Sunday, 30 October 2016

The dangerous scheming of stupid politicians


There is growing speculation that the Governor of the Bank of England, Mark Carney, will not extend his term. Carney originally agreed to a five-year term, which would end in 2018, but it had been thought he might extend to the more usual eight years for a Bank of England governor. This is now looking increasingly unlikely.

Carney has come under fire from pro-Brexit politicians for warning that Brexit is likely to increase inflation and unemployment and reduce economic growth. They accuse him of "talking down" the UK. This is some chutzpah, from politicians whose incompetence and arrogance has stunned the world. If anyone is "talking down" the UK, it is the Three Clowns currently running the Brexit project, and their baying packs of supporters.

I have been severely critical of Bank of England policies. I don't like the over-reliance on QE: I think it is a useful crisis tool, but far too much has been expected of it. I think that the independence of the Bank of England was undermined by George Osborne's expectation - stated openly even before Mark Carney arrived on the scene - that the Bank of England would provide monetary support to offset the effects of fiscal consolidation. I disagreed with the Bank of England's support for the Help to Buy scheme: this scheme was blatantly intended to buy votes, and the Bank should not have touched it with a barge pole. The FLS scheme was also suspect for the same reason. Under Carney, there has been too much playing second fiddle to a very political Chancellor, and not enough flexing of independent muscles.

That said, Carney has been an effective Governor in many ways. He understands banks and markets, and has taken a personal interest in measures to promote financial stability. Perhaps his moves to regulate banks don't go far enough, but at least he has taken them seriously, unlike his predecessor. I was frankly astounded when the Brexit camp on Twitter lauded Mervyn King as a far better Governor than Carney. How on earth could the man whose inattention to financial stability allowed dangerous imbalances to build up in the UK financial system be a better Governor than the man who has spent most of his term putting in place measures to prevent such imbalances building up again?

But the Brexiteers have extremely short memories. Not only have they forgotten the disaster that Mervyn King helped to cause, they have forgotten the near-disaster that their own actions caused. After the Brexit vote, both UK political parties went into meltdown. The Prime Minister resigned, the Labour party disintegrated, and the Brexiteers - visibly shocked by their unexpected victory - went into hiding, fearful that they would now have to deliver on their promises. The election process for a new Conservative party leader became a toxic charade of backstabbing and poisonous lies.

In the middle of this maelstrom, one man remained standing. That man was Mark Carney. On 24th June, as sterling slid and bank stocks fell, he stepped forward to calm the markets. Here is part of his statement:
The people of the United Kingdom have voted to leave the European Union. Inevitably, there will be a period of uncertainty and adjustment following this result. There will be no initial change in the way our people can travel, in the way our goods can move or the way our services can be sold.And it will take some time for the United Kingdom to establish new relationships with Europe and the rest of the world.
Some market and economic volatility can be expected as this process unfolds. But we are well prepared for this.  The Treasury and the Bank of England have engaged in extensive contingency planning and the Chancellor and I have been in close contact, including through the night and this morning. The Bank will not hesitate to take additional measures as required as those markets adjust and the UK economy moves forward.
In which parallel universe is this "talking down" the UK economy?

Largely because the Bank of England was seen to be in control, the fact that the UK had no effective government for the entire summer did not cause major problems. Sterling stabilised, gilt yields fell and stock markets rose.

In August, the Bank of England cut interest rates and re-started QE in anticipation of lower growth and rising unemployment due to the Brexit shock. Markets responded positively - but the right-wing press took it badly, once again accusing Carney of "talking down" the UK. They pointed to the comments of Mervyn King, who criticised the policy decision and the Governor's forward guidance that further easing might be necessary, saying that the decision was panicky and Brexit could make the UK better off.  But why we should we give King's views any credence? Or, for that matter, those of Lord Lawson, the architect of the 1980s housing bubble, who is now calling for Carney's resignation? These two men presided over two of the worst financial crises ever to hit the UK, though the slimy Lawson got out before the brown stuff hit and has since rebuilt his credibility among the gullible. They are  hardly reliable witnesses.

Apart from the accusations of political bias, Brexiteer criticisms of Carney's performance are frankly ignorant. Firstly, it is not the job of the Governor of the Bank of England to "talk up" the economy. That is the job of politicians - a job that they have spectacularly failed to do. The Governor's job is to present a fair and balanced analysis of the state of the UK economy using forecasts produced by Bank of England staff. This is what Carney has done.

Secondly, the Governor does not make interest rate decisions. That is the job of the MPC. The Governor is only one member of the MPC, though obviously an important one. He can be overruled.

Thirdly, on forward guidance, since when have economists been clairvoyant? Forward guidance is information provided to the markets about the expected path of future policy - but it is not a guarantee. If conditions change, the policy changes and the forward guidance is therefore wrong. This is a feature, not a bug.

Now the summer of calm is over and a new government is in place. And we are facing chaos again. The reason is, once again, the utter stupidity of politicians.

The Conservative MP and arch-Brexiteer Jacob Rees-Mogg has been pursuing a sustained campaign to have Carney removed from office. Rees-Mogg claims that by not being more positive about Brexit, Carney has "politicised" his job and undermined the independence of the Bank of England. Other prominent Brexiteers, such as Daniel Hannan, have repeated this claim.

This might have been dismissed as Brexiteer imagination had it not been for the new Prime Minister Theresa May's comments at the Conservative party conference. She appeared to criticise the Bank of England's monetary policy and indicate that a change of regime might be on the cards. In fact, the term "A change has got to come" was a strap-line that she repeated at intervals throughout her speech: it was not aimed at the Bank of England, let alone its Governor. But it was seized upon by those who want to undermine Mark Carney.

Now, legitimised by May's comments, the campaign against Carney is intensifying. The right-wing press is awash with articles criticising his actions, questioning his competence and repeating the allegations of political bias. Some openly call for his replacement. And, in the most insane twist of all in this psychotic fantasy, the Spectator has fingered Jacob Rees-Mogg as Carney's successor. Rees-Mogg, whose degree is in history and whose only qualification for this job is that he worked for a Hong Kong wealth management firm. Plus his extreme right-wing views and hardline support for Brexit, of course.

