. And where capital flows, people inevitably follow, since capital investment generates jobs, and people generally migrate in search of work. Production and trade are both enhanced by the free movement of capital and people.

Restricting the movement of capital restricts both trade and migration: but the restriction operates in the other direction too. Where trade is restricted, capital will not be invested: and when people are prevented from migrating to certain places, those places eventually suffer investment failure as capital moves to places with an unrestricted supply of people to fill the jobs created. At its most extreme, restricting the movement of capital, people goods and services is autarky: and as North Korea shows, autarky impoverishes.

So there is a conundrum. The EU's "four freedoms" are theoretically beneficial to the peoples of Europe. But we now know that complete freedom of movement of capital and people can be destructive. How should the EU re-frame its "freedoms" to ensure that member states can protect themselves when necessary, while benefiting in general from those freedoms? The "safety brake" in David Cameron's "deal" is nowhere near adequate: it is not yet ratified, and since it would only apply to the UK it seems likely that it would be challenged on legal grounds.

"Freedom" is not really freedom if its effects are destructive to others. The "free movement" of capital, people, goods and services must have limits. If it remains in the EU, the UK would have an important role to play in defining what those limits are and how they would apply in practice.

And the UK has an even more important role to play. A two-speed EU in which non-Euro members are systematically sidelined cannot be sustainable. The UK, as the second largest economy in Europe and by far the largest of the non-Euro countries, should lead the reconstitution of the EU into a multi-currency area in which countries have the right to use their own currency or the Euro as they decide. A sovereign bankruptcy procedure is needed, along with a formal exit procedure for the Euro: the UK, which has been friendly to Greece and other distressed countries throughout the crisis, is well placed to campaign for these. And going further, the UK can help the EU to decide how best to reform the Euro, retaining its important role as an international trade currency while dismantling the straitjacket that it creates for domestic users and for the ECB.

Further integration of the EU is not the right way forward. Ultimately, EU member states will break the bonds that further integration creates, since in the absence of any willingness to share risks and losses, they are far too restrictive. The EU needs to be looser, not tighter: wider, not deeper. It is not yet too late to turn around this particular Titanic. Rather than launching a solo lifeboat, the UK should take the helm.

I hope and pray that the people of Britain recognise the vital role that the UK can have in the essential reforms that the EU must undergo if it is to survive, and vote to Remain. I shall do so.


Image: Prague, photographed by me from the Lobkowicz Castle. 

* There are some exceptions, of course: Switzerland, Norway, Liechtenstein and Iceland have chosen not to join the EU. And the Balkan states Albania, Serbia, Montenegro, FYR Macedonia, Bosnia and Kosovo have not yet been accepted as members, though most of them are candidate countries. The most controversial candidate is Turkey, an Islamic country which borders both Greece and Syria and has an ongoing dispute with EU member Cyprus over the status of the north part of the island of Cyprus. It remains to be seen whether the EU's need of Turkey's assistance in controlling the flow of refugees and migrants will be sufficient for it to be admitted as a member. Consistent with its historic support of enlargement, the UK is supporting Turkey's application. However, this might change if the UK government suffered a change of management after a Leave vote.

Wednesday, 8 June 2016

Sisyphus,Tantalus and a prisoner's dilemma

Should Greece leave the Euro? That was the title of the Oxford debate at the Prague Summit in which I had the pleasure of participating yesterday.

But this is the wrong question. Unless there is a considerable shift in Eurozone politics, Greece WILL leave the Euro - eventually. The question is when, and how.

To see this, we need to look at the motivations of all the players involved in the negotiations. The Greek negotiations resemble a "prisoner's dilemma", in which the best outcome for everyone is achieved through collaboration but the participants don't trust each other enough to collaborate. Games are fundamentally psychological, and their outcome is often determined by unspoken or even unconscious drivers. In this case, despite the collaborative rhetoric of the Memorandum of Understanding, distrust and self-interest are the real drivers of the negotiations. In such a situation, true collaboration is impossible and the eventual outcome must be negative for all players.

So, let's look at each player in turn.

Firstly, Greece. Greece's attempt to play the cliff edge game ("go on then, push me") backfired badly last year when the European Council called its bluff. The essence of the cliff edge game is that the player at the edge of the cliff must be prepared to be pushed over the edge, because otherwise the psychological barrier for the other players ("if you push them over you are a murderer") is not credible. But when the European Council threatened to push Greece over the edge ("agree to our terms or leave the Euro"), Greece backed off. In a long and intensely painful night of negotiations, its prime minister, Alexis Tsipras, effectively accepted the European Council's terms.

