Coppola Comment

False dawn

2012-02-21T21:38:00.000Z

As dawn broke on 21st February 2012, the leaders of the European Union announced that they had agreed terms for additional financial support to Greece to enable it to meet scheduled debt repayments on 20th March. European Union officials pronounced that "the European debt crisis is ended". Light has dawned, the sun is shining and everything is rosy.

Except it isn't. Not one commentor on the dawn deal thinks that it solves anything. As the BBC Breakfast reporter said, all it does is "buy time". Time for what? Time will solve nothing. Even with this deal and a VERY large amount of economic luck, Greece's debt is only forecast to reduce to 120% of GDP by 2020, which for a country as poor as Greece looks unsustainable. And that assumes that Greece is able to return to growth in 2013 despite the extra cuts imposed in this deal, which are almost certain to deepen recession further. And it also assumes that Greece somehow manages to maintain a primary surplus in excess of 4% from 2013 onwards. Neither assumption looks remotely believable. The IMF's worst case scenario (in its Debt Sustainability Report, leaked yesterday - timing impeccable, as always) is that Greece's debt in 2020 will be 160% of GDP, which is about the same as it is now and completely unsustainable. Zero Hedge, pessimistic as ever, commented that the IMF's "worst case" scenario looked decidedly upbeat and things could be much worse. Other commentors have joined in what is rapidly becoming a storm of criticism. This deal is yet another flavour of Eurofudge - and a particularly bitter one at that, because despite even more austerity and surrender of sovereignty being demanded of Greece, it does not appear remotely adequate.

Let's be clear what this deal is NOT. It is not, in any sense, a rescue of Greece. Greece itself will receive very little of the additional lending provided under the terms of this bailout. The vast majority will go to foreign holders of Greek debt. And the measures that Greece has had to agree to put in place to qualify for this "assistance" will push more people onto the breadline and drive the economy deeper into recession - if they can be imposed at all, which is looking increasingly unlikely. No, in no sense is this deal a bailout of Greece.

Contrary to popular belief, it isn't a bailout of private banks and financial institutions either. Private sector holders of Greek debt are being expected to take a reduction of 53% in the nominal value of their holdings and a total NPV loss (including interest payments) of 75%. By any standards that is a substantial loss. Yes, any prudent financial institution will have written down the value of its bond holdings to junk long since, so this haircut doesn't necessarily hurt their reported profits - in fact properly marked-to-market Greek bonds are probably worth even less than this haircut, so the debt restructuring might reduce their realised losses. But that is cold comfort. However you look at it, this deal leaves private sector investors taking heavy realised losses on their portfolios. And the "voluntary" description of this restructuring looks increasingly thin. The Institute of International Finance (IIF), which is the "private sector representative" that has agreed to this debt swap, actually only represents about 50% of private sector bondholders. The rest haven't been asked, but it is widely believed that hedge funds, at any rate, would prefer not to participate. Furthermore, even those bond holders represented by the IIF still have to agree to the deal. So the private sector could still scupper it. The Greek government is putting in place Collective Action Clauses (CACs) to force reluctant bond holders to participate in this deal. I don't call that voluntary. It remains to be seen whether the almost criminally useless ISDA agrees with me. Somehow I doubt it....even though it is hard to see that this is anything other than a structured default, so it should trigger a credit event.

It has been argued that the European Central Bank (ECB) and Eurozone National Central Banks are benefiting from this deal, because they are not taking a haircut. But since when has not losing your shirt been a "benefit"? The ECB is taking steps to ensure that it doesn't get caught up in the debt swap and end up taking losses, and National Central Banks are expected to follow suit. So their investments are more-or-less secure. The private sector is understandably annoyed about the ECB's behaviour, since it means that their investments are effectively subordinated to the ECB and the ECB can rewrite the rules at any time to suit itself. This may make it even more difficult to persuade private sector firms to participate in the haircut, which increases the likelihood of some form of coercion. I can't help wondering whether the ECB accepting some losses might have been a wiser course of action.

The only people who benefit from this deal are the politicians who have staked their careers on the survival of the Euro. That now includes the unelected "technocratic" Greek government, which now has a vested interest in preventing Euro breakup at any cost. But the benefit to politicians is starting to look doubtful as well. National politicians in the Northern states of the Eurozone are finding Greek bailout hard to sell. The increasingly draconian measures demanded of Greece by politicians from Germany, the Netherlands and Finland are without doubt intended to sweeten the pill for their electorates. And in Greece, the population is tired of seemingly never-ending austerity and angry at both their own government and the Eurozone leadership. Memories of World War II are resurfacing in Greece and German leaders are being portrayed as Nazis. The benefits of the European Union - free trade, freedom of movement, support of certain industries and poorer areas, and above all peace - are quickly being forgotten, as the price paid by weaker and stronger countries alike for propping up the misbegotten Euro starts to look too high and old wounds are reopened.

The biggest losers from the failed Euro project are the people of Europe. The principles of democracy and self-determination are being sold down the river to maintain the illusion of unity and common purpose. Across the board, measures are being put in place that undermine national democracy:

- Greece must write into its own constitution a legal requirement to give higher priority to paying foreign creditors than to paying welfare and state pensions, and the money to pay these creditors must be placed in a so-called "escrow account" so that it can't be diverted to other purposes - in other words, Greece will no longer be able to default on its debts. Unless Greece manages to create a primary surplus within the next three months, which seems almost impossible, it will either have to default on its commitments to its own people or borrow yet more money to meet those obligations

- Hungary faces a funding freeze until it cuts its budget deficit - by means of austerity, of course. The fact that its budget difficulties are at least partly caused by Eurozone banks reducing cross-border commitments in order to appease the Eurozone leaders, who insisted that they must not reduce Eurozone lending portfolios while they recapitalise, is apparently lost on the EU leadership

- Countries in "deficit reduction programmes" - currently Greece, Portugal and Ireland - are facing "surveillance" from Brussels to ensure they comply with the terms of these programmes. Under the terms of this deal Greece's surveillance is to be increased and Eurocrats are to take up residence in Athens, despite being deeply unpopular with the people

- Even countries that are not actually in "deficit reduction programmes" are now being monitored from Brussels to ensure they comply with the terms of the Stability and Growth Pact, and face sanctions and possibly fines if they fail to do so. That is most of the countries in the European Union, actually......

All of these are being imposed by unelected Brussels bureaucrats. Yes, in October 2011 EU national leaders agreed to the principle of these measures, but I wonder if they really appreciated the implications. No Europe-wide referendum has been held on any of this and the European Parliament has not been asked to approve these measures - in fact the European Parliament has been systematically sidelined and is so toothless now that Jack Straw today called for its abolition on the grounds of uselessness. The people of Europe have not agreed to any of this, and it is evident that many of them oppose the actions of the European leadership. Why should the governments of Germany and the Netherlands be able to dictate to national goverments in the rest of Europe how they should run their affairs? Why should unelected bureaucrats be tasked with "supervising" national governments? This is not democracy.

If the price of European union is abolition of democracy, then it is too high a price to pay. But I don't think European union is being bought. On the contrary, the sacrifices demanded of ordinary people to preserve the single currency are a huge threat to European union. As externally-imposed austerity bites, not only in Greece but in other countries too, there is a real risk that Europe will fracture along historic lines and people will seek to settle old scores. The single currency is the biggest threat to European peace since the Second World War.

Like everyone else, I don't think this latest deal solves anything. I don't think it even buys much time. Even if private sector bondholders and national parliaments agree to the deal, and default on March 20th is avoided, it will only be a temporary respite. We will play this game all over again - for much higher stakes - in a few months' time. And waiting in the wings are other countries in debt distress. How long till Portugal needs bailing out? Its economy is already going into the same death spiral as Greece's, and for the same reason - harsh and inappropriate austerity measures. And then there is Spain.....at which point the wheels come off. Spain is much too big to bail out.

The dawn agreement is a false dawn, and the darkest hour is still to come. There is no solution to this crisis which can preserve the Euro in its present form. For the sake of all the people of Europe, Greece should default and leave the Euro now, before the "debt service primacy" requirement prevents it from doing so. And other countries should reassert their national sovereignty and their right to self-determination. Yes, there will be pain, and chaos, and huge cost. But surely it is worth it to preserve peace and democracy in Europe?

Thoughts on inflation

2012-02-13T02:02:00.004Z

This extended post is prompted by numerous debates on whether or not Quantitative Easing (QE) is inflationary, whether or not creating new money to fund public spending is inflationary and whether inflation is really such a bad thing anyway.

Note to any real economists out there. In this post I will be describing some economic concepts, such as NAIRU, in layman's terms. If I get something wrong, please correct it (gently), but remember that I am not writing for an audience of economists so am trying to keep things simple!

I am old enough to remember the inflation of the 1970s. In 1975 wage-price inflation in the UK touched 25%. This is nowhere near high enough to qualify as hyperinflation, which is defined as a monthlly inflation rate of 50% or more (Cagan 1956). The UK has never experienced hyperinflation. But the inflation of the 1970s was quite bad enough, since it destroyed people's savings and led to a vicious spiral of higher prices leading to increased wage demands leading to increased production costs leading to higher prices..... The 1970s inflation was also coupled with economic stagnation - it was then that the term "stagflation" was coined. Those who suffered from the inflation of the 1970s tend to have a horror of price inflation that is perhaps out of proportion: they will put up with all manner of economic ills and injustices as long as price inflation is low.

We see this effect more clearly internationally. Germany, which suffered appallingly from the hyperinflation of the Weimar republic in the early 1920s, has a horror of inflation which drives their economic policy - and recently not only their own economic policy, but because of their economic dominance in Europe, much of the EU's economic policy. The consequence of this, in European countries experiencing recession, is deflation (not inflation) and appallingly high levels of unemployment, especially among young people.

Many people are now arguing that inflation is no worse an evil than unemployment, and that higher inflation may be a reasonable price to pay for economic policies that increase employment. I suspect that many of the people calling for higher inflation have never lived through an episode of high inflation. Because the fact is that there has not been high price inflation in any major Western economy since the 1980s. Retail price inflation has substantially been contained.

We have become so used to retail price inflation being contained that we now don't notice the policy that contains it. People argue that government since 1979 has abdicated its responsibility for economic management to the whims of the market. They use as justification for this view the fact that unemployment has generally been higher since then than at any time in the post-war period. This is indeed true - because at the margin, higher unemployment is the trade-off for lower price inflation. Let me explain.

When there are more people chasing jobs than there are jobs to be had, wages tend to fall because employers can dictate the amount they are prepared to pay and generally speaking job-hunters will accept it. This is basic supply & demand logic. I don't intend to discuss here whether this is a good thing or a bad thing, and the merits or otherwise of government intervention to support wage levels (such as the minimum wage and unemployment benefits) or trade union muscle to force up wages. I'm simply describing the basic dynamic when there is unemployment.

When everyone who wants to work is fully employed, employers have to compete with each other to attract workers. So the supply-demand equation is reversed: job-hunters (who are, of course, simply seeking to change jobs, rather than being unemployed) can choose among employers and will tend to choose those that pay the most. This tends to push up wages. So far this is obvious, yes?

Labour costs are a significant factor in production costs for most goods and services. So rises in wages will affect one or more of three things: the price eventually charged to the customer, the profits made by the company, and the productivity demanded of labour. Companies don't like to earn less, and workers don't like to work harder for their pay, so unless there is limited demand for the product or service, the price to the end customer tends to rise. If prices to end customers rise in aggregate across the economy as a whole, that is price inflation.

In simple terms, therefore, if everyone who wants to work is fully employed, there can be price inflation arising from the fact that employers will prefer to agree to high wage demands rather than lose workers. And if price inflation is anticipated by workers, they will price that inflation into their wage demands, which will push prices up further. This is known as cost-push inflation - or, in 1970s jargon, a wage-price spiral.

If the aim of the government is to control retail price inflation, therefore, it is necessary for there to be some degree of unemployment. Exactly how much is a matter of debate. The aim of economic policy is to have what is known as the "Non-Accelerating Inflation Rate of Unemployment", or NAIRU - which is the amount of unemployment that maintains equilibrium between workers' tendency to demand more pay and employers' desire to drive down pay. If it is achieved, the theory is that labour costs will not affect inflation. The trouble is no-one agrees on what the NAIRU is, and it has been used to justify very high levels of unemployment in some societies, especially where there are benefits systems and legislation that limit the downward pressure on wages that high unemployment causes.