It is hard not to conclude that Rees-Mogg's support for Brexit is the real qualification - and indeed the Spectator explicitly says this. Brexiteers wanted a Brexiteer Prime Minister. They didn't get one, though May seems to be trying to out-Brexit the Brexiteers. So now they are trying for a Brexiteer Bank of England Governor. Political bias in a Bank of England Governor is fine as long as it is in the right direction, it seems.

Today, the Daily Mail - which has been vilifying Carney for months - gleefully reported that Carney could announce his resignation "within days". This was a repeat of The Times's allegation that Carney could use the inflation report due out on Thursday this week as an opportunity to announce his departure. The Sunday Times, more balanced and thoughtful, says that this is unlikely, but that Carney will make his position clear before the end of the year.

I have no doubt that a suitable replacement for Carney could be found, if there is sufficient political will. By "suitable" I don't mean the insufferable Rees-Mogg. I mean another senior financial economist with a spotless track record and a reputation for neutrality. These rare beings aren't easy to find and they don't come cheap. But the Bank of England is among the world's premier central banks, and the top job there is prized.

However, I now wonder whether the political will to maintain the Bank of England's independence is diminishing. Philip Hammond, the Chancellor, has defended Mark Carney, saying that he would welcome him extending his term to 2021. But Hammond himself has come under pressure from hardcore Brexit supporters on the right wing of the Conservative party: after the awful Daily Express scented blood, May was forced to express her "full confidence" in her beleaguered Chancellor. This does not bode well.

The Chancellor's weakened position further weakens Carney, since it will be hard for a Chancellor suspected of trying to "water down" Brexit plans to support a Governor suspected of trying to derail the whole thing. And worse, it increases the likelihood of a political replacement. The government may find it very difficult to resist Brexiteer demands that the next incumbent should have pro-Brexit views. May herself seems to want a more hawkish monetary policy stance to please Tory core voters. The pressure to appoint a political Governor may become too intense for Hammond to resist.

It is very worrying indeed that the future of the Bank of England as an independent, non-political institution rests in the hands of an already weakened Chancellor. The populist surge in the UK is dangerous beyond belief. If Carney is forced out, and is replaced with a right-wing, pro-Brexit politician, the consequences for sterling, gilt yields and the UK economy don't bear thinking about.

Related reading:

Defend Central Bankers, Even If You Think They Shouldn't Exist - Forbes
Hands Off - The Economist

Image from Huffington Post. 

Monday, 24 October 2016

Raising interest rates is not that simple, Lord Hague

The present period of very low interest rates is widely assumed to be temporary, a consequence of the 2008 financial crisis and subsequent central bank action. Because of this, as the financial crisis fades into the mists of time, there is growing political pressure for "normalisation" of interest rates. Here, for example, is William Hague warning that central banks must start to raise rates or face losing their independence:
The only way out is for the US Fed to summon the courage to lead the way to higher interest rates, and others to follow slowly but surely. If they fail to do so, the era of their much-vaunted independence will come, possibly quite dramatically, to its end.
Hague gives ten reasons why low interest rates are a bad idea. His points can be summarised thus:


  • the "reach for yield" by savers who want higher returns drives up the price of assets
  • higher asset prices increase wealth inequality, fuelling popular anger
  • pension funds are struggling, forcing businesses to put more money into them
  • banks are struggling to make a profit
  • people are struggling to save enough for their retirements
  • companies would rather buy back shares than invest productively
  • low interest rates support zombie companies
  • pumping up asset prices could result in an almighty crash
  • "emergency measures" shouldn't still be in place after nearly a decade anyway


  • Few would disagree that these are the adverse effects of very low interest rates. But unfortunately none of them necessarily mean that interest rates should rise. If interest rates were naturally very low, rather than being artificially depressed by central banks as Hague implies, these effects would still occur. As Larry Summers has pointed out (pdf), asset price bubbles are a feature of "secular stagnation", where the economy becomes stuck in a low-growth, low-inflation, low-interest rate equilibrium:
    Let us imagine, as a hypothesis, that this decline in the equilibrium real rate of interest has taken place. What would one expect to see? One would expect increasing difficulty, particularly in the down phase of the cycle, in achieving full employment and strong growth because of the constraints associated with the zero lower bound on interest rates. One would expect that, as a normal matter, real interest rates would be lower. With very low real interest rates and with low inflation, this also means very low nominal interest rates, so one would expect increasing risk-seeking by investors. As such, one would expect greater reliance on Ponzi finance and increased financial instability.
    Raising interest rates above their natural rate is ultimately unsustainable, since it means that the productive sector is slowly drained to provide rents to the unproductive sector. The problem therefore is identifying what the "natural" rate is. Is this just a blue funk by central banks, as Hague thinks - or are there other reasons why interest rates are still so low?

    There is a growing body of research that suggests that not only are very low interest rates the "new normal", they have further to fall. And the reasons have little to do with the financial crisis.

    In an important new paper (pdf), Federal Reserve researchers blame demographic factors not only for the falling equilibrium real interest rate, r*, but also for declining GDP growth:
    We find that demographic factors alone can account for a 1.25 –percentage-point decline in the equilibrium real interest rate in the model since 1980—much, if not all, of the permanent decline in real interest rates over that period according to some recent time-series estimates, such as Johannsen and Mertens (2016b) and Holston et al. (2016). The model is also consistent with demographics having lowered real GDP growth 1.25 percentage points since 1980, primarily through lower growth in the labor supply; this decline is in line with changes in estimates of the trend of GDP growth over that period.
    And they add that the apparent correlation between the financial crisis and low interest rates is an illusion:
    Interestingly, the model also implies that these declines have been most pronounced since the early 2000s, so that downward pressures on interest rates and GDP growth due to demographics could be easily misinterpreted as persistent but ultimately temporary influences of the global financial crisis.
    Gavyn Davies identifies three reasons why r* will remain low:


  • falling labour supply growth rate
  • rising dependency ratio
  • rising longevity


  • Together, these add up to an environment in which there is a growing propensity to save, a rising capital share and sustained downwards pressure on interest rates. Admittedly, as the US baby boomers retire, their propensity to save should diminish. But the rising dependency ratio will force working-age people to save a larger percentage of their incomes in order to support the growing number of elderly. This is the case regardless of the method of saving, as John Eatwell pointed out.