Since then, Greece has agreed to everything the Eurozone institutions have thrown at it. Everything, however unreasonable. Having failed at the cliff edge game, Greece is now trying to collaborate, apparently in the hope that this will eventually lead to the prized debt relief, along with easing of monetary conditions and the return of investment. It is quite a gamble, but since it has rejected leaving the Euro, Greece has no alternative. This is a very weak negotiating position.

Secondly, the European creditors, led by Germany. Despite its name, the Eurogroup essentially represents the European creditors, since its members are the finance ministers of Eurozone member states.

The creditors want their money back. All of it. Their sole objective in this game is to achieve full repayment. They have no interest in restoring Greece's economy except in so far as it would enable them to extract more of their money. And since the failure of the cliff edge game, psychologically they have the upper hand. They know Greece will not take the risk of being pushed out of the Euro, and so they can make whatever demands they wish in the certain knowledge that Greece will comply. Unless some Exocet hits the negotiations, they can't lose.

But of course there is the European Commission (EC). Isn't that interested in an outcome that benefits everyone, including Greece?

Not really. The EC is interested in furthering the goal of EU integration. Since a state leaving the Euro would be (at least) a step backwards, and there is a not insignificant risk that other states might follow, furthering EU integration means doing whatever it takes to keep Greece in the Euro. If keeping creditors happy is the only way of keeping Greece in the Euro, then the EC will side with the creditors. Of course, since blatantly siding with creditors makes it look biased, which is a bad political message for a supposedly neutral institution, it may attempt to push the creditors towards a gentler approach. But if the creditors resist it will give in, thus making itself look weak.

So the EC also has a very weak negotiating position. In fact the weakness of the EC is telling. One of the fundamental problems with the Euro is the weakness of its institutions relative to the governments of nation states.

Hang on though - what about the ECB? Surely that is a powerful Eurozone institution?

No. The ECB is by far the weakest of the major central banks. Despite its supposed independence and protection from political influence, it is in reality fenced in by treaties and subject to both political and legal challenge. It has been forced into a political role that it should not have. In this game, the ECB is trying (and mostly failing) to stay out of the limelight and preserve the appearance of political neutrality. And beneath this, its primary objective is to keep the Euro together. Since Greece leaving the Euro carries unquantifiable risks to financial stability and the integrity of the Eurozone, the ECB does not wish this to happen. Therefore its natural bias is towards the creditors. It will do whatever it takes to force Greece to comply with creditor demands.

It should be apparent by now that the Eurozone dimension of this game has reached an unhealthy equilibrium. Greece has been cast in the role of Sisyphus, forever pushing a rock up the hill of "structural reforms" only to see it roll back again as it fails to meet fiscal targets or creditors impose more demands. Or perhaps in the role of Tantalus, forever reaching for the water of debt relief only for it to be drawn out of its reach. These perpetual-motion myths are descriptive of the psychological traps created by more powerful players to perpetuate the game.

This is not simply a problem for Greece: any debtor country is potentially in the same situation. Such toxic game-playing does not bode well for the long-term future of the Eurozone. Sisyphus and Tantalus were punished in perpetuity for offending the gods. But the Eurozone is a human construction: the political pressures created by such a power imbalance between debtors and creditors will eventually tear it apart. If the Euro is to survive in the longer term, this imbalance must be corrected.

The Eurozone desperately needs to strengthen its institutions relative to nation states, develop procedures for managing sovereign insolvency, and impose loss sharing on official as well as private sector creditors. But since these reforms would not serve the interests of creditor countries, it seems unlikely that they will ever happen. Eventually, therefore, the Euro is likely to fail.

Of course, there is one more player in this toxic game. To its credit, the IMF has been trying to force a resolution. Everyone knows that Greece's debt is unsustainable, but it suits the European players to pretend that if Greece does enough "reforms", it can be made sustainable. It is this pretence that locks Greece into its Sisyphean role, and keeps debt relief tantalisingly out of reach. But it is a bluff, and the IMF has called it.

However, the IMF itself is a creditor - an expensive one. And like the rest of the creditors it wants its money back. Unsurprisingly, therefore, the IMF's demand that other creditors accept losses while it accepted none did not go down too well. The European creditors dismissed the IMF's assessment that the demands placed on Greece were impossible, and its forecast that eventually Greece would default, They pointed out that the IMF's record of accuracy in forecasting is dismal, and repeated their assertion that Greek debt could be made sustainable through structural reforms. And to stick the knife in further, they offered to refinance IMF loans to Greece at lower interest rates than those charged by the IMF. Ouch.