So inflation targeting in Western government economic strategy since 1980 has indeed contributed to higher unemployment. But that's not abdication - it is simply a different strategy from the strategy adopted by most Western governments from WWII until 1980, which targeted full employment and legislated wage and price repression (prices & incomes policies) to control inflation. It could be argued that the pendulum has moved too far, and unemployment has been allowed to rise freely when more interventionist policies to control it would have been appropriate even at the cost of higher inflation in the short term. But the move to inflation targeting happened because the traditional (Keynesian) assumption that it was not possible to have both rising inflation and rising unemployment was shown to be false. The 1970s was a decade of high inflation, economic decline and increasing unemployment - so-called "stagflation". To this day there is no agreement on the reasons for this: some economists say that the main problem was the external supply shocks caused by the oil price hikes of 1973 and 1979, while others argue that the problem was inefficiencies in the labour market (notably, excessive union power) coupled with loose monetary policy. Personally I suspect that both views have some validity. But the stagflation of the 1970s is in my opinion one of the reasons why Keynesian economics fell out of favour. It simply did not explain the phenomenon and could provide no solution for it.

The other accusation that is levelled at governments since 1980 is that progressive deregulation has rendered them unable to prevent or control inflation in other areas of the economy - notably in asset prices (especially housing) and credit (the money supply). There is some merit in this view. It is painfully evident that while retail price inflation has indeed remained pretty stable since the late 1980s, asset prices have been anything but stable. There have been two house price bubbles during that time, the first of which burst in the recession of the early 1990s and the second in the recession of 2008/9. Both were preceded by progressive relaxation of lending standards, enabling people to obtain mortgages that in normal times would have been denied to them. Contrary to popular belief, subprime mortgages and negative equity are not new phenomena. I bought my first house in 1988 with a 100% endowment mortgage and consequently spent the first half of the 1990s trapped in a tiny house which was worth less than the mortgage. And other asset prices have not been stable either: there have been several stock market crashes, the most severe being the falls of 1987 and 2008. So with hindsight, it is evident that inflation targeting alone is not sufficient to prevent serious economic problems arising. It successfully addressed the dominant problem of the 1970s. But it doesn't address the problems that have arisen since.

The challenge for governments is to develop an economic management strategy that addresses all areas of the economy, rather than focusing on one indicator and ignoring the rest. We really don't want to see a return to 1970s-style inflation, which destroyed savings and reduced real incomes for anyone who wasn't in a union. But the deflationary policies we are seeing in much of Europe at the moment are equally destructive, wiping out jobs by the million and wrecking the future of an entire generation. Greece is now in its fifth year of deep recession but is being expected to impose severely deflationary measures on its economy. And in the UK, the government is busy imposing a range of public spending cuts on an already depressed economy while the central bank is creating money at a rate of knots in order to ward off an anticipated deflationary spiral. Interest rates are at an all-time low, but people are saving like mad and businesses are hoarding cash. This is what Keynes called a "liquidity trap". In an odd reversal of the 1970s, this time Keynes both describes the situation and has an answer for it. Monetarism does too, though - and at the moment it is monetarist, rather than Keynesian, solutions that are being adopted.

The Keynesian solution to a liquidity trap would be to increase public spending to compensate for the deflationary effect of private saving. Conversely, the monetarist solution is to expand the money supply to compensate for the deflationary effect of private saving. Both agree on the problem, but the Keynesian solution is fiscal expansion whereas the monetarist solution is monetary expansion.

Worldwide, there is a fashion for austere fiscal policy and public spending cuts, offset by the loosest monetary policy in history. We are in uncharted territory: never before has money been created at the rate that the Fed, the Bank of England and the Bank of Japan have created it in the last few years. Even the European Central Bank has now joined the party, providing cheap funding for European banks through the Long-Term Repo Operation (LTRO), which has already created nearly 5 billion new Euros and will create a whole lot more at the end of February.

All this money creation is renewing fears of inflation in some quarters. Despite what I have said above about cost-push inflation, to monetarists the only cause of inflation is excessively loose monetary policy. Interest rates are currently close to zero and various central banks are doing, or have done, QE or some variant of it. This is, by definition, loose monetary policy, hence their worries. But is it loose enough to cause significant inflation? Well, by all reasonable measures, the money supply in the UK and indeed in much of Europe is falling despite QE. So on that basis, no, it isn't. It is simply compensating for the deflation caused by tight fiscal policy, private sector saving and general economic decline. And it doesn't do it very effectively, either. Although base money - money created by the central bank - is increasing, broad money - money created by commercial banks, which is most of the money that actually circulates in the economy - is still falling. This is because despite the increase in their reserves provided by QE, banks aren't lending enough to offset the amount of money being destroyed or removed from circulation by businesses and households paying off debt and/or saving.

I am personally of the opinion that QE makes very little difference in the short run. I've explained elsewhere why QE is simply ineffective. Yes, all that extra money will have to be withdrawn at some point in the future, whether by allowing purchased gilts to expire, doing reverse QE or simply by raising interest rates. But at the moment it is largely irrelevant. I believe we have reached the limits of monetarism.

So if the monetarist solution is ineffective, what about Keynesian fiscal stimulus? The problem with this, of course, is that if done conventionally, that would increase public debt - which already stands at about 80% of GDP. Borrowing costs are, of course, very low at the moment, but there are still worries that massively increasing public debt would result in much higher interest costs. And, increasingly, people who favour fiscal expansion as a solution to the liquidity trap - or are simply suffering because of the depressed economy - are looking enviously at the QE programme and asking why, if money can be created for monetary expansion, it couldn't also be created for fiscal expansion. So there are calls for money created by the Bank of England to be spent directly into the economy rather than used to purchase financial assets. The so-called "helicopter drop" would give a free handout to everyone in the country, either to spend as they please or to pay off debt (this alternative is also known as a "debt jubilee"): saving could be prevented by time-limiting the handout. Other suggestions are for created money to be used to finance investment in public infrastructure, including green initiatives and housing. There have also been suggestions for new money to finance job guarantees and benefits increases, cut income and consuption taxes, and guarantee all retail bank deposits.

Money-financed fiscal expansion would in my view be far more powerful than QE and far more effective at getting us out of the liquidity trap. But it is certainly not risk-free and if not carefully planned and managed it could have unfortunate effects. This is a bit of a no-brainer, really - if it is a more powerful stimulus than QE, as I believe, then it is also much more dangerous if misused.

I think there are some essential rules for "safe" money-financed fiscal expansion:

- The business case for every public infrastructure project should show how it will generate the future taxation required to pay for it. If projects can't generate the returns required to pay for themselves then higher taxes or spending cuts would be needed at some point in the future.

- Short-term expansionary measures targeted at particular groups such as people on low to middle incomes must not create expectations of longer-term support.

- All expansionary measures must be strictly limited to the purpose of fiscal expansion and not be capable of extension to meet political objectives or buy votes. Maybe I'm displaying my own political scepticism here, but I don't trust politicians not to take the opportunity to pursue pet projects and build white elephants.

Failure to adhere to these rules could have very serious consequences. Money financing is just as much a form of debt as actual borrowing, but without the "brake" of interest costs and the possibility of investor flight. And historically, there is a strong association between money financing of public spending and inflation. Admittedly, that is because as far as I know, money financing has always been a last resort of distressed sovereigns unable to raise finance elsewhere because their economies are in such poor state, so runaway inflation was a risk anyway. I'm not aware of any examples of money financing by sovereigns that weren't associated with an inflationary spiral - if anyone knows of any, please let me know. But because of that association with inflation, there is a worldwide fear of money issuance as a means of financing public spending. So great is the fear of inflation that direct financing of public spending by central banks is actually illegal under EU and IMF rules, although those rules could probably be circumvented by a determined government. And however well-managed these interventions are, some inflation is inevitable. Indeed "some" inflation is the whole point, really.

You see, both monetarist and Keynesian solutions to a liquidity trap involve pursuing policies that lead to higher inflation. And therein lies the problem. Keeping inflation low has for so long been the main priority of government and central banks that pursuing policies that seem to undermine this priority are anathema. Hence the Bundesbank's continuing opposition to any form of monetary expansion by the ECB, and Germany's insistence on maintaining fiscal austerity even though it is running large trade and fiscal surpluses to the detriment of other members of the Eurozone.

The UK's problem, though, is rather different. Here inflation is NOT low - it is currently running at 4-5%.*UPDATE - now down to 3.6%* The Monetary Policy Committee (MPC) forecasts that it will fall significantly this year. But the MPC's record on inflation forecasting is frankly terrible - it has persistently understated inflation by 1-2% for several years. Why should anyone believe it this time? And why on earth would we pursue expansionary policies - monetary or fiscal - when inflation is already above the MPC's target?

Actually, on this occasion I think the MPC is right. The other characteristics of a liquidity trap - excessive saving and restricted bank lending - are evident. We have inflation due to commodity price rises and sterling devaluation (and until recently, consumption tax rises), not because of domestic demand or cost pressures. So maybe it could be safe to indulge in a small amount of carefully-targeted fiscal expansion. In fact, because it is potentially far more powerful than QE, we should need much less of it. So this can't be an opportunity to open the floodgates and spend huge amounts of money on political hobbyhorses. There are always lots of ways of spending money. It doesn't grow on trees.

For me, the best use of created money for fiscal expansion would be a partial debt jubilee. Figures show that the private debt burden in the UK is enormous - it dwarfs public debt. Overall - even leaving out financial services - the UK is the most indebted nation in the western world. About half of non-financial services private debt is owed by households, of which the greatest part is mortgages: the rest is unsecured debt of one sort or another. Servicing this debt takes up a large amount of many people's incomes, and voluntarily paying it off takes even more. I argued some time ago that worrying about public debt when the private debt level was so high was insane. I have not changed my mind about that. Freeing people of some of their debt burden would enable them to spend more, which would be quite an effective short-term stimulus. There should in parallel with this be measures to improve the availability of finance for SMEs, and perhaps other measures to encourage companies to expand and employ more people.

Will this lead to inflation? Well, yes. It's supposed to, actually. But a bit of domestically-generated inflation would enable the MPC to get interest rates back to something approaching a normal level, which would benefit the savers who are currently getting terrible returns on their investments. And the impact on borrowers would be mitigated by the partial debt jubilee. I don't see any great danger of runaway inflation from such a limited use of created money for fiscal expansion, especially if the MPC is doing its job properly. But there would be other dangers: in the prevailing economic ideology across the world, such fiscal "profligacy" is anathema and the UK would undoubtedly be punished in the international bond markets if it attempted it.

I actually see a greater inflationary danger from the enormous amounts of base money being created by the QE programme: they aren't doing anything much at the moment, but when banks start lending again and people and businesses start spending again, what will they do with all that extra money? Milton Friedman said "Inflation is always and everywhere a monetary phenomenon". Too much money chasing too few goods and services....will production in our economy really expand fast enough to absorb all the extra cash? And if not, will the BoE reverse QE quickly enough to mop it up? If not, then we can expect high inflation to appear once more.

I don't ever want to see high inflation again. But the fear of inflation is preventing governments in the Western world from taking the fiscal steps necessary to restore their economies to health and growth. And the millstone of private debt is weighing us down. The real risk we face at the moment is deflation and depression, not inflation. It's time to put fear aside and do something about it.

Breaking the mould - a personal reflection on corporal punishment

2012-01-30T18:01:00.002Z

This post is prompted by David Lammy's call for parents to be allowed to smack children, but it isn't in any way intended as an argument for or against physical discipline. Instead I have chosen to reflect on my own experience of corporal punishment as a child, and my quest as a parent to find a better way - to break the mould.

Both my parents used smacking routinely as their primary method of discipline. I know from comments made by my mother that I was first smacked when I was well under a year old, and by the time I remember being smacked, probably at about two or three, she had already moved on to using a slipper. The same was true for my three brothers. My father also smacked us, but at that age only with his hand. I would say that by the time we went to school all four of us were being smacked probably several times a day. I now know such extensive use of physical chastisement was unusual in the 1960s, but it was by no means unique and no-one at the time would have thought it unreasonable. And I know that some families today still act this way: recently I watched an episode of Supernanny US in which undoubtedly well-intentioned (and desperate) parents used constant smacking with hands and wooden spoons to discipline three- and five-year-olds.

The effect on us was perhaps not quite what my parents intended. We were not well-behaved children. We fought constantly: my eldest brother and I beat up our younger brothers and were in turn beaten for it. We also bullied other children, repeating with them what we were receiving at home and then being beaten for that as well. Photographs at the time show four scared and angry children: we smile, but the smile is tense and doesn't reach the eyes. My parents never made any connection between our violent and disruptive behaviour and the way in which they disciplined us: to them, we deserved the punishment we received and they did it with the best intentions.

The primary school that my eldest brother and I went to used corporal punishment. The head of the infants school used to smack us round the legs or on the hand with a ruler as an informal punishment. Formal punishment for boys was the cane and for girls the slipper, and only with parental permission. In practice hardly anyone was ever caned or slippered, and anyone who was instantly became something of a hero. My brother's street cred went up hugely when he was caned at the age of seven after the school had exhausted all other means of controlling his behaviour. I can't help thinking that this entirely defeated the purpose of the punishment, and it certainly had no effect on my brother's behaviour. He carried on behaving as badly as before. But the caning meant little to him anyway. He was already getting more severe punishment at home.