    Just how severe the demographic pressures will be in future is evident from these "beehive" charts produced by researchers at Cambridge University:



    The researchers identify the introduction of the contraceptive pill in 1967 in Western countries as the principal cause of this striking demographic change. I would probably add to that liberalization of abortion services at around the same time. The effects are particularly pronounced in Germany:
    .....the fertility rate fell from 2.5 in 1967 to 1.4 in 1970. In the long run, this will lead to a decline of the steady state population growth from 1.5% to -0.5% per year. However, during the transition to the new steady state, the age composition of the population will deviate strongly from its steady state structure. The fall in fertility led to substantially smaller cohorts born just after the introduction of the pill, with an echo-effect when the first, smaller, post-pill cohort of women starts giving birth themselves. The last cohorts born before the introduction of the pill are therefore much larger than the cohorts born before and after. For Germany, the cohort born in 1995 is just half the size of that born in 1968.
    In China, where the fertility shift lags the others, the cause was undoubtedly the one-child policy. Interestingly, the US does not show such a dramatic fall in cohort sizes: the researchers don't discuss the reasons for this, but I suspect it is due to immigration. But even in the US, increasing longevity will mean a rising dependency ratio.

    The researchers go on to discuss the effect on saving and spending patterns of this demographic shift:
    People initially borrow to finance their education; next they enter the labour force and begin saving, at first to repay this loan and then to save for retirement; finally they deplete these savings during retirement. For this reason, the desired stock of assets is at its maximum just before retirement. The current demographic profile, with large cohorts approaching retirement, means that the population is disproportionately biased towards saving.  As the large cohort desires to hold a large stock of savings, there is a surplus of savings. At the same time, the absorbers of savings – the young cohorts who borrow to finance their education – are in short supply. This implies that the real interest rate will be low, in fact even negative.
    The researchers omit to note that in many Western countries the young borrow to buy property, not just to finance their education. In theory, demand for housing should help to support the interest rate. But most people buy houses with mortgage loans. As property price rises outstrip wage rises, mortgage demand pushes up the price of property, putting additional downward pressure on interest rates. Rising property prices mean the young must take on ever larger mortgages, and rising mortgage debt relative to household income is unsustainable unless interest rates fall. When the acquisition of assets is generally financed by debt, asset price bubbles provide only short-term relief to the problem of falling interest rates. Over the longer term, they make the problem worse.

    This striking chart shows the sharp decline in the real interest rate since the 1980 peak:



    Worryingly, this chart shows that the real interest rate still has further to fall. By 2035, if the researchers are correct, the real interest rate will have fallen to minus 1.5%, purely due to demographic factors. I suppose we should be relieved that it will gradually rise after that, eventually stabilising at minus 0.5% by the end of this century. But unless something changes, it will never be positive again.

    Permanently negative real interest rates have huge implications for the structure of finance. Firstly, banking as we know it will become impossible, since credit intermediation reverses when rates are negative. Secondly, maturity transformation would become unprofitable: although in theory yield curves could still be positively sloped when rates are permanently negative, they would be very flat. There would have to be a major rethink of the way in which financial intermediaries whose job is maturity transformation (banks, pension funds, insurance companies) work.

    More importantly, permanently negative real interest rates fundamentally affect the ordering of society. They do not support debtors at the expense of savers, as is popularly believed: rather, they favour those who own assets (mainly the old) at the expense of those who do not (mainly the young). This potentially sets up a highly damaging intergenerational conflict. The older people who expected higher returns on their savings than they will receive are already angry, and their anger is likely to increase. The younger people who see their hopes of owning their own home receding into the distance are also angry, and their anger is likely to increase too. And when younger people face confiscation of growing amounts of income, either in the form of taxes (even if disguised as social security contributions) and/or compulsory saving (auto-enrolment springs to mind - there are already calls for the percentage contribution to be increased), in order to support a rising number of elderly, they will become even angrier.

    So what is the solution? Sorry, Lord Hague, it certainly isn't raising interest rates. That would simply transfer still more from young to old, and it would put financial stability at risk. When the supply of savings exceeds the demand for them, the returns on them must fall. However angry the baby boomers are, they have to accept that the high interest rates of their youth are gone forever, and their future is consequently poorer than they expected. This is not because they have been robbed by governments or screwed by central banks: it is largely because of their own failure to produce enough of the next generation to support them in their old age.

    Rather, we need to find ways of raising the real interest rate. The risks associated with NOT doing so are simply too great. So, since the real problem here is a structural imbalance between the supply of safe assets for retirement saving and the demand for them, the obvious thing to do is to improve the supply of safe assets. The Cambridge researchers point out that sovereign bonds, state pension schemes and asset price bubbles are logically equivalent:

    In an economy with perfect foresight, bubbles, PAYG, and sovereign debt are perfect substitutes for trade in bubbly assets. Whether resources are transferred from the young to the old by the trade of bubbles, by a government enforced PAYG pension scheme, or by a government that sells bonds to the young to repay the last period’s bonds held by the old, the outcome is the same in all three cases.
    Asset price bubbles put financial stability at risk, and government enforced PAYG pension savings sufficient to provide pensions for all those elderly are likely to worsen intergenerational conflict. So the solution is sovereign debt. Lots of it. Enough to meet the saving needs of the entire population. Or, if you prefer, government savings schemes - safe high-interest savings accounts such as those provided by NS&I. Lots of them.

    And, at the other side of the government savings bank, investment of those savings in productive enterprises. After all, the structural imbalance is not just a problem of supply but also of demand. It is not central banks that are in a blue funk, but the whole world. Everyone is terrified of loss, no-one wants to take any risk, and the productive enterprises of the future are being starved of investment at the same time as savers are being deprived of returns. The effect of this will be to depress wage growth and productivity far into the future. If investment doesn't improve, the future for both young AND old is an impoverished one.

    As I have pointed out many times before, the primary purpose of sovereign debt is not to finance government, but to enable people to save. And when the private sector is too scared to invest, government must step in. In a world of ageing populations, growing need for saving and fear of loss, the political obsession with reducing sovereign debt/GDP must end.