The truth is that there is no genuinely independent arbiter in this negotiation, and there is a massive institutional bias in favour of creditors. True, the latest Memorandum of Understanding (MoU) includes some sensible reforms: but the overriding aim throughout is to construct the sustained 3.5% primary surplus that would be necessary to make Greece's debt sustainable without debt relief. The MoU imposes a fiscal tightening of 3% of GDP on an economy that has already contracted by 27% and is now back in recession. To counter the IMF's argument that 3.5% was neither desirable nor sustainable, the MoU provides for an additional contingent tightening of 2% through unspecified spending cuts and tax increases should Greece fail to meet its primary surplus target. Claims that Greece has "done" its internal devaluation are clearly wrong. Greek prices and incomes have a lot further to fall.

While this remains a wholly intra-Eurozone matter, with the IMF involved only because the creditors don't trust the EC to promote their interests (and itself significantly weakened by partisan interests), there can be no collaborative resolution to the game. But the longer it continues, the worse the eventual outcome will be, not only for Greece but for the other players too. A disorderly breakup of the Euro, possibly involving not only Greece but other countries too, would be terrible for everyone. But unless there is a major shift in the political stance, that is what will eventually happen.

European creditors have no incentive to offer debt relief unless they are faced with the credible threat of losing much more of their money. And they are hardly going to allow Greek default on official sector debts while remaining within the Euro. So as long as there is no prospect of Greece leaving the Euro, there will be no debt relief. Therefore, as Sisyphus and Tantalus cannot exist forever in our human world, eventually Greece WILL default and leave the Euro, whether it wishes to or not.

Related reading

The Eurogroup statement on Greece, annotated
The Greek bailout: repeating the mistakes of the past - Forbes
The Great EU-IMF Standoff - Forbes

Monday, 6 June 2016

If only we could return to the glorious 1990s.....

The chart below comes from the Rockefeller Institute's report on Public Pension Funding Practices (h/t @Silver_Watchdog on Twitter). It illustrates perfectly the point I have been trying to make for quite some time now. Pension funds are not taking on more risky investments because the risk premium has fallen, but because the risk-free rate has fallen:

In fact, as the chart shows, the risk-free rate has been falling steadily for over thirty years.  This is not a post-crisis blip. It is a secular trend.

Yet pension investors have not adjusted their expectations of returns as the risk-free rate has fallen. Rather than targeting a spread above the risk-free rate that reflects their risk appetite, they target an historic rate. The chart suggests that the rate they are targeting has not significantly changed since 1990. Thus the risk appetite of pension fund investors has increased.

In similar vein, the Wall Street Journal mourns the passing of the 100% bond fund:

There seems to be a huge problem with mean reversion in expected returns on pension investments. Would-be pensioners expect to receive the same return on their investments as they would have received in an environment of much higher risk-free rates.

But why do investors expect to receive the returns of two decades ago? Firstly, let's consider the effect of inflation. Here is US CPI inflation since 1990 (since that appears to be the last time the risk-free rate met investors expectations):

Now, CPI inflation was a bit high in 1990. But if we look at the trend since 1991, we can see that CPI inflation has fallen - admittedly not steadily, but it has come down by about 2%. So part of the explanation is money illusion. Investors are actually targeting higher real returns than they were two decades ago.

So to allow for the secular fall in inflation, investors should perhaps be targeting a return of 5.5% rather than the 7.5% that the Wall Street Journal describes as "reasonable". This would give a real return of about 4.5%.

But even this is a considerable spread above the current risk-free rate. The fact is that investors have to take more risk in order to achieve the same real returns as in 1990.

I don't yet have a coherent explanation for this. But it adds a dimension to the "secular stagnation" argument. It appears we have a problem with the pricing of risk.

Of course, it is possible that investors are persistently pricing in much higher inflation (and being persistently wrong). And it is also possible that fund managers are trying to generate the returns of two decades ago in order to justify their exorbitant fees. But there could be another explanation.

The WSJ's table is interesting, but the falling risk-free rate does not indicate that there is any serious "reach for yield" going on. Some like to think that central banks are artificially depressing the risk-free rate: but the thirty-year downwards trend does not support this. Rather, it speaks of a growing demand for safe assets relative to other forms of investment. So to my mind the growing wedge between the risk-free rate and the historic rate of return is consistent with rising risk aversion.