You see, when we became too big (or too hardened) for a smack on the bottom to bother us much, our parents moved on to using weapons. I've already mentioned that my mother used a slipper on us. By the time we were six, my father had taken to using sticks, and from that time on increasingly my mother handed over responsibility for punishment to him. If we misbehaved during the day we would receive a beating when he got home from work. And the crimes for which we received beatings became more and more trivial: I remember being beaten with a cricket stump at the age of 12 because I had taken strawberries from the garden.

Whether or not this was an effective way to discipline children is a matter of debate. My parents were convinced they were doing the right thing. But I believe it did not work. My eldest brother and I remained disruptive bullies for most of our school careers, and consequently continued to receive frequent and severe physical punishment well into our teens. My middle brother became ever more withdrawn, which deflected much of the punishment towards his more overt elder siblings. And my youngest brother became ill, thus more-or-less avoiding punishment completely. This did not go down well with his eldest brother, who tormented him. We were dysfunctional children, and we became dysfunctional adults. My working life was dogged by difficulties with interpersonal relationships and problems controlling my temper. For a long time I thought this was just me, because throughout my life I had been frequently told that I couldn't get on with people - until one day my youngest brother commented that his problem was that he didn't know how to behave. At that point the penny dropped, and I started to see that the punishment that we had received as children had deterred us through fear, but taught us nothing. Like my brother, I had no idea how to behave.

Punishment alone does not teach children the right way to behave: for that, teaching and modelling of good behaviour is needed. Punishing children without explaining what they have done wrong and how they should have behaved instead is pointless, yet that happened all too frequently: I can still remember occasions where to this day I do not know what I did wrong. Punishing children for crimes that you have not taught them about beforehand simply makes them angry. Punishing children for making honest mistakes makes it impossible for them to learn. But these principles apply WHATEVER form of punishment is used - they are not limited to physical chastisement.

The problem with my parents' discipline was not so much the violence as the inconsistency (my brothers could get away with things that I could not), the mixed messages (being punished for copying parents' behaviour) and the lack of good teaching and modelling. And above all, the injustice. Most people I know who were beaten as kids are philosophical about the occasions when they consider it was a "fair cop". What rankles is the occasions when they were punished unreasonably, whether because they didn't actually commit the crime, they didn't know it was a crime or the punishment was out of proportion. For me, being punished for things my brothers had done on the grounds that I should have stopped them was the greatest injustice. I am only 14 months older than my eldest brother. How on earth was I supposed to stop him? And if I had succeeded, I would then have got into trouble for bullying. It was impossible to win.

The big problem with such dysfunctional families is that the pattern repeats. Most of us model our parenting on our own childhoods, because it is what we know. However unpleasant it was, and however angry we feel about it, it is familiar. When we are desperately trying to manage two toddlers throwing simultaneous tantrums in the supermarket, it is all too easy to do what our parents did, because we don't have to think about it. Finding another way takes imagination, information and emotional control - all of which are in short supply when a parent is stressed. And when we are angry, hitting makes us feel better, even if it doesn't solve anything. So when I realised that the problem was that I had never learned how to behave, I understood why my parents behaved as they did. They were repeating (more mildly, actually, in the case of my father) what they had received from their parents. They had never learned how to behave, either.

When my son was born, I decided that I did not wish to repeat that pattern again. I did not want to be a heavy-handed parent. I wanted my children to love and trust me, not be scared of me. But I did not know any other way. I had to learn how to be a parent "from scratch".

Fortunately I had help. I went spectacularly to pieces after my son was born and ended up spending eight years in therapy, during which time I did a significant amount of reparenting work. From that I learned what a "better way" might look like, and I have tried to the best of my ability to put it into practice. My children have not experienced anything like the level of physical violence that I did. I did smack both my children when they were small, though never with anything other than my open hand. But looking back now, even that was too much for someone whose background contained so much violence, and I should have found other ways. The pull to escalate smacking into something much nastier was very strong and I don't doubt my children were aware of it, even though I never acted on that impulse. I still remember the first time I smacked my son, and I realise now that it fundamentally changed my relationship with him: after that, the unconditional trust was gone, and he was always a little bit wary. Mummy could hurt him....And smacking my daughter made her angry and rebellious: the close relationship that we had previously had changed to something slightly more distant and strained. I bitterly regret this. If I could turn back time, replace those smacks with other forms of discipline, I would do so.

I don't believe that anyone who has experienced serious violence in their childhood should smack their children. They are like reformed alcoholics - one drink is too many. Other people, whose childhoods were more balanced, perhaps could safely use occasional smacking within the general context of a loving, consistent and above all educational approach to discipline. But is it really necessary? David Lammy clearly thinks it is, and I know many people agree with him. I don't know, and I am not a safe judge. All I know is that to this day I feel sick when I see and hear children being smacked and I would rather no child ever experienced that pain.

There is a happy ending to this story, though. My parents may have struggled as parents, but they are wonderful grandparents and my children love them dearly. And as my children grow into adults, I see them able to manage their emotions and deal with people far, far better than I ever could. They squabble from time to time, as siblings do, but they care deeply about each other. And they have good, solid friendships with people their own age. So maybe I have done enough. Maybe, despite the mistakes I have undoubtedly made in my parenting, I have succeeded in breaking the mould.

Scotland's currency conundrum

2012-01-16T20:53:00.002Z

This post considers some of the issues that would arise if Scotland were to vote in favour of independence. The timing of the referendum is not yet clear, and there are ongoing debates as to the actual questions to be asked of the Scottish people. This post only considers full independence, i.e. Scotland leaving the United Kingdom and becoming a separate sovereign country. Other proposals that stop short of full independence are also likely to be on the table, and I will return to these in a subsequent post.

One of the major arguments has been whether Scotland leaving the Union would in effect mean that the United Kingdom (UK) ceases to exist. The Scottish National Party (SNP) seems to think that it would have this effect, and appears almost gleeful at the prospect. But I concur with the writer of this paper from the Centre For European Reform (1999), who concluded that the principle of parliamentary sovereignty, which is fundamental to the UK's constitution (and historically one of the major areas of disagreement between England and Scotland), means that the Westminster parliament can simply change the rules. It would probably repeal the Treaty of Union and create a new Treaty redefining the UK as England, Wales and Northern Ireland: this is similar to what was done when Ireland was brought into the Union, and again when Ireland left it. It is completely wrong to assume that dissolving the existing Treaty of Union would destroy the UK parliament (which I think is what the SNP believe). Nor would it mean that the Westminster parliament would become the "English" parliament. Wales and Northern Ireland would still be represented there, although there would probably need to be fundamental changes to prevent them being swamped by the dominance of England.

As I am of the opinion that the Westminster parliament will have both the desire and the ability to ensure the continuation of the UK as an entity in the event of Scotland leaving the Union, I will assume in the remainder of this post that the UK would continue to exist as a union of England, Wales and Northern Ireland.

Much of the discussion around the economic case for Scottish independence has centred on its GDP and its claim to North Sea Oil. And much of the discussion around the political case for Scottish independence has centred on the Scottish people's historic and current grievances against the English. I don't propose to address those in this post, although they are serious matters. I want to look at the financial implications for Scotland, and in particular, the question of its currency. I appreciate that for many Scots this is a sideshow compared to their sense of injustice and their desire to run their own affairs, but I believe understanding the currency issue is essential if the Scottish people are to make an informed and rational decision on their future. If they make the wrong decision, Scotland could end up like Greece.

As I see it, the currency options for an independent Scotland are as follows:

- retaining sterling
- joining the Euro
- issuing a new Scottish currency

Each has significant economic and political implications.

1) Retaining sterling

There are in my view serious issues with Scotland retaining sterling. The relationship between the UK and Scotland would be fundamentally different from today. Alec Salmond's remarks the other day suggest that the SNP does not fully appreciate the extent of this difference, and this has been borne out in conversations I have had with members of the SNP. To them, sterling has historically been Scotland's currency and they don't see why they should have to change it - and indeed, as sterling is freely traded the UK cannot prevent them using it. The reality, though, is that if Scotland left the union it would also lose any right to issue sterling or control it in any way. It would in effect be using a foreign currency.

Adopting a foreign currency means giving up control of monetary policy to a foreign state. The value of sterling is controlled by the Bank of England through interest rate policy, base money creation and open market operations. At present, as a member of the UK, Scotland can reasonably expect to have its needs taken into account in the conduct of monetary policy - and indeed the SNP's 2011 manifesto contains a commitment to press for Scottish representation on the Monetary Policy Committee (MPC). But after independence Scotland would have no right to have its needs considered or to be represented on the MPC. It would simply have to suffer the consequences of the MPC setting monetary policy to suit the needs of the UK only.

The SNP argues that this is not significantly different from the present situation. But I'm afraid they are wrong.
Yes, the MPC sets monetary policy for the UK as a whole, not to suit particular parts of it. But the UK is a fiscal union. Monetary strains are offset by fiscal transfers, which in the UK are of the "shared taxation" variety: Scotland does not levy its own income and corporation taxes, but shares in the total "pot" of UK taxation. The formula by which Scotland receives back tax revenue in the form of a block grant is known as the Barnett formula. It is widely seen by English people as benefiting Scotland at the expense of England, and is one of the main reasons why Scottish independence is more popular in England than it is in Scotland.

An independent Scotland would levy its own taxes and would receive no money at all from the UK. It would still be in monetary union with the UK, but no longer in fiscal or political union. As we have seen in the Eurozone, when there is monetary union without fiscal union smaller countries suffer because monetary policy is inevitably set to suit the dominant economy. In the case of the Eurozone, peripheral countries have suffered catastrophic loss of competitiveness because monetary policy for over a decade has suited Germany but been completely wrong for them. In the case of the UK and Scotland, this imbalance would be aggravated by the fact that monetary policy would actually be set by the dominant economy, which isn't the case in the Eurozone. If Scotland chose to run a looser fiscal regime than the UK - which from the electoral dynamics seems very likely - it would suffer the same loss of competitiveness as peripheral countries in the Eurozone. Because it would not be in any sort of political union with the UK, Scotland would not suffer externally-imposed fiscal discipline as peripheral Eurozone countries are experiencing. But it wouldn't get any help either. It would no longer have the protection of the fiscal transfers it currently receives. And its banking system would no longer automatically have access to "lender of last resort" support from the Bank of England - and I suspect that if the Bank of England were seen to be supporting Scottish banks after independence, there would be a political storm from English people already angry about the extent of the support that Scottish banks received from the UK government in the 2008 financial crisis.

2) Joining the euro

Until recently, this was the SNP's preferred option, and it still remains their long-term policy - although in the conversation I had with Dundee SNP, they suggested that this might actually be indefinite.

The first, and most obvious question here is - as only EU members can join the Euro, would an independent Scotland retain its European Union (EU) membership, or would it have to apply for membership in its own right as an independent entity? There are differing opinions on this. The SNP assumes that Scotland would remain a member of the EU, but this stems from its belief that the UK would no longer exist and therefore the EU would have no basis on which to determine which of the four countries should inherit EU membership. I've explained above why I think this belief is mistaken and the UK will continue to exist. In my view the EU is likely to acknowledge the re-formed UK as simply a smaller version of the old UK - sort of Germany in reverse. But it is by no means certain that it would automatically recognise Scotland as an EU member separately from the UK. As the Centre for European Reform paper explains (op. cit.), accepting Scotland's membership independently from the UK would involve treaty amendment because the number of EU members is written into the treaties. Treaty amendment to increase the number of members requires unanimous agreement from all existing member states. I suspect that Scotland would formally have to apply for membership, but the ever-pragmatic EU would fast-track its application and attempt to waive the normal convergence requirements to get it approved quickly. There may be objections to this from existing EU members.

If Scotland retains EU membership, it would probably also retain the UK's opt-out regarding Euro membership, although it could apply for membership if it chose. However, if Scotland has to apply for EU membership, the EU leadership would be likely to make joining the Euro in due course a condition of membership.

Membership of the EU creates a problem if Scotland is still using sterling. The central banking model in Europe places the European Central Bank (ECB) as the "hub" of a system of national central banks. Scotland would have no central bank of its own but would not be represented or supported by the Bank of England. It could not meet the ECB's requirement for submission of gold and foreign currency (FX) reserves unless it established its own central bank and persuaded the UK to relinquish a share of its gold and FX reserves at the ECB. But that central bank would have no currency-issuing powers. Even Eurozone central banks can issue Euros!