    Related reading:

    Rethinking government debt
    Bond yields and helicopters
    Keynes and the Quantity Theory of Money
    The Great Yield Divergence
    The safe asset scarcity problem, 2050 edition
    Weird is Normal - Pieria
    The broken contract - Pieria

    Thursday, 20 October 2016

    State pensions: property right or benefit?


    I know that lots of you are heartily sick of the WASPI campaign, but it does have a tendency to throw up interesting issues. This time, it is the legal status of the UK's state pension.

    A couple of days ago, the WASPI campaign announced a crowdfunding campaign to raise funds for legal action against the Government. Their CrowdJustice page says that legal action would potentially be twofold:


    (this is a screen print from the CrowdJustice page. Regular readers of my blog will be aware that I do not post direct links to WASPI campaign material.)

    Personally, I am of the opinion that judicial review of the legality of the state pension age changes in the 1995 and 2011 Pension Acts is a non-starter. The timetables for the changes are built into the Acts themselves, so any successful challenge to them would require repeal or amendment of one or both Acts. Since the UK has no written constitution and Parliament is sovereign, judicial review cannot be used to challenge primary legislation unless EU law is violated.

    But I am no lawyer, and there may be an angle to this that I don't understand. As WASPI campaign has already met and exceeded its CrowdJustice target for legal advice, there will in due course be a barrister's opinion on the likelihood of the High Court granting leave for judicial review.

    What is far more interesting is the question that the proposed judicial review raises. Is the state pension a property right, or a state benefit?

    Many in the WASPI campaign claim that the state pension is their right. They paid in during their working lives, so now the government should pay out in accordance with the terms and conditions agreed with them when they started work. Failing to do so is robbery. "We paid in - you pay out!" they screamed at their London demonstration in June this year. Twitter and Facebook are awash with posts claiming their pensions have been "stolen". It is tempting to dismiss all of this as hyperbole, but buried in all the anger is a serious point.

    For women who started work before the 1995 Act came into force, the original age at which they would have qualified for a state pension was 60.  If the state pension is a property right, then the state pension age rises in the 1995 and 2011 Acts could be viewed as violation of their property rights, since the total amount of pension they will receive over their lifetimes will now be substantially less than it would have been if the state pension age had not been raised. Whether or not they knew about the changes is irrelevant, though not knowing about them obviously adds to the anger and distress, and for some may have meant consequential losses for which they could seek redress through a maladministration claim against the DWP. The loss of state pension itself would be illegal, and they would be entitled to financial compensation to the equivalent of state pension from 60. I assume that this would be the ground for the proposed judicial review.

    But there is a recent legal battle whose outcome seriously undermines the argument that the UK's state pension is a property right. This is the so-called "frozen pensions" case.

    In 2002, a UK pensioner living in South Africa challenged the Government in the High Court under the Human Rights Act 1998 over its refusal to give her the same pension increments as those paid to pensioners living in the UK. She argued that her state pension was a property right, and that in refusing to pay the increments the UK government was depriving her of part of her property. And she further argued that she was being discriminated against because she lived in South Africa.

    The judge disagreed, saying that "the remedy of the expatriate United Kingdom pensioners who do not receive uprated pensions is political, not judicial. The decision to pay them uprated pensions must be made by Parliament" (my emphasis). In other words, Parliament decides who should receive state pensions, and how much to pay them.

    The judge went on to explain that although the claimant had a right to a pension, she could not lay claim to the increments paid to UK residents, since UK legislation did not give overseas pensioners the right to increments:
    In the present case, UK legislation has never conferred a right on the Claimant to the uprating of her pension while she lived in South Africa. She does not satisfy and has never satisfied the conditions for payment of an uprated pension. She has never had a right to an uprated pension. There can therefore be no question of her having been deprived of any such right.
    He dismissed her discrimination claim on the grounds that the government was entitled to restrict payment:
    It seems to me that a government may lawfully decide to restrict the payment of benefits of any kind to those who are within its territorial jurisdiction, leaving the care and support of those who live elsewhere to the governments of the countries in which they live. Such a restriction may be based wholly or partly on considerations of cost, but having regard to the wide margin of discretion that must be accorded to the government, I do not think it one that a Court may say is unreasonable or lacking in objective justification....
    And importantly, he added:
    It is also difficult to criticise the position of the government if the limitation on the benefit has been published for some time, so that those who have gone to live abroad did know, or could easily have ascertained it, before deciding to live abroad. That is the case in relation to pensions.  
    The Government had published information leaflets for those considering retiring abroad, which contained information about the effect on their UK pension. These were available on request from DWP. Clearly, the judge thought it was reasonable for people considering moving overseas to obtain information before making the decision. WASPI maladministration claims will hang on whether the DWP provided adequate information on the state pension age changes, and whether women should reasonably be expected to inform themselves. The WASPI campaign argues that the DWP should have notified women individually of the changes rather than expecting them to ask for information. The "frozen pensions" judgment does not exactly help its case.

    However, the High Court's judgment appeared to undermine the principle of equal receipts for equal contributions. Age Concern, which supported the cause of people living overseas whose pensions have been "frozen", said:
    People have to pay National Insurance contributions throughout their working life to be entitled to the full basic state pension, and therefore it is scandalous that they should not benefit from the annual inflationary increase that pensioners living in Britain receive
    Unsurprisingly, the claimant appealed. Her appeal was heard in the Court of Appeal in March 2003 - and rejected. However, she was granted leave to appeal to the House of Lords. She duly did so. The case was heard in February 2005, and the House of Lords gave its judgment in May 2005.

    The House of Lords rejected the appeal. Lord Hoffman dismissed the discrimination claim on the same grounds as the High Court judge, namely that the decision as to who should receive pension increments was a matter for Parliament not the courts.

    But it is the next part of Lord Hoffman's judgment that fatally undermines the argument that state pension is a property right. Dismissing the claimant's argument that she was entitled to the same pension increments as a UK resident because she had paid in the same amount of NI contributions, he said (my emphasis):
    In effect, her argument was that because contributions were a necessary condition for the retirement pension paid to UK residents, they ought to be a sufficient condition. No other matters, like whether one lived in the United Kingdom and participated in the rest of its arrangements for taxation and social security, ought to be taken into account. But that was an obvious fallacy. National Insurance contributions had no exclusive link to retirement pensions, comparable with contributions to a private pension scheme. In fact the link was a rather tenuous one. 
    National Insurance contributions are used to fund a range of benefits. Broadly speaking, the purpose of National Insurance is to "insure" people against the risk of them being unable to work, the aim being to provide them with an income until either they are able to work or they die. The risks insured against include unemployment, sickness, maternity and bereavement, as well as old age. National Insurance also partially funds the National Health Service. In short, National Insurance is not a pension scheme and should not be regarded as in any way similar to a private or occupational pension scheme.