I noted in a previous post that German savers are becoming increasingly risk averse as the population ages. I wonder if this is a general problem in ageing populations? On the face of it, we might expect that an ageing population would become increasingly risk averse, since as people age they become more sensitive to losses. This effect would be felt even more strongly in an ageing population with a large middle class, since middle classes do not have the capacity to absorb capital losses as the very rich can.

Some degree of risk aversion is of course healthy. Taking stupid risks endangers both the individual and society. But when risk aversion is pervasive, it becomes toxic. It engenders a mentality that regards risk as something to be avoided, not managed. It encourages unproductive and even dangerous investments in the quest for total safety - which of course can never be achieved. It dampens economic activity, as propping up the relics of past glories takes precedence over developing new enterprises.

And over the longer term, risk aversion is completely counterproductive. A systemically risk-averse economy is deflationary, stagnant and prone to bubbles, as capital is diverted from productive enterprise to "safe assets" such as property or passing fancies in the search for yield.

It is also an unstable economy. Risk-averse investors forced into riskier investment classes in search of yield are likely to run at the first sign of trouble. So we have a "risk-on, risk-off environment".

There are ageing societies the world over. If risk aversion is a defining feature of ageing societies, perhaps instability and falling real rates of return are the shape of things to come?

Related reading:

The safe asset scarcity problem, 2050 edition
Public Pension Funding Practices - Rockefeller Institute

Friday, 3 June 2016

Schroedinger's assets

In a new paper*, Michael Woodford has reimagined the famous “Schroedinger’s Cat” thought experiment. I suspect this is unintentional. But that’s what happens when, in an understandable quest for simplicity, you create binary decisions in a complex probability-based structure.

Schroedinger imagined a cat locked in a box in which there is a phial of poison. The probability of the cat being dead when the box is opened is less than 100% (since some cats are tough). So if p is the probability of the cat being dead, 1-p is the probability of it being alive. The problem is that until the box is opened, we do not know if the cat is alive or dead. In Schroedinger’s universe of probabilities, the cat is both “alive” and “dead” until the box is opened, when one of the possible outcomes is crystallised.

Now for “cat”, read assets. In Woodford’s model, when there is no crisis, the probability of asset collapse is zero. But if there is a crisis, the probability of an asset collapse is greater than zero but less than 100% (my emphasis):
The sequence of events, and the set of alternative states that may be reached, within each period is indicated in Figure 1. In subperiod 1, a financial market is open in which bankers issue short-term safe liabilities and acquire risky durables, and households decide on the cash balances to hold for use by the shopper.8 In subperiod 2, information is revealed about the possibility that the durable goods purchased by the banks will prove to be valueless. With probability p, the “no crisis” state is reached, in which it is known with certainty that the no collapse in the value of the assets will occur, but with probability 1−p, a “crisis” state is reached, in which it is understood to be possible (though not yet certain) that the assets will prove to be worthless. Finally, in subperiod 3, the value of the risky durables is learned.
Here is Woodford’s Figure 1 showing his sequence of events:

The binary forks are clear. Either there is a crisis, or there is not. If there is a crisis, either assets collapse or they do not, and until either the asset collapse happens or the crisis is over we do not know which it will be.

To keep things simple, Woodford also assumes that asset collapse after a crisis renders assets worthless. The reality in most cases is not so extreme, of course, but hey, why destroy a perfectly good binary argument with unhelpful facts. So, following Schroedinger, we can say that until one of the two possible outcomes is crystallised, our assets are both worthless and valuable.

But Woodford thinks investors can’t cope with such uncertainty. Faced with a probability 0.5<q<1 that the value of their assets will collapse, rational investors will sell. So whereas the patient Schroedinger waits to open his box, and presumably only cremates the cat if it is dead, impatient investors cremate the box with the cat – whether dead or alive - inside. This changes a probability of perhaps 60% that there will be an asset collapse into a dead cert, since if all investors sell, the value of the assets falls to zero. Investors’ rational decision not to accept the risk of total loss resolves uncertainty in a way that ensures the majority of them lose. It’s the madness of crowds.

The economic consequences of panicky investors all selling assets at once can be extremely serious. Sharply falling asset prices quickly bankrupt financial institutions, corporations and households, while impaired collateral values disrupt funding, causing a sudden stop in financial flows. So what is Woodford’s solution?