Joining the Euro is fraught with problems. Convergence criteria are strict, requiring public debt/GDP under 60% and cyclical deficit no larger than 3% (structural 0.5% or less). If Scotland were to take on its share of the UK national debt, its debt/GDP would be about the same as the UK's and its deficit between 5% and 11% depending on how much of North Sea Oil revenues it was able to claim. It would have to experience significant GDP growth to reduce these to the level required for euro membership. If Scotland were able to negotiate taking a significantly reduced share of the UK national debt (perhaps as quid pro quo for relinquishing any claim to past North Sea Oil receipts) it might run close to the debt requirements. But even 100% of North Sea Oil receipts would not bring its deficit down to the 3% target.

Furthermore, Euro membership would not confer the fiscal benefits that membership of the UK does. It is not a fiscal union in any meaningful sense, and there are at present no plans to make it one, despite all the rhetoric from EU leaders. Scotland would receive no fiscal transfers as at present, but would be forced through sanctions and budgetary supervision to impose fiscal austerity even against the wishes of its electorate. And it is clear from recent events that the EU leadership expects non-Euro members to meet convergence criteria too. This is much tougher than anything Scotland has experienced in the UK.

Scotland should think very hard before abandoning the UK's full fiscal union for the half-baked and increasingly authoritarian Eurozone.

3) A new Scottish currency

The three largest Scottish banks already issue Scottish pound notes that are widely accepted both north and south of the border, although not legal tender. An independent Scotland could therefore simply declare the "Scottish pound" as its legal currency. What value this would have internationally would be difficult to determine since Scotland would have no "credit history", and if Scotland was carrying a fairly high level of inherited debt in relation to GDP and a largish deficit the currency markets might not be too keen on the new currency. They would be even less keen on it if Scotland increased its deficit to support the SNP's social and investment spending commitments. To prevent the Scottish pound collapsing, therefore, Scotland might have to peg it to one with a more solid history, such as sterling, the US dollar or the Euro (although I would suggest pegging a new currency to one on the verge of collapse wouldn't be too clever). The history of exchange rate pegs is not a happy one: economies have to be broadly equivalent economically for the peg to hold, as the UK's experience with the ERM shows, and if the peg is at an inappropriate exchange rate a serious trade imbalance can result. Holding a currency peg would require the same sort of fiscal convergence that retaining sterling or joining the Euro would need.

Having its own currency would at least give Scotland control of its monetary policy, although if the currency were pegged monetary policy would be largely defined by the need to hold the peg. In theory it wouldn't have to have a central bank (although this would probably be a requirement for EU membership). But its three currency-issuing banks would all be foreign-owned. Royal Bank of Scotland (RBS) is 84% owned by the UK government: Halifax Bank of Scotland (HBOS) is wholly owned by the English bank Lloyds TSB, itself 43% owned by the UK government: and Clydesdale is owned by the National Bank of Australia. Having all its currency issuance capability in foreign ownership may not be acceptable to Scotland's electorate, in which case setting up a central bank would seem to be essential.

There are also serious questions about the future in Scotland of its two biggest banks, RBS and HBOS. The SNP currently claims that Scotland should not have to accept any of the costs (paywall) of the bailout of those two banks: their arguments for this are that the banks were regulated in London, large parts of their retail operations are in England, and many of the activities that failed were south of the border or overseas. The counter argument is that although regulators bear some responsibility for failing to supervise banks properly, the failure of those banks was due to their appalling management. The view of many English people - and, it seems, some Scots - is that they can't see why England should bear all the costs of the mismanagement of Scottish banks, especially when it seems that some of their disastrous decisions were supported and endorsed by the Scottish government. The destruction of a major English bank (NatWest) by a Scottish megalomaniac still rankles with many English people, and the fact that they are being expected to pay for this adds insult to injury.

Personally, I don't think the fight is worthwhile. The solution is easy. If Scotland refuses to accept any responsibility for the cost of bailing out Scottish banks, then it should not have any share in their ownership. The UK government should retain its current stake in both banks, and return them to the private sector in due course. Scotland would have no claim on any profits from their privatisation. I would also personally like to see the UK government repatriate the headquarters of RBS to London and rename it NatWest, in recognition that it would be a UK-owned bank with 90% of its operations in the UK.

General conclusions

There are no simple solutions to Scotland's currency conundrum. Economic convergence and some surrender of monetary and fiscal sovereignty seems inevitable under each scenario, although issuing a new currency would at least give the possibility of genuine financial independence once the credibility of the new currency was established. But whichever currency alternative is adopted, deficit spending by an independent Scotland immediately after independence would carry terrible economic risks because of the inflexibility of any form of currency peg and the negative view of sovereign deficits that bond and currency markets tend to have. In my view, therefore, current SNP spending plans would not be sustainable post-independence - which begs the question why they are apparently sustainable now. Maybe there is some truth in the prevalent English belief that Scotland is subsidised by England?

And finally, I question what, in a world where countries and corporations are increasingly interconnected and interdependent, "independence" really means. Can any country truly be said to "run its own affairs" any more? Or are nation states in reality subservient to the demands of supra-national organisations, international markets and multinational corporations? Across the world, the drive is for nation states to band together and form economic unions as a response to increasing globalisation. Scotland's demand for independence seems to run counter to this. But as the SNP wants a future in a different kind of union, namely the EU, I wonder whether "independence" is really what they are asking for, or simply decoupling from England and the political system that they hate? And would this give them real economic benefits? For me, the economic case for Scottish independence is not made, and the currency issue appears fatal.

If the call for Scottish independence is simply based upon ancient grievances, current injustices and dislike of the union as currently consituted, surely it would be better to address these issues and have a sensible debate as to how the union could be reformed to suit all its members better? For although Scotland can leave the United Kingdom, it cannot leave the British Isles. England and Scotland still have to coexist peacefully.

The trouble with Hungary.....

2012-01-06T19:37:00.002Z

.... is the European Union.

Let me explain.

Hungary has a silly government which is doing some objectionable things and playing fast and loose with the country's finances. On that we can all agree. But it has a two-thirds majority in its parliament and the disarray of the opposition parties means that there really isn't a credible electable alternative. Yes, there have been street protests against its policies. So what, frankly. There have been street protests against government policies in many European countries now, including the UK. That is no indication that the government is either undemocratic or about to fall.

Hungary, unlike the Eurozone members, is a sovereign country that issues its own currency, the forint. It is therefore technically unable to go bankrupt since it can if necessary print the money it needs. It also has control of its monetary policy as well as fiscal policy, which means it can raise interest rates to counter inflationary pressures and protect the value of its currency. There has been a lot of hype recently about the yields on Hungarian government debt, after it refused to pay over 10% on newly issued debt. But this isn't quite what it seems. The base rate in Hungary is a whopping 7.5% at the moment. Which means it is paying a spread of 2.5% over its own base on its debt. That doesn't sound nearly so bad, does it? It's actually about the same as the UK is paying on gilts.

However, Hungary has very large amounts of government and private debt denominated in Euros and Swiss francs. This is its real debt problem - not its forint-denominated debt. There is some evidence that Hungary wouldn't be in such dire straits if the rest of Europe wasn't a mess as well - and in particular, if Eurozone banks were in better shape. In this post, Robert Peston notes that Eurozone banks have been shedding cross-border assets at a rate of knots to improve their capital positions. The Eurozone leadership prohibited them from unloading Eurozone assets or scaling back lending to the Eurozone. So they have been selling off non-Eurozone assets - which includes Hungarian private and government Euro-denominated debt. What a surprise, the yields on that debt have been rising as a result, and the Hungarian government is therefore having to find more Euros just to pay the interest. It can't print Euros, so it has to buy them on the open market. Furthermore, because of those rising yields on both foreign and forint-denominated debt, coupled with investor nervousness about the behaviour of the Hungarian government, the forint is dropping like a stone versus just about everything else, so Euros are becoming more and more expensive. Rising yields on forint-denominated debt really aren't the issue. The major problems for Hungary are firstly capital flight causing rising yields on foreign currency debt, and secondly the collapse of the forint.

What can the Hungarian government do about this? Well, it could raid its foreign currency reserves. The Hungarian central bank is currently holding over 36 billion euros, which the government would dearly like to get its mitts on to meet its foreign-currency obligations. Alternatively, it could do a Weimar and print more and more forints to meet the ever-rising cost of buying the foreign currency it needs to meet its debt obligations. So far the central bank has steadfastly refused to give the government the keys to the vaults or allow access to the printing presses. So it's not surprising, is it, that part of the legislation that the Hungarian government has railroaded through parliament is a measure that would allow it effectively to take control of the central. bank.

Both the IMF and the European Union have objected to this legislation. Central bank independence is a requirement of European Union membership and a basic tenet of IMF fiscal prudence. Hungary was bailed out by the IMF in 2008 and is still paying IMF loans - most of the debt payments due in the next 6 months are to the IMF. Not surprisingly, the IMF still calls the shots. And because the Hungarian central bank is refusing to allow the government to monetize debts or seize reserves, it is increasingly likely that the government will have to borrow more money to meet its debt obligations. It has already commenced talks with the IMF and EU about further financial assistance. So far the IMF and EU have refused to cooperate unless some of the legislation forced through parliament is repealed - not only the measures compromising central bank independence, but also flat income taxes, which in the IMF's view will not enable the government to raise sufficient in tax to meet its obligations.

What most sovereign governments tend to do when debts skyrocket and currencies collapse is the following:

- impose capital controls to stop people taking their money out of the country
- impose exchange controls so the external value of the currency is fixed
- redenominate foreign currency debt in local currency (or repudiate loans that cannot be redenominated)
- print enough money to monetize fiscal deficits and stimulate the economy
- wait for inflation and/or growth to sort out debts.

Hungary has actually managed to do one of these - it has forced external banks to take losses on their Euro loans, much to their annoyance, which amounts to fixing the exchange value of the forint for payments to private banks. But it can't do that to IMF loans. And all the other measures are prohibited under European law.

You see, although Hungary isn't a member of the Euro, it IS a member of the European Union. And the European Commission has made it clear that Hungary will not be permitted to break the rules, even to save its economy from collapse. Further, in order to qualify for the financial assistance that it will need because it is prohibited from sorting out its own problems, it must conform to the legislative and economic norms of the European Union even against the wishes of its elected government. So Hungary's position is no different from Italy's. It cannot do all that it would like to do. It does not have the right to choose its own path to hell.

So Hungary's problem is the European Union, isn't it?

Tax oddities

2012-01-06T14:06:00.003Z

I am puzzled. On Thursday 5th January, there was a report on the BBC's Newsnight programme which outlined five ways in which people and organisations might seek to avoid tax:

1. by changing the location of transactions to take advantage of lower tax rates
2. by changing the timing of payments
3. by changing the identity of the person or organisation to which the taxable income is allocated
4. by changing the type of transaction to one that attracts a lower tax rate
5. by obscuring information

Now, all of these can be perfectly legal methods of minimising tax bills, although the last can run dangerously close to unlawful evasion. Most of us use some of these methods of avoiding tax - for example, giving gifts to grandchildren to reduce inheritance tax (point 3), or accepting part of our remuneration in shares instead of money (point 4 and possibly point 2). And indeed, no-one in the report suggested this activity was unlawful, though Richard Murphy of Tax Research UK did say it was unethical.

The report then went on to give, as an example of tax avoidance of borderline legality and dubious ethics, the Vodafone settlement with Her Majesy's Revenue and Customs (HMRC). This is a complex issue involving a German acquisition, so involves both UK and European tax law. The reporter said that the Vodafone dispute was ended last year when Vodafone made a payment of £1.25bn. But this isn't quite right. Yes, Vodafone has settled its dispute with HMRC. But UKUncut protestors, footage of whom outside a Vodafone shop formed the background to this part of the report, argue that Vodafone's settlement with HMRC was itself dubious and claim that HMRC was complicit in reducing Vodafone's bill to a lower amount than that which UKUncut believe they really owed. This is currently being investigated by the National Audit Office (NAO). Until they report, we really can't say for certain whether this was an example of illegal tax evasion (with HMRC's involvement, so government corruption too), lawful tax avoidance, or even simple interpretation of the European tax laws with no tax benefit intended. Allegations fly, but nothing is proven.

Following this, footage was then shown of Bob Diamond, CEO of Barclays Bank, failing adequately to explain to the Treasury Select Committee the breakdown of Barclays' payments to HMRC in 2010. Now, Diamond's behaviour is in my opinion mendacious - I simply don't believe that a CEO as capable as he has shown himself to be wouldn't know how much of his headline corporate tax bill was payroll taxes (income tax and employers' & employees' National Insurance, deducted at source and paid by the employer on behalf of the employee) and how much was corporation tax. But the implication in this report was that Barclays was deliberately avoiding tax. In fact the 2010 corporation tax bill was unusually low due to prior year losses carried forward. Barclays had suffered severe losses in the financial crisis of 2008-9 which it offset against profits in 2009-2010. Carrying forward losses in effect gives companies a tax rebate when they return to profit after making losses, and can make a difference between marginal profitability and insolvency. It is a completely legal accounting practice and does not constitute tax avoidance unless the loss itself was engineered for the purpose of obtaining the tax rebate, which no-one is seriously suggesting in this case. Despite this there have been continual calls for Barclays to pay more tax, and suggestions that the law should be changed to prevent banks (but not other companies) carrying forward losses. Why banks should be discriminated against in corporate tax law is one of the things that puzzles me.