    Following this judgment, the claimant appealed to the European Court of Human Rights, alleging that the UK government had violated Article 1 of Protocol 1 and Article 14 of the European Convention on Human Rights (ECHR). Article 1 of Protocol 1 gives protection to property rights, while Article 14 prohibits discrimination in the right to enjoy that protection. On 4 November 2008, the ECHR rejected the claim.

    The ECHR's judgment defined the UK's state pension as state benefits intended primarily for UK residents, not property rights enforceable from anywhere in the world:
    ....the Court noted that the Contracting State’s social security system was intended to provide a minimum standard of living for those resident within its territory. Insofar as concerned the operation of pension or social security systems, individuals ordinarily resident within the Contracting State were not therefore in a relevantly analogous situation to those residing outside the territory. 
    And it endorsed the view of Lord Hoffman that there is no exclusive link between National Insurance and the state pension (my emphasis):
    National Insurance Contributions were only one part of the United Kingdom’s complex system of taxation and the National Insurance Fund was just one of a number of sources of revenue used to pay for the United Kingdom’s Social Security and National Health systems. The applicants’ payment of National Insurance Contributions during their working lives in the United Kingdom was not therefore any more significant than the fact that they might have paid income tax or other taxes while domiciled there. 
    But it didn't end there. The case was referred to the Grand Chamber of the ECHR and was heard on 2nd September 2009.

    The Grand Chamber dismissed the case on 8th March 2010. Its summary is a clear and unequivocal statement that the UK state pension is a social security benefit, not a pension scheme (my emphasis):
    The Court did not consider that it sufficed for the applicants to have paid National Insurance contributions in the United Kingdom to place them in a relevantly similar position to all other pensioners, regardless of their country of residence. Claiming the contrary would be based on a misconception of the relationship between National Insurance contributions and the State pension. Unlike private pension schemes, National Insurance contributions had no exclusive link to retirement pensions. Instead, they formed a part of the revenue which paid for a whole range of social security benefits, including incapacity benefits, maternity allowances, widow’s benefits, bereavement benefits and the National Health Service. The complex and interlocking system of the benefits and taxation systems made it impossible to isolate the payment of National Insurance contributions as a sufficient ground for equating the position of pensioners who received uprating and those, like the applicants, who did not. 
    The "frozen pensions" case has now hit a wall. It can go no further. Pensioners still grumble, of course: but unless the UK government relents, which it shows no signs of doing, their choice is either to accept that their pensions are frozen or to return to the UK.

    The unfortunate precedent that this sets for WASPI should be evident by now. The WASPI campaign's claim for financial restitution rests on the belief that woman are "owed" their pensions. Although women are also pursuing maladministration claims, maladministration claims alone will not restore them to the position that they would have been in had they been excluded from the state pension age rises in the 1995 Act - which was the original WASPI "ask". Admittedly, the "ask" published on the WASPI website has now been changed to "fair transitional arrangements", with an explanatory paragraph as follows:
    This translates into a 'bridging' pension to cover the gap from age 60 until State Pension Age - not means-tested and with compensation for losses for those women who have already reached their SPA.  
    But this appears to imply that the WASPI campaign believes women are entitled to some or all of the pension that they have "lost" due to the changes in the state pension age. Sadly, the outcome of the "frozen pensions" case suggests that this is not the case. Parliament can change the terms and conditions of the state pension as it sees fit, just as it can any other contributory benefit.

    However, there is possibly a loophole. The High Court judge dismissed the claim of the overseas pensioner to an uprated pension on the grounds that UK legislation has never conferred the right to uprated pensions on overseas pensioners. Since she had never had those rights, therefore she could not have been deprived of them. Could WASPI claim that women DID have the right to state pension at 60, and have now been deprived of that right?

    We shall have to wait and see what m'learned friend says. But myself, I doubt that this is a flier. The WASPI case that women have been deprived of property rights is fatally undermined in my view by the finding of both the House of Lords and the ECHR that the state pension is a benefit, not a pension scheme. You can't have property rights to a benefit.

    The precedent set by the "frozen pensions" case would seem to indicate that the WASPI campaign has little hope of winning the thousands of pounds in "lost" pensions that it has promised its supporters. The wording of the CrowdJustice campaign suggests that the pressure for judicial review comes from the WASPI campaign leadership, not from its lawyer: Bindmans LLP appear much more interested in helping women to pursue individual maladministration claims against the DWP, even though you don't need a lawyer to pursue these. And as I noted above, maladministration claims alone cannot restore the "lost" pensions (I shall explain why in a later post).

    I fear this will not end well.

    Related reading:

    An introduction to judicial review - Public Law Project






    Monday, 17 October 2016

    The dominance of Brexit

    Some people have been saying that sterling's fall has nothing to do with the Brexit vote. Sterling was already falling before the vote, they say, because of the UK's wide and growing current account deficit. So I thought I would fact check this.

    Here is the UK's current account deficit since 1987, courtesy of ONS:


    Well, ok, it has rarely been anywhere near balance in the current century, and it has been trending downwards since 2011.

    Now let's look at sterling. Here is sterling's trade-weighted exchange rate since 1992, courtesy of the Bank of England (via this House of Commons briefing paper):


    Umm. The correlation between the current account deficit and the trade-weighted value of sterling appears to be negative. Sterling has been rising since 2011 - until this year.

    This is actually reasonable. The trade-weighted value of a currency reflects the external performance of the economy. And for a long time now, current account deficits have not been regarded as important for countries with floating exchange rates and independent central banks. So sterling has risen because the UK has been doing well compared to other countries - notably the depressed EU.