Step forward, central banks. Woodford’s big idea is that central banks should resolve the uncertainty by buying the risky cat box and replacing it with their own breed of risk-free cat. We replace the certainty of asset price collapse with the certainty of no collapse. Schroedinger’s cat is alive and well.

But what on earth is new about this? We have known for years that central banks can support asset prices. It is the main benefit of quantitative easing. When a central bank credibly stands as buyer of last resort for a given asset class (JGBs, anyone?), it effectively sets the price – to the annoyance of those who would really like to make money from shorting those assets. Central banks cannot prevent their own currencies from collapsing, but they can prevent the value of any asset denominated in their own currency from falling. This is pretty basic and doesn’t need a very long paper and lots of complicated mathematics to explain it.

But Woodford’s intention is not simply to remove the possibility of asset price collapse after a crisis. It is to remove the possibility at all times. He wants to wipe out both the second AND the first binary fork in his diagram. Specifically, central banks should provide sufficient public sector safe assets to eliminate the possibility of the private sector creating things that it calls “safe assets” which can turn out to be anything but safe. So not only should the cat not be cremated while still in its box, it should not be put in the box in the first place.

There is nothing new about this idea, either. Gary Gorton (whom Woodford cites) has been saying for years that the private sector cannot create genuinely safe assets. And back in 2012, BIS produced a paper arguing that governments in good standing (by which it meant reserve currency issuers, particularly the US) should issue sufficient safe assets to meet demand. BIS did not specify what it meant by safe assets: but Poszar defined them as cash and various varieties of short-term government debt (such as Treasury bills). Woodford follows Poszar in regarding these as as equivalent to cash.

Widening the definition of “cash” to include short-term government debt securities as well as currency and reserves eliminates an obvious criticism of any proposal to replace “safe assets” with cash. Reserves are only available to regulated banks, while physical currency is inconvenient in large quantities. But non-banks need safe assets too. Pozsar explains that a shortage of public sector safe assets for non-banks contributed to excessive production of private sector “safe assets” prior to the 2007-8 financial crisis.

And this is the heart of Woodford’s paper. He thinks he can dismantle the US banks’ securitisation engine by removing the incentive for them to fund themselves by issuing short-term asset-backed securities. If the central bank floods the place with short-term liquid government securities, demand for bank-issued “safe assets” will collapse, banks will stop funding themselves by issuing the things and there will never be another 2008.

Of course, there would have to be a large increase in the supply of short-term liquid government securities. This has significant implications for fiscal finances. Short-term they may be, but T-bills are still debt. So to accommodate the demand for T-bills, either the US government would have to increase the total amount of US government debt in circulation, or it would have to fund itself primarily with very short-term debt. But governments funding themselves largely with very short-term debt suffer interest rate risk. Normally, the only governments funding themselves in this way are in distress.

And there remain question marks over the effect of very high debt/gdp levels on growth and welfare. BIS's idea that government should issue far more debt but ensure its future safety by permanently running primary surpluses shows an incredible naivety about the political process. How could a democratically-elected government possibly maintain continual austerity while storing up the proceeds from unprecedented levels of public debt issuance? Such blatant favouring of the demands of the financial system over the needs of its population would seriously raise political risk.

So there is a conundrum. To meet demand for safe liquid assets, the US government must shorten the average duration of its own debt. But doing so raises its risk, hence making its debt less "safe". How to resolve this problem?

This brings us to Woodford’s REALLY big idea. The Operation Twist variant of QE shortens the duration of government securities held by the private sector. So the US government can still fund itself with long-term debt, but much of this would be exchanged by the Fed for T-bills (Operation Twist) or monetary base (QE). The T-bills would of course also be issued by the US government, so the nominal amount of US debt would increase significantly. But because the majority of long-term debt would be held by the Fed, the amount of US debt held by the private sector would not significantly increase. Only its composition would change. And of course the Fed controls short-term interest rates, so interest rate risk on such short-term funding of government spending would be neutralised. What's not to like?

Woodford’s scheme is consistent with BIS’s argument that the central bank should routinely monetise its own government’s debt in order to control the price. Safe assets have to remain safe, after all.

Now, as a cat lover, I am all in favour of not cremating cats until we know for certain they are dead. But why deprive cats of the boxes that they love, simply because not all cats are immune to poison? And why create a special breed of cat that is immune to poison? Why not remove the poison?

This, to my mind, is a serious weakness in Woodford's paper. He makes no attempt to identify what the poison is. What is it that kills the cat?