So neither of the two cases chosen by the BBC was a reliable example of deliberate tax avoidance. One is still under investigation and the other isn't tax avoidance at all. I'm sure there are enough examples of genuine tax avoidance and evasion to fill a hundred BBC documentaries, so why did the BBC choose these two? Surely it isn't simply because they have been the subject of noisy protests and newspaper headlines? If it is, that is lazy research and sensationalist reporting. As a publicly-funded organisation, the BBC should do better than that.

Following the report, there was a discussion between Simon Hughes MP (LibDem) and Jesse Norman MP (Conservative), hosted by Emily Maitlis, about Graham Aaronson's proposal for a General Anti-Avoidance Rule (GAAR). At this point I became even more puzzled. There was no discussion of the five "tax avoidance" methods outlined in the report. Instead all three participants were discussing the general principle of preventing "abusive" tax avoidance practice. What did they mean by "abusive"? And how does it relate to the five legal methods of avoiding tax outlined by the BBC reporter?

I was so puzzled by this that I spent about three hours reading the Aaronson report. But this didn't help. I couldn't find anywhere in the report itself any reference to the five tax avoidance methods outlined by the BBC reporter. In the appendix there is a suggested draft GAAR which includes the following:

3. (1) For the purposes of this Part an “abusive tax result” is an advantageous tax result (see section 15) which would be achieved by an arrangement that is neither reasonable tax planning (see
section 4) nor an arrangement without tax intent (see section 5).

(2) For the purposes of this Part an abnormal arrangement is contrived to achieve an abusive tax result if, and only if, the inclusion of any abnormal feature (see sections 6 and 7) can reasonably be
considered to have as its sole purpose, or as one of its main purposes, the achievement of an abusive tax result by –
(a) avoiding the application of particular provisions of the Acts, or
(b) exploiting the application of particular provisions of the Acts, or
(c) exploiting inconsistencies in the application of provisions of the Acts, or
(d) exploiting perceived shortcomings in the provisions of the Acts.

So "abusive", it seems, means deliberately benefiting from the fact that tax legislation is incomplete, inconsistent and avoidable. I can't help wondering whether it would be better to simplify, streamline and broaden the legislation so it is less easily abused, rather than spending huge amounts of time and money chasing abusers. And to be fair Aaronson does suggest this, particularly in relation to trust law. But the more significant points that Aaronson raises in the body of the report are firstly, that most tax planning is simply prudent management of finances and not abusive; that the aim of the GAAR would be to end the minority of abusive tax avoidance cases, not make normal tax planning impossible; that changes to reduce the incidence of abusive tax avoidance must not make the UK tax regime unattractive to business; and that there are features of the UK tax system that are INTENDED to reduce tax liability in certain cases and that people and businesses should not be prevented from taking advantage of these when appropriate. It would be HMRC's responsibility to prove abusive tax avoidance, not the taxpayer's to defend; and there would be safeguards to stop HMRC using the threat of GAAR as a weapon to enforce payment of disputed taxes.

None of this told me where these "five methods" came from. Aaronson identifies the following characteristics of tax arrangements (legal structures and transactional processes) that would in his view constitute abusive tax avoidance:

(a) they may understate taxable returns from a transaction
(b) they may overstate the tax-deductible expenses associated with a transaction
(c) they may deliberately misprice a transaction with the intention of reducing the tax payable
(d) they may be inconsistent with the legal obligations of the parties to a transaction
(e) they may include a person, a transaction, a document or significant terms in a document, which would not
be included if the arrangement were not designed to reduce tax liability
(f) they may omit a person, a transaction, a document or significant terms in a document, which would not
be omitted if the arrangement were not designed to reduce tax liability
(g) they may include the location of an asset, a transaction, or the place of residence of a person, which would not have been so located if the arrangement were not designed to reduce tax liability

These sort of relate to some, but not all, of the BBC reporter's five methods of tax avoidance:

- Point g) is changing the location of transactions to take advantage of lower tax rates (method 1)
- Points e) and f) involve changing the identity of the person or organisation (method 3)
- Points a), b) and c) all involve changing the nature of a transaction

Point d) looks much like money laundering to me, which isn't mentioned by the BBC. And Aaronson doesn't mention timing of payments or obscuring information. So I was left still wondering where the BBC reporter got his definitions from. Evidently it wasn't from Aaronson.

Now oddly enough, Richard Murphy issued a blog earlier on 5th January. In it he outlines the following methods of tax avoidance (I have summarised them here, follow the link to read the full version).

Reallocate their income to a person or entity that has a lower tax rate than the individual whose activity really generates the income
Change the location of a transaction
Change the nature of a transaction so that it appears to be something different from what it actually is
Delay recognition of income e.g. delaying a bonus so that it is taxed later
Obscure the information available on a transaction

How odd. Apart from the order in which they appear, these match the BBC reporter's definitions exactly. I can't believe this is coincidence. It would seem that Murphy not only appeared on the programme, but was a consultant to it. I do think the reporter should have acknowledged his sources. He gave the impression that these definitions were from Aaronson's report, since that was the subject of the subsequent discussion. It seems they weren't - they were Richard Murphy's definitions. Now, Murphy gave evidence to the Aaronson committee in his capacity as tax advisor to the TUC, but he was not a member of that committee. The Aaronson committee was made up of academic professors, legal experts and industry practitioners who are acknowledged experts in the area of tax. Why did the BBC reporter ignore what these people said and instead use definitions from someone who represents a particular special interest group, namely trade unions?

And here's something that puzzles me even more. In that blogpost, Murphy is severely critical of the Aaronson recommendations. He claims that they are simply ineffective in relation to his five definitions of abusive tax avoidance:

....none of them will be touched in any significant way by Graham Aaronson’s General Anti-Avoidance Principle which Cameron claims will beat tax avoidance.

But back in November, when the Aaronson report was published, Murphy was very supportive of it:

Graham Aaronson QC’s report for HM Treasury on the desirability of a General Anti-Avoidance Rule (GAAR) for the UK is published this morning, and I warmly welcome it.

He went on to write two more blogposts (here and here) supporting Aaronson's recommendations and promoting their adoption into law. But now he is claiming that they are pointless. Now as far as I can tell Aaronson's report has not been changed since November and its proposals have not been watered down - in fact the Government seems to be planning to implement them in full. So why on earth has Murphy's opinion of this report undergone such a sea-change? He must have missed something in his initial reading of it. I am puzzled.

In fact I end this very long blogpost more puzzled than when I started. I don't understand why the BBC prefers the opinions of special interest groups over the findings of acknowledged experts, and I don't understand why two groups who are both seeking to curtail abusive tax avoidance are failing to present a united front. The Newsnight programme explained nothing and raised more questions than it answered. It was no credit to anyone.

It doesn't work like that - government finances edition

2012-01-04T17:56:00.004Z

This is intended to be a short "idiot's guide" to how government finances REALLY work. I'm writing it partly as background for my posts on economic policy in the UK and Eurozone (and maybe the US), and partly to debunk various urban myths about government spending.

Firstly, let's define some terms.

"Deficit" is the excess of government spending over its income
"Surplus" is the excess of taxes over government spending.
Please note that for the purposes of this post, these terms relate only to government finances, not to trade finances. We also use the terms "deficit" and "surplus" to mean the excess of imports over exports and vice versa, but that is not how they will be used in this post.

"Taxes" are the contribution of the population to government spending - this is by far the largest part of government income, but there can be other components to government income such as asset sales. "Taxation" is the process of obtaining taxes from the population.

"Fiat currency" is currency whose value depends on the economic worth of the issuing country rather than an underlying asset such as gold. In practice the value of a fiat currency depends on the perceived trustworthiness of the issuing government.

Now to the urban myths that I mentioned in my introduction. This is how most people think government finances work:

1. Governments receive taxes from their population
2. Governments determine their spending plans on the basis of those taxes
3. Governments spend the taxes they have received
4. If governments spend more than the taxes they have received, they have to borrow the difference

These beliefs lead to the following value judgements:

- Governments should only spend what they receive in taxation. A government that runs a deficit to fund public spending is irresponsible.
- Government borrowing is a bad thing because it has to be paid off from future taxation, which means higher taxes in the future. We should get rid of government debt and "live within our means".
- Government surpluses are a good thing because it means we are being prudent and can pay off debt.

The problem is the beliefs are wrong, and therefore the value judgements are wrong as well. Government finances don't work like that.

The first thing to get your head around is that government spending PRECEDES taxation. Yes, that's right - governments spend first, tax later. This is roughly similar to the precedence of bank lending over saving that I explained in a previous post. Just as banks lend, then look for reserves to settle that lending, so governments spend, then extract taxes from their populations to extinguish the debt obligations created by that spending. It's always been like that throughout history: kings go to war, borrow to pay for their campaigns, then extract punitive taxes from their subjects to pay off their debts. The fact that present-day governments are spending money on many other things than war doesn't change the way it works. They spend, then extract the taxes.

The fact that spending precedes taxation means that government must establish its spending priorities on the basis of ANTICIPATED income, not actual income. And as anyone who has tried to forecast a business budget knows, what you anticipate you will get and what you actually get can be very different. So the idea that government should only spend what it receives in taxation is actually impossible. Tax forecasting is about as reliable as weather forecasting. Even spending plans are by no means certain.

Deficits and surpluses

There is a prevalent belief that deficit=bad, surplus=good. This belief is even being forced into law in the European Union. But value judgements such as "good" and "bad" have no place in finance and economics. Government spends according to the priorities agreed with its electorate, and it taxes that electorate to extinguish the debt obligations arising from that spending. In a perfect world the taxation would exactly balance the spending, so there would be neither a surplus nor a deficit. However, the world isn't perfect and taxation rarely if ever exactly balances spending. There will therefore in practice always be either a deficit or a surplus. And budget plans have nothing to do with this either. Government plans to run a surplus may be completely undermined by a sudden economic downturn that causes tax receipts to crash. A surplus can turn into a deficit in one budgetary cycle.

In fact, because there is a time delay between government spending and taxation, there must always be a gap - a temporary deficit - within a budgetary cycle. This has to be funded, either with surplus taxation from the previous cycle, or if there is no surplus, by borrowing or by creating new money. If the currency in which government spends and receives taxes is tied to an asset such as gold, government has to borrow against the value of its holding of that asset in order to finance its spending. Conversely, if the currency is not tied to any asset but exists simply because the government says it does - what we call "fiat" currency - the government can print unlimited amounts of that currency, or it can borrow against the security of the productive assets of the country. For various reasons that I won't go into here, most governments don't choose to print money even if they have fiat currencies - they opt for borrowing. Short-term funding is used to cover the spending-to-taxation delay. Longer-term borrowing is used to cover deficits that aren't paid off within one budgetary cycle. Governments that run persistent large deficits over several years can end up deeply in debt.

Keynsian economics argues that governments should run surpluses in boom times and deficits in recession. This looks like a good idea - saving up reserves in the good times to cover the shortfall in recession, when tax receipts fall and benefits payments increase. The problem of course is how do you know when you are in good times so should be running a surplus? There are always calls on public money, problems to be fixed, pockets of poverty to be alleviated. And of course, when times are good governments believe they will last for ever, so there will always be more money and there's no need to save. The Blair/Brown government famously said they had "fixed Tory boom and bust". They had to eat their words.

The reality is that governments DON'T generally run surpluses in good times - they increase spending. But boy do they run deficits in bad times. So generally, governments tend to get deeper and deeper into debt.

There are exceptions, of course - for example, Germany and the Netherlands both run large surpluses. If a government runs a surplus, it has the option of cutting taxes and/or reducing debt. Government debt does not automatically reduce when there is a surplus. The government decides whether to pay off debt, and on this they should be guided by the electorate: if the electorate wishes the government to return that surplus in the form of tax cuts instead of paying off debt, that is what the government should do.

The idea that a government persistently running a surplus is more "prudent" than one running a deficit is another value judgement, and fundamentally wrong. A government that persistently runs a surplus is every bit as irresponsible as one that persistently runs a deficit, because it is overcharging its population for public services and reducing their capacity to provide for themselves.

Automatic stabilisers and other uncertainties

Automatic stabilisers are changes in government spending and income that help to smooth out economic highs and lows - rather as the stabilisers on a ship help to stop it rolling excessively in a storm. They are set up to happen automatically as a consequence of economic performance, and once established the government has little or no control over them. In general, in an economic downturn tax receipts fall and benefits bills rise, while in an economic boom tax receipts rise and benefits bills fall.

Examples of automatic stabilisers are as follows.