    Breaking down the current account into its component parts shows why the current account and the value of sterling have been negatively correlated. Broadly speaking, the current account is made up of the goods and services trade balance, plus net investment income. The second of these is the income that UK investors earn from their investments abroad minus the income that foreign investors earn on their investments in the UK.

    This is what has happened to net investment income (this chart from ONS also includes other financial income, but net investment income is by far the largest component for the UK):


    As ONS explains, the fall in net investment income is driven by two factors:
    • rising FDI into the UK from 2011 onwards
    • higher rates of return on foreign holdings of UK assets than on UK holdings of foreign assets
    This chart shows these effects clearly: 



    In days gone by, higher rates of return would have reflected higher risk and would therefore have been accompanied by a lower currency exchange rate. But we live in strange times. These days, depressed economies such as the Eurozone have low rates of return, partly due to central bank action and partly due to a generally poor economic outlook. Higher rates of return accompanied by increased FDI indicate relative economic strength. The negative net investment income position is thus a net positive factor for the UK economy, and until recently this was reflected in the rising value of sterling. Thus the negative correlation of current account and sterling exchange rate is not a bug, it is a feature arising from the peculiar construction of the UK's current account - which in turn reflects the UK's position as one of the world's premier financial centres.

    ONS shows that the trade balance (goods and services) has been pretty stable, though negative, for the whole of this century:


    We do see some positive correlation between the trade deficit and the value of sterling, though we can't tell from these charts whether sterling responds to the trade deficit or vice versa - or whether both are responding to something else. But this relationship is dwarfed by the negative correlation of the net investment income balance and the external value of sterling. Basically, people like investing in the UK.

    Or they used to. This is what has happened to sterling recently:


    This chart could be interpreted as showing a downward trend since the mid-2014 peak. But in fact it is showing reversion to previous levels from the mid-2014 peak, followed by three abrupt falls, one at the beginning of 2016, a larger one in June and a third that has not yet bottomed out. The first of these was due to the market turbulence and worries about bank profitability at the beginning of 2016. But the other two are unquestionably due to the Brexit vote.

    The fall of sterling from the beginning of 2016 is even more obvious in the sterling-euro exchange rate:



    Sterling rose immediately prior to the EU referendum because of opinion polls suggesting that Remain would win. As the referendum result was announced, it fell sharply against both the US dollar and the euro. Although it stabilised in the summer, it has not recovered from this fall.

    A second fall was recently triggered by comments by the Prime Minister, Theresa May, at the Conservative party conference, and the growing likelihood that Britain will leave the EU in the most economically damaging manner possible - a "hard Brexit". Financial markets are particularly concerned at the prospective loss of "passporting rights" to the EU. The UK's position as the world's premier financial centre is under serious threat - and this is reflected in the falling exchange rate of sterling.

    And not just in the sterling exchange rate. Gilts are affected too, as this Reuters chart shows:



    After the Brexit vote, gilt yields fell as output forecasts for the UK were slashed and a Bank of England interest rate was priced in. Remember we live in strange times: cutting interest rates is now a negative indicator for an economy, whereas in the inflationary 1970s and 1980s (and indeed in countries such as Russia where inflation has been very high in recent years) it was a positive one.

    So used are we to the weirdness of low interest rates that we have forgotten how normal risk pricing works. But we are now being reminded. As it became ever clearer that the UK government was contemplating a hard Brexit, gilt yields started to rise. Now, sterling is falling as well. This is what capital flight looks like in a country that issues its own currency.

    Last time we saw capital flight in an advanced economy was the Greek crisis last summer. Everyone remembers Greek bond yields spiking and Target2 imbalances growing as investors and depositors fled from the prospect of Grexit. But there was no currency component to that (well, there was, but you wouldn't find any charts showing the sharply falling implied exchange rate between euros in Greek banks and euros everywhere else). Now, we have capital flight from another advanced country - and this time it is reflected not only in rising yields but in a falling exchange rate. The UK has become a risky place for investors.

    Of course, this might only be a short-term effect. The UK government and the EU authorities are both considering their options at the moment, and once the form that Brexit will take becomes clear and the path defined, both sterling and gilts may well bounce back. Sterling has had larger falls than this, and  always bounced back:



    But there is, of course, the elephant in the room. All of the sterling shocks in this chart occurred during Britain's membership of what started as the EEC and later became the EU. Indeed, the UK has been a member of the European Union project for the whole of its recent experiment with fully floating exchange rates, which started in 1979 with the lifting of exchange controls. To what extent has EU membership helped to stabilise sterling's exchange rate - and does it now face a more turbulent future? We do not know.

    Recently, some have expressed concern about the UK's dependence on external investors - what Mark Carney, quoting Tennessee Williams, called "the kindness of strangers". This is because the UK has both a current account deficit and a fiscal deficit: if both deficits are dependent on external financing, a "sudden stop" can force a very sharp fiscal adjustment and a rapid, highly damaging fall in GDP. There is an outside chance that the current combination of falling currency and rising gilt yields could be the start of a "sudden stop". However, the Bank of England's staff blog recently looked at the financing of the UK's twin deficits and concluded that the fiscal deficit, at any rate, was largely domestically financed so was not in any immediate danger. The current account deficit of course could be subject to a wrenching adjustment if investors fled, although FDI generally tends to be fairly stable. But the two deficits are largely separately financed, so there is little danger of the sort of toxic feedback loop that can ultimately lead to economic collapse and debt default.

    What does seem likely is that the net interest income deficit will close, not because returns for UK investors in foreign assets improve but because returns for foreign investors in the UK will now fall due to lower interest rates, QE and a poorer growth outlook. FDI, too, seems likely to decline, though perhaps gradually. No doubt those who are obsessed with current accounts will cheer as the net interest income deficit shrinks, but I wouldn't regard this form of rebalancing as positive, personally. I'd much rather see net investment income turn positive due to higher returns to UK investors from improved growth in Europe.

    And what about that trade deficit in goods and services? Well, that might shrink too. Exports will be flattered a bit by the lower exchange rate, and higher inflation will force UK households and businesses to cut back spending, reducing imports. But in the longer term, the outlook for the trade balance depends on what sort of trade deals the UK can cut.

    And that brings me back to where I started. Those who thought the fall in sterling was due to a widening current account deficit have the causation wrong. The current fall in sterling is entirely due to Brexit. And the current account deficit is likely to close because of the effect of Brexit on trade and investment. Brexit will determine the behaviour of every UK metric for the foreseeable future.