Recall that, prior to 2008, the supposedly safe private sector assets were mispriced. They were believed to be safer than they turned out to be, and when the nakedness of the emperor was disclosed for all the world to see, their value crashed. But why were they believed to be safe?

The clue is in this paragraph (my emphasis):
 Lowering the equilibrium return on risky investments (such as the “durable goods” modeled here, which one may think of as housing) by lowering the return on safe assets works only insofar as the increased spread between the two returns that would result if the return on risky investments did not also fall increases the incentive to finance additional risky investment by issuing safe liabilities, thus increasing the leverage of the banks and the degree to which they engage in liquidity transformation; this results in a reduced equilibrium return on risky investment, but not by enough to fully eliminate the increased spread that induces banks to issue additional safe asset-backed liabilities.
I'm afraid this is a serious error. Housing is not thought of as a risky investment. It was - and still is - believed to be safe.

This is the poison that kills the cat. And it was put in the box by Franklin D. Roosevelt back in 1934.

The National Housing Act established the principle of persistent government support of the housing market - a principle that was extended and developed by subsequent governments, often to prevent property market collapses. For example, the Savings & Loan crisis of the 1980s resulted in further federal and state guarantees for mortgage lending and bailout of institutions that had bought mortgage-backed securities. By the end of the 20th century, the US mortgage market was the most government-controlled in the world and property prices had been protected from significant falls for seventy years. No wonder people believed that property was a safe investment.

So the securities issued by banks were "safe" because they were backed by safe physical assets. They collapsed because those safe physical assets turned out not to be safe. Nor is this the only time this has happened. Indeed, the National Housing Act itself came about because of the terrible property market crash in the Great Depression, in which real estate prices fell by 30%.

Woodford correctly notes that real estate is a risky investment, but he fails completely to note that governments have fostered the illusion of safety, not because they wish to deceive but because they really believe that risky investments can be made safe. The securitisation engine that Woodford hopes to dismantle grew from seeds sown in the New Deal, seeds that - as the Market Realist explained in 2013 - were sown with the best of motives:
The use of securitization came out of the Great Depression. Prior to the Great Depression, local banks largely served their communities, and if the local community suffered an economic shock—like an employer going out of business or a weather-related problem—the entire bank’s customer base would have problems all at once. This put undue risk on the bank but also left the community with no source of credit if the bank started having problems. Securitization allowed lenders from outside the area to provide capital to borrowers within the community. It also allowed the local bank to lay off some of its geographic risk.
In short, securitisation was believed to make the financial system more stable.

Nor has Woodford thought about the economic consequences of dismantling the mortgage securitisation engine. Removing the incentive for securitisation is presumably intended to force banks to keep mortgages on their balance sheets. In combination with macroprudential regulation (which Woodford suggests should be used in conjunction with QE), this would be likely to cause a considerable reduction in mortgage origination. How long would it be before a desperate government looked for ways of circumventing this restriction in order to stimulate the property market in the interests of improving economic growth? How long before the Fed trod the path that the Bank of England laid with its "funding for lending" scheme, accepting mortgage loans in return for short-term government debt to enable banks to reduce their cost of funds and thus increase mortgage lending?

For over seventy years, the combination of government intervention and a liquidity transformation engine (for that is what securitisation is, in the US) created the illusion that property prices could never fall. But no government can entirely insulate markets from shocks: and the securitisation engine, far from dispersing risk safely, in fact concentrated it. The crash, when it came, was made far worse by the deliberately fostered belief that real estate was a safe investment.

Now Woodford calls for for permanent government intervention in financial markets, and for routine use of liquidity transformation to reduce risk. Like this worked so well last time.

But why should financial markets be protected from shocks? Why should governments preserve the illusion of safety by creating "safe assets" purely for the use of the financial industry, regardless of the needs of their population? In short, why should we continue to put poison in the boxes that cats love to sit in?

There is no such thing as a safe asset. The idea that any asset is, or can be made, completely safe, is dangerous folly. Financial markets must learn to price risk correctly and manage it appropriately. Until they do, they will continue to put the whole of society at risk.

Related reading:

Have we done enough to prevent another crisis?
When governments become banks
Safe assets and Triffin's dilemma
Central banks, safe assets and that independence problem
On risk and safety
Shadow banking's enduring perils - Perry Mehrling

Brad Delong's take on Woodford's paper is here.

* I'm very sorry about the paywall. Academic publishing, meh. I have quoted the bits of Woodford's paper that I think are relevant to my argument. Brad Delong has done likewise.

Image from heinakroon.com.