- When unemployment rises, tax receipts fall because fewer people are paying taxes. At the same time, the government's benefits bill rises because it is paying more in unemployment benefits.

- If there is a system of top-up benefits for low wages (as there is in the UK), wage cuts and short-time working when the economy is performing poorly also increases the government's benefits bill and reduces its tax take.

- If corporate profits decline due to poor aggregate demand, collapse of exports or other such economic problems, tax receipts also decline. Companies that make losses can carry those forward and offset them against future profits, too, so corporation tax receipts may take some time to recover.

- If corporate profits rise due to high demand in a booming economy, tax receipts rise

- If unemployment falls, tax receipts rise and benefits fall

- If wages rise and/or working hours increase, tax receipts rise and benefits fall

None of this is under government control. But these changes can be sufficiently large within one budgetary cycle to move the public finances from surplus to deficit, or vice versa.

There may be other areas of spending that occur as a consequence of things beyond the government's control, such as hardship payments to elderly people in cold weather and compensation payments to farmers for crop failure in drought. These are spending commitments which are not known in advance and the amount of which cannot be realistically estimated.

Automatic stabilisers and other uncertain spending commitments make it difficult if not impossible to maintain a balanced budget over the business cycle - as our European friends would like.

Government debt

People who have grown up with the Anglo-Saxon virtuous model "savings good, debt bad" tend to feel very uncomfortable if their country has much in the way of debt. It offends their values. But as I said above, value judgements have no place in economics and finance.

Government debt can be regarded in a number of ways.

1) It is deferred taxation. Debt obligations created by government spending are extinguished through taxation, so if the taxes aren't raised from current taxpayers, they fall upon future ones. Additionally, there is an interest cost to debt which has to be paid from future taxation even if the debt itself is not paid off. When people talk about government debt being a burden on their children and grandchildren, this is what they mean.

2) It is spending brought forward. Government debt is a way of enabling present citizens to share in a country's future wealth. If a country is growing fast and living standards are rising - as is the case in emerging markets, for example - future generations will have a better standard of living than their parents and grandparents who have worked hard to create that economic growth. Bringing forward some of that wealth from the future enables the older generations to experience some of the material benefits from their hard work. Note that this only applies in a young, growing economy. It should be obvious that in an older, richer economy that is stagnating, bringing forward spending from the future in this way benefits no-one and could leave future generations with a debt burden that they cannot service.

3) It is a savings scheme. In most countries, government debt is generally bought by their own citizens as an investment for their future, often - though not always - as part of pension schemes. In countries that have developed capital markets, the debt may additionally be bought directly or indirectly by the citizens of OTHER countries. Government debt is regarded as the safest form of investment, because it is guaranteed by a sovereign government and is backed by the worth of the entire country. Owning, directly or indirectly, the debt of the country in which they live makes people stakeholders in their country's future.

4) It is another form of money. Yes, I mean that. Or, if you prefer, it is a liquid asset which is backed by the productive assets of the issuing country - which is the same thing as money (see my definition of "fiat currency" above). The debt of rich fiat-currency-issuing nations such as the USA and UK is essential to the functioning of the capital markets - so much so that when that debt is in short supply, market representatives have been known to lobby for more to be issued.

Now, you ask - if government debt is simply another form of money, why not just issue currency? Provided that a fiat currency is allowed to float freely against other fiat currencies, there is in my view no reason to prefer debt issuance over currency issuance, or vice versa. I have heard it argued that fiat-currency-issuing governments should prefer to issue currency rather than debt, because currency would be interest free. Yes, there would be no interest to pay. But the interest cost on government debt issues is directly related to the value of the currency through its exchange rate. Issuing more currency reduces the value of each currency unit, which causes the exchange rate to fall, raising the cost of imports and creating inflationary pressures in the economy. Correcting those pressures involves increasing interest rates to private sector borrowers. The overall cost to citizens of the country I think would be equivalent.

I admit I have not done the maths to prove this and haven't seen anyone else do it either, not even Bill Mitchell who is a staunch advocate of governments funding deficits with currency issuance rather than debt. I'm aware that the relationship of currency issuance to inflation is disputed, and I should emphasise that the above paragraph is my personal opinion.

If I am right, though, then Quantitative Easing as conducted by the UK government cannot possibly be inflationary, since all it is doing is issuing one form of money to buy an equivalent quantity of another form of money. Yes, the government debt purchased is held, rather than being redeemed - but it is removed from circulation, which is what matters. And yes, the government still pays interest on that purchased debt, but only to itself (the Bank of England gives the interest back to the government).

How governments get rid of debt

Note that I did not say "pay off" debt. Generally governments don't pay off debt. They refinance it - by which I mean that when one lot of debt falls due and has to be repaid, they issue some more debt so they can repay the debt that is maturing.

Nevertheless, government debts historically have reduced. The UK's public debt after World War II was considerably higher than it is now. At least that is what we are told by those who think that the way out of our economic difficulties is to issue loads more public debt.

The trouble is, it isn't true. The nominal amount of public debt only reduces if it is REPAID, which it hasn't been. What has actually happened is that UK public debt has reduced AS A PROPORTION OF NATIONAL INCOME. Government debt is nearly always quoted in relation to Gross Domestic Product (GDP). There are two ways in which the proportion of public debt to GDP can be reduced:

- GDP can ACTUALLY increase through economic growth (this is what happened in the 1950s and 1960s, when the UK was a young economy growing fast after the Depression and the War)

- GDP can APPEAR to increase through inflation (this is what happened in the 1970s after the OPEC oil crisis)

Either way, because the nominal amount of debt is fixed, it declines as a proportion of GDP. Obviously we like to reduce our debt/GDP ratio through growth and are much less happy about inflating it down, because inflation erodes people's savings and reduces their real incomes. But both methods are equally effective at reducing the debt/GDP ratio, so if growth is hard to come by and debt is a real problem (perhaps because investors are getting nervous about the amount of debt and demanding higher interest rates), it is very, very tempting to go for inflation.....

The relationship between government and private spending and saving

I mentioned above that a government that runs a surplus is depriving its population of the opportunity to provide for themselves, because it is overcharging them for public services. That government surplus represents LOST private sector savings and/or spending. Running a surplus in an economic downturn is counterproductive, because it reduces people's spending power. And it can be argued that running a surplus in a boom is unnecessary if public debt is under control, because people are perfectly capable of saving for themselves and don't need the government to do it for them.

Conversely, a government that runs a deficit is undercharging for public services. That means its population is paying less in tax than it should and therefore has the capacity both to spend more and to save more. In good times, undercharging for essential public services is in my view irresponsible. But in an economic downturn it can be helpful, if the problem is a failure of aggregate demand. For example, cutting taxes to low- and middle-income earners can be an effective way of stimulating demand. If the propensity of the population is to save, though, cutting taxes can simply allow people to save more, which doesn't help demand - this is the "paradox of thrift". A government that deficit spends excessively in a downturn when people prefer to save can end up with a stagnant economy and very high debt.

If the private sector (households and corporates) is highly indebted and paying off debt, government must run a deficit. This is because economically, paying off debt is the same as saving, and as I pointed out above, government surplus represents LOST private sector savings. The excess taxes that people pay when government overcharges for public services reduce their capacity to pay off debt. I hope this is clear to my readers, because it is a fundamental principle and one I shall return to in future posts.

Loneliness

2011-12-27T17:00:00.001Z

This year, for the first time in my life, I was faced with the prospect of being alone on Christmas Day. I have no doubt it will not be the last time. My children will fly to new nests in far-away places, my friends and family will gradually leave this world or become too frail to travel. Being alone, often for extended periods of time, is characteristic of elderly life. I look forward twenty years and realise that much of my future will be spent alone.

I choose my words carefully. I said "alone". I did not say "lonely". Being alone does not necessarily mean being lonely.

At Christmas we assume that anyone who is alone must of course be lonely. There are campaigns to persuade people to visit elderly neighbours and take them to jolly Christmas parties at special centres for the elderly. Personally I can't think of anything worse than spending three hours in a hall full of total strangers being patronised by well-meaning youngsters determined to ensure that I "have a good time". Or, for that matter, spending an hour in the company of a neighbour that I don't know, because she hasn't spoken to me the rest of the year, and with whom I have nothing in common. I would be far lonelier in such company than I would be in my own home with music, books, a telephone and, above all, memories. And I would resent having to be grateful to such people for showing me the "kindness" of disturbing my aloneness.

Loneliness is the state of having no real relationships. Fake, transient episodes of "company" for the sake of "human contact" are no substitute for the real thing. For me, the relationships I have with authors through their words, with composers and performers through music and with my family and friends over the telephone or through my memories are more real than anything that can be created by strangers in a couple of hours. I suppose I have always been comfortable with my own company, and what works for me would not work for everyone. There are no doubt people for whom the prospect of being alone at Christmas is indeed terrible. But we should not assume that that applies to everyone.

Nor should we assume that because someone is in the company of family and friends that they are not lonely. The woman whose husband sits and reads the paper, or watches the television, or surfs the net while she prepares dinner.....who says not a word to her while they eat, then leaves her to the dishwashing while he returns to whatever he was doing before. She may be lonelier in the company of her husband than the elderly lady next door whose husband died ten years ago. Or the family at war among themselves, whose conversation is only of trivial things, who substitute presents for love and who guard their feelings for fear of being hurt. Or the people who are embarrassed to share anything about the pathetic reality of their lives so put on a good show to impress their "friends". Are these people not lonely? Are they not, in reality, perhaps lonelier than those who we assume must be lonely simply because they are alone?

But why is being alone at Christmas apparently so much more terrible than being lonely the rest of the year? Why do we put in the effort at Christmas to speak to neighbours that we otherwise ignore? Why do we send Christmas cards to family and friends that we don't bother to speak to from one year-end to the next? There is nothing in the Christmas story to justify such obsession with transient human contact and presents as symbolic restitution for the love and care that we withhold the rest of the time.

We have come to believe that Christmas is a time for being with family and friends, for parties and socialising. Shops sell party clothes and party food. Being alone seems terrible when everyone around you is apparently having the perfect party, spending time with the people they love, who love them. But is this really what is happening - or is this just the show we put on to hide the hollowness and unreality of our lives?

The Christian festival of Christmas celebrates God made man, come among us to die. Among the presents that Jesus is given is myrrh, used for embalming corpses. And in our secular Christmas, too, there is death. More marriages end at Christmas than at any other time of year. More people get into serious financial difficulty at Christmas than at any other time of year. More people commit suicide at Christmas than at any other time of year. It seems that in our expectation of the perfect party we substitute transient contact for real relationship, and when we fail to achieve our expectation the shallowness of our desire is exposed and we are left with nothing but despair. At the heart of our parties and socialising is loneliness, emptiness and a desperate search for love.

In the end, this year I was not alone. My children decided to spend Christmas with me. So I don't know if I would have been lonely. No doubt I will find that out at some time in the future. We are all lonely at some time in our lives. And we can be just as lonely among people as we can when alone. "Human contact" alone is not enough. It is the quality of our relationships that matters - and that is born not from trivial conversation on one day in the year, but from care and concern for each other day in, day out throughout the year. When we know we are really loved by the people closest to us, we can be alone at Christmas without being lonely.

There are indeed many lonely people at Christmas. But many of them are not alone. Do you notice them?

The ICB's fig leaf

2011-12-21T21:03:00.001Z

It was announced on Monday 19th December that the Independent Commission on Banking's (ICB) proposals for reform of the UK banking system would be accepted in full. Or not quite, actually - HSBC managed to wring a concession from the Government that it would not have to meet higher capital requirements for business it conducts overseas. As HSBC's overseas business dwarfs its UK business this is important for them, but the quid pro quo must surely be that problems in the overseas businesses cannot be bailed out by its UK operations. The ringfencing proposal should help to achieve this, although it remains to be seen how well this would hold in practice.

Inevitably, there have been criticisms of both the proposals themselves and the Government's handling of them. Tony Greenham of the New Economics Foundation (NEF) wrote this post describing why he believes the proposals are ineffectual. I think the Vickers reforms are indeed ineffectual, but not for the reasons Greenham gives.

These are my concerns about the proposals.

1) Ring-fencing and full legal separation

Ring fencing will only apply to three banks – HSBC, Barclays and RBS. And the Government has also announced proposals to reduce the size of RBS’s investment banking significantly and force it to concentrate on retail and corporate lending as its major business activities. So that leaves only two whose investment banking operations might conceivably present a serious threat to their retail arms.

I have previously criticised the ringfencing proposal as failing to address the risks in retail banking, which were the main cause of UK bank failure in the 2008 failure crisis. However, I accept that ringfencing would make universal banks easier to resolve in the event of a collapse. And as I noted above, it may prevent HSBC and Barclays from using their UK retail bank to support overseas operations.

Full separation would not provide greater protection than a ring fence unless steps were also taken to prevent retail and investment banks from trading with each other. Northern Rock was heavily involved in “risky” securitization with the assistance of a tame investment bank. It was fully separated from that investment bank.