    Related reading:

    Short-run effects of the Brexit shock
    The currency effects of Brexit

    Thursday, 13 October 2016

    The currency effects of Brexit

    Sterling is falling. Predictably, the financial press describe its slide as a "pounding" and gleefully tell us that sterling is the worst-performing currency after the Argentinian peso.

    But some people are cheering. Falling sterling is good for exports, isn't it? So if the pound keeps falling, the UK's large trade deficit will start to shrink, reducing the UK's dependence on external financing and hence its vulnerability to a "sudden stop".

    Sadly, it's not that simple. Falling sterling is not an unalloyed good for exporters. The real effect is considerably more nuanced, and over the longer term, not necessarily positive.

    As an exporter myself, I am certainly enjoying the pound's fall. These days, most of my income is in US dollars. This is how GBRUSD has performed this year:


    Since my income is in dollars but my outgoings are in sterling, I've had a pretty substantial pay rise.

    But my chickens will come home to roost shortly. The price of petrol is about to rise by 5p a litre because of sterling's fall. That is a real cost which I cannot avoid, since my singing teaching requires use of a car. My income is still rising, but my profits will be diminished by rising costs. When the fall in sterling affects other business costs too, such as air fares, train fares, hotels and subsistence, I might be looking at a rather substantial rise in my costs.

    Business costs are already rising for exporters whose business inputs are raw materials and intermediate goods. And all of us face higher energy and transport costs, because the UK is dependent on imports of oil and natural gas, and those are priced in dollars and euros.

    This chart from Reuters shows that producer price inflation is already rising fast:


    The net gain for exporters is still positive, but energy price rises have yet to bite. Exactly how much of the income improvement due to currency effects will be wiped out by rising input costs remains to be seen. For some exporters - especially in the UK's fragile manufacturing sector - it could even be a wash.

    And that is before we get to the effect of inflation on labour costs. I face rising prices for food, clothes and other consumer goods. As a sole trader, my profits are my income, so I will shortly face a reduction in my disposable income as inflation eats into my profits. But businesses with employees are likely to face demands for wage increases. The businesses most affected will be those that have skill shortages, powerful unions and/or need seasonal labour that could now be hard to come by, because the weak pound makes temporary migration from overseas less attractive.

    The fact is that the UK is an import-dependent economy, and sterling's fall makes imports more expensive. For businesses, this means higher costs. For households, this means lower living standards, at least in the short term. As Paul Krugman says, sterling's depreciation makes Britain poorer.

    Over the longer term, we might find that higher import prices encourage the growth of domestic industries producing goods and services that can substitute for expensive imports. But there are two obstacles to this.

    The first is the UK's dependence on imports for energy. High energy prices due to sterling's weakness will put downward pressure on domestic demand, simply because people will prioritise heating, lighting and fuel over consumables. We've seen this before: high oil prices in 2010-13 were a major reason for the failure of the UK's recovery after the financial crisis. There is no reason to suppose that this time would be different.

    The same energy price constraint bites on domestic businesses, which would face higher costs than their overseas competitors. Given this, would they really be able to undercut importers by enough to generate widespread substitution effects - especially if, after a hard Brexit, the Government decided to cut import tariffs unilaterally, as some have suggested?

    We need substantial investment in replacement energy sources as North Sea Oil dries up. The UK has neglected this investment over many years now, and it is about to pay the price for this folly. Replacement energy sources take quite some time to come on stream, and during that time the UK will face higher energy prices and associated inflation, to the detriment of households, businesses and the economy as a whole.

    The second obstacle is inward investment. The UK has historically been a favourite destination for foreign investors, attracting more capital investment than anywhere else in Europe. This is no doubt due to its dominant financial sector, deep and liquid capital markets, and enormous supply of investment assets. Being a favoured investment destination is of course, something of a double-edged sword: the UK's yawning current account deficit is to a considerable extent due to its attractiveness to foreign capital (the capital account is the mirror image of the current account, so a capital account surplus is matched by a current account deficit). But if the UK is to develop new domestic and export businesses, it will need inward investment.

    Some people seem to think that the current starry performance of the FTSE 100 indicates that inward investment into the UK is holding up. Sadly, this is not true. The falling currency is a clear sign that investment is leaving the UK, as are rising yields on gilts. At present, all the signs are that investors are becoming exceedingly wary of investing in the UK.

    All of this leads me to conclude that those who think a falling pound will somehow bring about radical rebalancing of the economy away from financial services and towards revitalisation of manufacturing are taking far too simplistic a view. The UK economy is highly financialised and largely consists of service industries. Manufacturing is still about 14% of the economy, but the heavy manufacturing of the past is gone: UK manufacturing now is specialised, highly skilled and makes extensive use of imports. Even were foreign investment to hold up, it would take a very long time for the UK to expand manufacturing to the level of say Germany. It's worth remembering that a 25% devaluation in 2008-9 made little significant difference to manufacturing production or goods exports. As I said above, why would this time be different?

    Sterling's fall should be regarded as at most a short-term monetary stimulus to the economy. The UK now has the loosest monetary policy in the G7 (eat your heart out, Kuroda-san!). This is in large measure the reason for the apparent calm in the UK economy, along with buoyant consumer confidence (which is no surprise, since the great British public apparently believe that leaving the EU and restricting immigration will make them more prosperous). It creates a breathing space in which the Government can devise a sensible approach to leaving the EU. But if it is to foster lasting change, it must be partnered with a radical fiscal response involving substantial infrastructure investment, a properly funded business bank and a realistic industrial strategy. Without these, sterling's fall will simply herald the dawning of a poorer, meaner future for Britain.

    Related reading:

    Brexit is making Britons poorer and meaner - The Economist
    UK's trade-weighted currency index slumps to historic new low on hard Brexit fears - The Independent
    Brexit and Britain's Dutch disease - FT Alphaville


    Tuesday, 4 October 2016

    Why is global trade so weak?