This whole proposal is a cave-in to the demands of politicians for a headline-grabbing solution. The ICB was primed to look at the options for separation, and the media and political hype around the idea of a "UK Glass-Steagall" meant that it was difficult for the ICB to propose "no separation" as a serious alternative. But the Glass-Steagall Act in the US applied to a banking environment that is very different from the UK's. We do not have their extensive investment banking sector, we do not routinely securitise retail loans and we have no equivalent of the American GSE. There is no way that American-style regulation is appropriate for UK banking. It seems yet again we have looked across the pond for an instant solution to our problems, rather than doing the painful job of analysing the faults in our own system and coming up with our own solutions.

2) Lack of competition in UK banking

The Lloyds/HBOS merger should have been unwound. The ICB report concluded that it was a mistake, but it chose to protect the Brown government’s reputation instead of doing the right thing by the British public. Frankly I thought this decision – explicitly stated in the report – was disgraceful. The merged Lloyds/HBOS business is the largest bank in the UK and dominates the UK mortgage market. Forced sale of branches is no substitute for breaking it up.

Nor did the ICB consider the future of RBS and Northern Rock, the other two nationalised banks. It did not look at the possibility of remutualising Northern Rock or breaking up RBS (demerging NatWest). Both of these would have given clear indication to the UK banking sector that further concentration is not acceptable. Because the ICB failed to address this issue, Northern Rock has now been sold to an existing player in UK banking (though admittedly one that did not previously have a high street presence), and RBS remains a publicly-owned megalith with no clear business direction.

This failure is bad enough. But the ICB was mandated to consider ways of improving competition in banking. It has actually recommended practically nothing that makes any significant difference. There are no suggestions for ways of lowering barriers to entry to new entrants into the banking marketplace, apart from a minor tweak that might make it easier for customers to switch accounts. There is no consideration of appropriate regulation of alternatives to traditional banking or ways of relaxing the stranglehold that clearing banks have on payments. The banking sector desperately needs more competition. These proposals do little to encourage it.

3) Higher capital requirements

The additional capital requirements will at the present time be very difficult to raise without asset sales and serious cuts in lending activities, which could potentially have a catastrophic effect on a very fragile economy.

To my mind the ICB's proposals rely too much on simple increases in amount of capital and do not address the far more difficult question of how capital is allocated. For that they rely on Basel – and that I think is partly the reason for the delayed implementation to 2019, which is also the Basel III final implementation date. Capital allocation in the financial crisis turned out to be utterly deficient, because the banks were allowed to use their own models to calculate risk weightings for more complex instruments, and because some classes of asset turned out to be much riskier than their weightings would suggest. Basel III still relies on bank-calculated risk weightings and therefore does not really address this matter adequately. Increasing the capital amount without vastly improving its allocation is an expensive and inefficient way of reducing risk.

I wish NEF writers - and other critics of the Western banking system - could get out of their heads the idea that the size of a bank’s asset base is an indicator of its risk. It is not. We should pay far more attention to the quality of its assets – including getting some proper regulatory supervision of risk weighting calculations – and the size of the gap between lending and borrowing maturity profiles. Unfortunately the ICB ignores these completely and simply throws money at the problem.

4) Regulation and supervision of banking activities

The ICB does not address the appalling failure of regulation and supervision by the Fiinancial Services Authority (FSA). It makes no recommendations for a more rigorous regulatory and supervisory regime that is less open to errors, conflicts of interest and corruption.

I have little confidence in the new regulatory body replacing the FSA, since it is under the aegis of the Bank of England (which notably failed to supervise BCCI and Barings adequately), and seems to be made up of many of the same players who failed so spectacularly to regulate or supervise HBOS, RBS and Northern Rock. Giving people a second chance to get it right after making errors of such magnitude seems like crass stupidity to me.

5) Risks in retail lending

No curbs are proposed on retail lending activities, despite the fact that it was excessively risky retail lending that brought down three of the four UK banks that failed in 2008. Instead, the ICB's report preserves the commonly-held – and totally wrong – belief that the financial crisis in the UK was caused by investment banks “gambling” with retail depositors’ funds. It wasn’t – it was caused by retail banks speculating on property. Yes, the worldwide crisis was focused more on investment banks, tho even there the ultimate cause was the excessive risk and fraud in American mortgage origination and securitization. But the UK crisis was definitely one of RETAIL banks.

In short, these proposals are long on "shock and awe" and short on anything that will make a real difference to the way in which banking is conducted in the UK. Banking is boring, and proposals to make it safer even more so. The nitty-gritty detail of loan-to-valuee caps, loan to deposit ratios and the like don't interest the media or politicians - which is the audience that the ICB plays to. So we may now go ahead with a half-baked separation of investment and retail banking, which will only really affect two banks, and higher capital requirements, which we dare not implement until the means are in place to calculate the allocation adequately and the economy is strong enough to take the increased cost and tighter criteria for lending that will result from them. We won't, it seems, make the deep detailed adjustments that we really need. Or if we do make them, it will be despite, not because of, the work of the ICB.

The ICB's proposals are nothing but a fig leaf.

Nightfall in Euroland

2011-12-12T08:55:00.002Z

On Friday 9th December, the leaders of the 27 European Union members held a summit to try to resolve the Euro crisis. In the few days before that summit meeting, Chancellor Merkel of Germany and President Sarkozy of France produced a proposal for closer fiscal union among the 17 Eurozone members. Key elements of the proposal are:

member states to balance their budgets and keep debt and deficits in line with existing provisions in the Stability and Growth pact.
there would be supervision from Brussels of member states' budgets and debt issuance plans, and sanctions such as fines for those who did not abide by the rules
the European Stability Mechanism - a larger and better bailout fund, but still mainly dependent for financing on existing member states, although the proposal does invite external contributions - would be introduced in July 2012, running alongside the existing EFSF instead of replacing it as previously planned.
there would be no further haircuts for private sector bondholders
funding would be provided to the IMF by member state central banks - not of course specifically to fund Eurozone bailouts, since that would breach the IMF's terms of business, but of course the IMF would be bound to help out, wouldn't they?

,It was believed that this proposal would require treaty change, and therefore all 27 members of the EU would have to agree to it.

The British prime minister, David Cameron, attempted to force through changes to the proposed new deal for closer union. The full text of his changes is here, but they amount to imposing a UK veto in areas pertaining to financial markets and regulation. Existing EU practice allows decision-making in these areas to be done by Qualified Majority Voting, which would in effect mean that a tighter, more unified Eurozone could consistently out-vote the UK and therefore impose on the UK's financial sector regulation and taxation against the will of the UK government. It isn't correct to suggest, as some commentators have, that Cameron was trying to evade tighter regulation of the financial sector, or prevent imposition of a Financial Transactions Tax (FTT). In fact paragraph 2 of the proposed changes would allow the UK to impose higher capital requirements than the EU requires and unilaterally implement the ring-fence recommended by the Vickers committee. And the FTT is not mentioned in the proposals at all - and it would require all 27 nations to agree to it anyway. No, this was simply an attempt to preserve the UK's authority over its financial sector, which dominates its economy.

When Merkel and Sarkozy made it clear that they would not agree to Cameron's changes, he refused to agree to their proposal. Unfortunately this resulted in the 17 Eurozone countries, plus 6 non-Euro countries, deciding to go it alone on tighter fiscal union despite the UK's opposition. It is unclear what the effect of being excluded from this Euroclub would be for the UK. The European press have almost universally consigned the UK to the outer darkness, and the UK press have generally been pretty critical of Cameron, although some right-wing writers have been more positive. Some American writers have been negative too: Reuters concluded that Cameron's action would be disastrous for the UK, which would end up being isolated.

But Felix Salmon (also writing for Reuters) took a completely different view. And for me, Salmon gets it right. You see, Cameron's action is completely irrelevant. Who cares whether the UK is in or out of a fiscal union that is born out of a desire to maintain a fundamentally flawed currency union, and is itself fundamentally flawed? It isn't going to happen. As Walter Munchau points out in the FT (paywall), it is unclear whether a "treaty within a treaty" is legally possible. And it doesn't address the real problems in the Eurozone anyway:

the underlying balance of payments problem is completely ignored - deficit countries would have to implement painful austerity measures without corresponding easing from surplus countries:
there are still no sensible proposals for recapitalising national banks:
the ECB would still be unable officially to support countries in trouble through unlimited debt purchases or capping yields on their bonds
the bailout funds (two of them now) would remain underfunded and unable to tap the ECB for funds since neither would have a banking licence:
issuance of pooled Eurozone debt (Euro bonds), and eventual replacement of national debt, is still off the table because of Germany's opposition to the whole idea of fiscal transfers to weaker states.

What is proposed is not a fiscal union in any meaningful sense. Real fiscal unions, such as the UK, the US and Canada, have mechanisms for transfer of funds from richer areas to poorer areas within the union, and overall budget-setting and taxation for common expenditures. No such facility is proposed for the Eurozone - and indeed the governance proposal, which envisages the Eurozone remaining a coalition of national states, would make this impossible. What is proposed amounts to the same old mantra of "fiscal discipline", based upon the Stability and Growth Pact that was flouted from the start, but this time brutally enforced with painful sanctions and accompanied by dilution of democracy in the weaker nation states. Germany can have democracy, it seems; but Greece, Italy, Spain and Portugal cannot. And as I've explained in a previous post, austerity measures in deficit countries without corresponding fiscal expansion in surplus countries will eventually drive the whole area - including the surplus countries - into recession.

But an even more immediate problem is the weakness of the European banks and the ongoing flight of capital from the European banking system. Liquidity for European banks is becoming a real problem, because banks don't trust each other enough to lend funds: and many banks are poorly capitalized and potentially insolvent in the event of sovereign debt writedown. And investors are removing their funds at a rate of knots - selling their holdings of sovereign debt from deficit countries, selling their holdings of bank shares and debt, and even (in Greece) removing funds from bank deposit accounts. Capital is leaving the Eurozone: the Euro is falling and safe haven investments such as US Treasuries are trading at negative interest rates. The financial sector is calling for a "big bazooka" to backstop sovereign debt and stem the capital flight. It didn't get one from this summit, so the European financial system will continue to haemorrhage money. Eventually it will bleed to death, and there will be massive banking failure that will make the 2008 crisis look like a minor blip.

In fact the summit was a massive failure. It didn't address the real problems in the Eurozone, and therefore it solved nothing. The Euro is still doomed, and the countries of the EU - including the UK - are still facing economic disaster because of it. Salmon's description of the summit as "disastrous" is accurate and damning.

Yes, the UK may be eclipsed in Europe. But over the Eurozone, darkness is falling.

The merits of a debt money system

2011-11-29T00:32:00.003Z

In my previous post I explained how the Western world's debt money system works. Currently, in our system, all money is created as debt. Debt precedes savings: it is lent out by financial intermediaries and becomes someone else's savings when it is spent. Therefore, contrary to popular opinion, for someone to have savings it is necessary for someone else to have debt. And because debt (in its widest sense, so including corporate equity) and savings are equally balanced over the economy as a whole, when debt is paid off savings are reduced by an equal amount.

In a debt money system the value judgements so frequently applied to debt and savings are unhelpful and can lead to completely inappropriate courses of action being taken by individuals, corporations and - particularly - by governments and supra-governmental organisations such as the IMF. Popular morality, particularly in the Anglo-Saxon world, has it that debt is a BAD thing and savings are a GOOD thing. These mores may be helpful when teaching fiscal responsibility to teenagers. But they are meaningless when applied to a debt money economy.

In a debt money economy, both debt and savings are necessary. Savings cannot exist without debt, and because of the way fractional reserve banking works, new debt cannot be settled without savings. It is completely circular and, as I noted above, economically balanced.

Socially, however, it is far from balanced. The fact is that most of the savings are held by richer people, and most of the debt is held by poorer people, or by governments on behalf of poorer people. And as a couple of people pointed out in the comments stream on this post, the imbalance is also inter-generational. Older people tend to have more savings, of all kinds, than younger people do, and conversely younger people tend to have more debt than older people. The commentators on Positive Money's post describe this incorrectly as a wealth transfer from younger to older. It is nothing of the kind: people build up wealth by saving from their lifetime's income, so it is inevitable that people who have lived and worked longer will tend to have more wealth (savings) than younger people. These savings are lent back to younger people to enable them to have things such as cars and - yes - houses that they do not yet have the wealth to be able to afford.This transfer of savings from older to younger, and from richer to poorer, to enable younger and less wealthy people to have a better standard of living than their present wealth would permit is in my view one of the principal benefits of a debt money system. Yes, that debt has to be paid back from future income, and if future income disappoints in relation to the money borrowed then paying back that debt can become very difficult. But as a way of redistributing wealth on a temporary basis it works pretty well.