    Global trade is awful. Really, it is. For the last five years, trade volumes have been growing at their slowest sustained rate since the early 1980s. Here's a horrible chart from the World Trade Organisation's latest forecast:

    And in the last year, things have got worse:
    Import demand of developing economies fell 3.2% in Q1 before staging a partial recovery of 1.5% in Q2.  Meanwhile, developed economies recorded positive import growth of 0.8% in Q1 and negative growth of -0.8% in Q2.  Overall, world imports stagnated in the first half of 2016, falling 1.0% in Q1 and rising 0.2% in Q2.  This translated into weak demand for exports of both developed and developing economies.  For the year-to-date, world trade has been essentially flat, with the average of exports and imports in Q1 and Q2 declining 0.3% relative to last year.
    Oh great. The WTO's chart shows that flat trade eventually translates into flat growth. And as this chart from the World Bank shows, growth is indeed flat:


    Now, ok, things were worse in the early 1990s, and much worse in the early 1980s. In fact if we went back further, we would also find things were pretty bad in 1973-5. Developed-world recessions are bad for global growth.

    But we don't have a developed-world recession now, do we? The developed world is struggling to get inflation off the floor, of course: interest rates are extremely low - in some places negative - and three major central banks are doing QE. In Europe, growth remains elusive and unemployment very high. The US is doing better, but has backed away from planned interest rate increases. Japan is now in its third decade of stagnation. And the UK, which was looking pretty good, has shot itself in the foot. In July, the IMF cut its global growth forecast by 0.1% because of the impact of the UK's decision to leave the European Union.

    It would, however, be a mistake to see the last five years of global trade slowdown as one event. There are actually two distinct phases, as these charts from the WTO show:

    In 2012, the story was one of developed countries in a slump: export volumes actually fell globally, but the strength of imports to developing and emerging countries prevented a disastrous collapse. The world should probably thank China and its satellites for preventing the Eurozone crisis causing a second global recession.

    But the current slowdown is not a developed-country story. No, it is caused by a considerable fall in imports to developing and emerging countries, starting at the beginning of 2015. Exports look better, but of course these charts only show volumes. Because of currency adjustments, export values are actually far worse:


    (this chart and the one below are from this IMF working paper)

    Global exports have been falling in value terms since 2014.  This is partly caused by the commodity and oil supercycle unwinding, which has crushed the dollar value of exports of raw materials and oil from developing and emerging market countries. But it is also a China story. As this chart shows, China is the single biggest contributor to the trade slowdown of the last two years:

    Of course, China's contribution to the current trade slowdown pales into insignificance compared to the Euro area disaster in 2008-9. In 2010, the then President of the European Commission, Jose Manual Barroso declared that the Euro was "a protection shield against the crisis". But that is not what this chart says - and it is not what I found when I looked at the effects of the crisis on countries like Slovenia and Latvia, which suffered terrible "sudden stops" in 2008-9, long before what is now known as the "Eurozone crisis". Far from protecting, the Euro appears to have amplified the adverse effects of what was, after all, originally a US disaster. (But I digress.)

    Nonetheless, China's slowdown has drastic effects on its satellites. It has become a trade hub in Asia, importing goods from other countries in the region as inputs to final processing of items for export to the West. So an import slowdown in China ripples back to other countries in the Asia-Pacific region through the south-south supply chains.

    Part of China's slowdown is driven by a rebalancing towards domestic production and consumption. But part is due to weaker demand for its exports from Western countries. And why is Western import demand weakening? Well, if we knew that, we would know why global trade is weakening.

    Most analyses of the current slowdown that I have seen focus on the effect of economic fundamentals on import demand. Some also discuss changes in international supply chains. Few seem to discuss finance, and if they do, they focus narrowly on trade finance, not on the global financial currents that drive all economic activity.

    But this is macroeconomics, and if there is one thing we have learned from the GFC, it is that finance is fundamental to macroeconomics. Papers that omit any discussion of the role of global financial flows - like, for example, the IMF working paper from which I took the above charts - are surely unable to explain adequately what is really causing the current trade slowdown.

    So let's look at what is going on in international finance. This pair of charts is from the Bank for International Settlements (BIS)'s latest review:


    Well now. Cross-border lending (loans and bonds) has been flat for the last six years. In 2012-13 there was a marked fall in both lending and securities issuance by banks. And there now appears to be another sharp contraction in bank lending (chart 1) and a tailing-off of securities issuance by both banks and non-banks (chart 2).

    In fact there is a striking resemblance between falling imports in emerging markets (see chart 2 above), and shrinking cross-border finance to emerging markets:


    Please don't tell me that this remarkable similarity is purely coincidental. Now that we know how fundamental finance is to macroeconomics, we must surely admit that changes in cross-border financing must be a key part of the global trade slowdown story. Indeed, although I would normally be the first to say correlation doesn't indicate causation, in this case I would stick my neck out and say the contraction in cross-border lending is the primary cause of the sick state of global trade. The reason why the cross-border lending slump precedes the trade slump is because businesses and households can run on reserves for a while when their funding is pulled, and because just as rising investment takes time to flow through into increased trade, so falling investment can take a while to show up as declining trade.

    Just how weak cross-border financing has become since 2010 is evident in this set of charts from BIS showing lending to non-banks in the world's three main funding currencies - the US dollar, the Euro and the Japanese yen:


    The one bright spot in this dismal set is the Euro debt securities issuance. But sadly this is not what it seems. The BIS explains that this is due to "reverse yankee" issuance by American corporations who have discovered that it is cheaper to fund in euros and swap into dollars than to fund directly in dollars. Accompanying this explanation, the BIS has an interesting paper on why "covered interest rate parity" appears to have failed. It is a story of over-enthusiastic regulation progressively destroying the mechanisms that make markets work efficiently.

    But if shrinking cross-border financing is a large part of the answer to "why is global trade so weak?", then the next question is surely "why is cross-border financing shrinking"? Why are investors pulling back from lending into emerging market and developing countries? Why are banks shrinking back behind their borders? Is this behaviour a consequence of falling demand in Western countries, and if so, why is demand falling? Or are there other drivers?

    I will attempt to answer this in another blogpost, with the help of the IMF, which has just released its October World Economic Outlook report. It does not look cheerful.

    Related reading:

    Slovenia and the banks
    How do you say "dead cat" in Latvian?
    Austerity and the rise of populism

    Image from Fotolia.