The opposite of a debt money system is a saved money system. An increasing number of people, including (but not limited to) Positive Money, are calling for changes to the Western debt money system which would amount to transforming it into a saved money system. In a saved money system, money is created through payments, not through debt, so savings precede debt. And because savings precede debt, it is of course not necessary for debt and savings to balance. Money stuffed under mattresses or buried in the ground never gets lent to anyone, so debt will tend to be less than savings.

Intuitively a saved money system "feels" better to many people, because it's how they've always thought the money system worked - partly because banking and economic textbooks incorrectly teach that savings precede debt in fractional reserve banking. And it fits better with the mores I described above: if savings can exceed debt - as they can in a saved money system - then Anglo-Saxon moral judgements about the evils of debt and the wisdom of saving can be applied with impunity.

But there is a huge problem with a saved money system. You see, it discourages lending to all except safe risks - which generally means people who already have wealth, not people who don't but might have in the future. This is because whereas in a debt money system savings don't exist unless there is debt, so there is a tendency for debt to increase, in a saved money system not only do savings precede debt, they can exist without it. In a credit money system lending is entirely optional and hoarding is very, very tempting, and in hard times people can be very reluctant indeed to lend. In a saved money system therefore, debt tends to be much lower than it would be in a debt money system.

Now, I can hear you all saying "but less debt, more savings is a good thing, surely"? No, it isn't. Remember that in a debt money system, the lifetime savings of wealthy (older) people are recycled through their investments back into lending to poorer (younger people)? That redistributive function is much less certain in a saved money system, particularly if money supply is kept tight to control inflation. The result is that instead of poorer (younger) people financing a better standard of living (and the start of saving) through debt, they are likely to have to fund far more of their major purchases from income alone, by "saving up for them". This is particularly the case if the older generation are applying value judgements to savings and debt, so are unwilling to lend to younger people unless they already have good incomes and savings - which sort of defeats the purpose. In a saved money system therefore I would expect to see levels of evident material poverty, particularly amoung the young, that in a debt money system would be mitigated by the use of debt. The wealth inequality between the richest and the poorest would be on show for all to see. Is this what we really want?

The other way of redistributing wealth between rich and poor is of course tax and benefits. But the older to younger distribution is much less effective here. In fact in most advanced tax systems there are transfers in both directions - from older to younger in the form of state education and benefits aimed at younger people, such as child benefit: and from younger to older in the form of state pension and benefits aimed at older people, such as free bus passes and fuel allowances - not to mention the fact that older people are much heavier users of a national health service than younger ones. If we moved to a saved money system, to mitigate the evident poverty of younger people intergenerational transfers would have to be skewed considerably in favour of younger people, for example by heavy taxation of equity held in property. And hoarding would have to be systematically discouraged, for example by heavy taxation of investments deemed "unproductive" and enforced contribution to forms of saving considered "socially desirable". I have seen proposals along these lines, but all of them depend on there being a far more authoritarian and invasive system of government than we currently have. Is that what we really want?

Neither a debt money system nor a saved money system is perfect, and neither can be left to run on its own. In a debt money system left to run on its own, debt generates more debt until eventually the debt levels overwhelm the economy and the population ends up in debt peonage. In a saved system left to run on its own, obscene wealth is juxtaposed with grinding poverty, older people who have done well in life hoard their savings while younger people - and older ones who have been less fortunate - starve.

I see no benefit in changing to a saved money system, and potential for great harm in the level of authoritarianism that would be required to mitigate the wealth/poverty imbalance through taxation and coerced lending. I would rather retain our debt money system, with all its faults, but seek to put in place an effective brake on its tendency to generate more debt, and limits on the lending practices that create this tendency. This to my mind is the function of government. In recent years governments have been increasingly "hands-off" with regard to the regulation of money creation through lending. This is not freeing the market to do its best - it is abdication of responsibility.

It may be that even with brakes such as tighter lending standards and taxation of bank balance sheet expansion, debt will still get out of hand from time to time. The "debt jubilee" proposal which is doing the rounds at the moment is an idea from early Jewish culture, in which debts were wiped out every seven years and people in debt slavery were able to return to their families. It may be that we, too, need to consider introducing routine writeoff of debt after a certain period of time, or a general wipeout of debt every few years. But we shouldn't be blind to the cost of this. When you wipe out debt, you also wipe out savings. And life being the way it is, you can absolutely guarantee that it won't be the excess savings of the very rich that will be wiped out. It will be the pensions and savings of ordinary people. Steve Keen's idea seems to be that government should step in to protect those savings - but is that really a jubilee, or is it just borrowing from a future generation to protect the current one?

Whatever system of money we have, the real issue is the growing wealth imbalance in our society. And unless we address that, the same problems will return again and again. The more wealth is concentrated in a very small number of people, the more everyone else has to borrow to have a decent standard of living (in a debt system) or the more poverty-stricken they are (in a credit money system). Changing the money system solves nothing.

Knowledge and belief

2011-11-24T00:50:00.001Z

This post is a long overdue response to Richard Murphy's post "I believe in belief", which directly criticises comments I made about another of his posts and makes false and unjustified assertions about my beliefs and my background.

I thought long and hard before writing this post. I don't want to be seen as someone whose aim is to discredit another writer: frankly, life's too short to expend much time on such a fruitless task, and I have far more interesting things to do. But this post touches on some fundamental issues. And that is my real reason for writing this post.

I reproduce here the comments I made on the Liberal Conspiracy blog regarding this post from Richard Murphy:

Can I comment on two quotes:

Quote number 1:
“A Courageous State is populated by politicians who believe in government. They believe in the power of the office they hold. They believe that office exists for the sake of the public good. They know what that public good is.”

Quote no. 2, six paragraphs later:
“A Courageous politician knows that there is a great deal that he or she does not know, and knows that despite that they will have to act.”

Conceivably that might mean they don’t actually know what the public good is, but they will act for the sake of it anyway. Or is the idea that politicians MUST know what the public good is, even if they know nothing at all about anything else? I can’t help feeling that logical inconsistencies like this should have been ironed out in the proof-reading process.

I am also a little concerned by the quasi-religious language. Beliefs abound, but on what are they based? Not much, it seems, except your definitions. What exactly qualifies you to define what politicians should believe?

In response, Murphy claims that my questions arise from my supposed belief in neoliberalism, which he seems to regard as more of a philosophy, or even a religion, than an economic theory. Here are two of his descriptions of me from this post:

This commentator’s observation is based upon that neoliberal thinking that presumes us automatons without, for example, belief systems....

....as this commentator shows, for those schooled in neoliberalism that whole exercise of normal human thinking and decision making has been utterly undermined by the false philosophy they follow.....

What concerns me is the manner in which Murphy presents his beliefs - about me, in this case, though he tends to do this generally anyway - as gospel truth. He has no evidence for these assertions. He is making a statement of faith.

Now, I don't have a problem with people making statements of faith, where there are no facts to be found. Humans need beliefs - it is how we attempt to make sense of a world we don't understand. But when facts are available, it is quite wrong to make assertions without checking those facts. And it is not only wrong, it is immoral to make assertions about another person that are not supported by anything they have said and done and are clearly intended to discredit.

Murphy knows NOTHING about what I believe. Nothing at all. All he knows is that I do not agree with him on the best course of action in relation to the problems in banking and finance and the future direction of economics in this country. He knows nothing at all about my background, my training or my personal beliefs. But because of our disagreement he BELIEVES that I hold "neoliberal" views - despite the many, many statements that I have made that undermine that belief. He BELIEVES that I regard humans as automatons who make decisions entirely on the basis of facts and knowledge, without any need for belief systems. And he BELIEVES that I have no other belief system.

Nothing could be further from the truth. I am not "schooled in neoliberalism". Yes, I did some economics as part of my MBA, and have voluntarily studied more since. But I read material from across the range of economic thinking, from left to right, Marx to Friedman, Keynes to Hayek, Adam Smith to modern MMT theorists (whom I rather like). And where I stand on economic and political matters is my own creation. I am the "cat that walked by himself". Many, many people have said that I am "hard to place" on the left-right political spectrum: my understanding of banking and finance, and my opposition to economic solutions that involve spending yet more government money, suggest right-wing tendencies, but my social views are decidedly lefty. I have been called both "hard-right" and "far left" by various people.

But even more important, I am not "without beliefs". Far from it, actually. What underpins everything I do and everything I say is my Christian faith. Indeed the reason why I started writing about banking and finance earlier this year was that I felt I was being called to do so. And it was absolutely against my wishes. When I left banking, I believed I would never return - that after years of holding my family together by doing well-paid jobs that left me no time for my family and no energy for singing, I was finally being given the chance to follow my heart and use the voice (and, it turned out, the teaching gift) that I have been given, both to keep my family and to benefit others. I still hope that I am not being asked to return - that my involvement will be limited to standing on the sidelines and chucking grenades. But my Lord has the last word, and my faith requires obedience. When he calls me to do something, I must do it. So if he makes it clear that I must give up all I have gained and return to the job that tore me apart, then that is what I will do.

So Murphy's notion that I think belief systems are unnecessary is so far removed from the truth that it is laughable. My whole life is driven by my Christian beliefs. I get it wrong, of course - because I am human. I say things I shouldn't, and I do things I shouldn't. When I get it wrong (which is pretty much every day) I am called to account for that and I have to repent, apologise and if possible make amends.

And further to this....if my own life is driven by my belief system, how could I possibly criticise others for acting according to their beliefs? That was not the point of my comments at all. My concerns are twofold:

that politicians acting on faith alone, and refusing to acknowledge facts that, if considered, would suggest an alternative course of action, are dangerous;
that people who think they have the right to define what other people, especially those in public life, should believe, are also dangerous

Murphy's response does not address either of these points. Distressingly, if he had actually taken the trouble to address my concerns instead of trying to discredit me by imputing to me beliefs I don't hold, he might actually have agreed with me on the first, at least. After all, ideological adherence to an austerity agenda despite overwhelming evidence that this is driving economies into recession, is a large part of what is already terrribly wrong in the Eurozone and is rapidly going wrong in the UK.

But the most worrying part of all of this is that he has completely misunderstood my second point. Instead of answering my question "what qualifies you to define what politicians should believe?", he redefines it as questioning his "right to believe in belief". I have no problem with Murphy believing in belief, if that's what he wants to believe in, though it sounds a tad tautological to me: personally I'd rather believe in God, but there you go. And I defend absolutely a politician's right to believe in whatever they want to, even Murphy's ideas if that's what floats their boat: they are human just as I am, and as I said above, humans need beliefs. But I reject absolutely the notion that Murphy has the right to define what politicians SHOULD believe. No-one, absolutely no-one has the right to tell someone else what they should believe. That way lies the Inquisition: repression, persecution and genocide....it has happened so many, many times before. Freedom of belief is one of the great blessings of our Western society, and a rare thing in our world even now. We must guard against the desire - that we all have - to suppress dissent and force others to adopt our worldview.

The other side of debt

2011-11-20T19:40:00.018Z

This post is sparked by the debate that there has been in the last few days around Positive Money's proposals for reform of the monetary system in the UK. You can read their proposals here. I'm not in this post aiming to debunk Positive Money's ideas so much as to clarify for people's benefit the nature of our debt money system and how fractional reserve banking works in practice. If more people understood how things REALLY work (rather than what the textbooks say) we would be better able to have a sensible debate about how we want it to work in future.

The matter I want to address in this post is relationship between debt and savings. Positive Money correctly describe the way bank lending works, but they ignore the impact on savings, and therefore tell only half the story. And in the course of the debate it became apparent that there are many people who simply don't understand the relationship between debt and savings. Yet the relationship between debt and savings is fundamental to our monetary system. The other side of debt is savings. For every debt there are equivalent savings, so across the monetary system as a whole debt and savings are equal.

Now before someone screams at me that it's obvious that there's more debt than savings, innit, because bank lending far exceeds bank deposits, let me define what I mean by debt and savings.

Debt is deferred payment for goods or services desired now, or in economics-speak, "consumption brought forward". For example, you need a new car, now, but you haven't saved up enough money to pay for it outright. So you borrow the money. You are prepared to pay more for the car than the current price, because you benefit from being able to use the car now and defer part of the payment until later. You therefore pay your lender interest on that borrowing. The total cost to you of that car is not the amount you pay to your dealer, it is the loan principal plus all the interest payments over the course of the loan, discounted by the rate of inflation over the period of the loan, minus any deposit you pay now from your own savings.

There are many different forms of bank lending. From an economic point of view, though, the major difference is between committed and uncommitted lending. In committed lending, such as a bank loan, the money is legally committed to you at the time the agreement is signed and cannot subsequently be withdrawn without notice. In uncommitted lending, such as an overdraft, a credit facility is granted to you which you MAY use, but the undrawn portion of the facility can be withdrawn at any time without notice. I've generalised here considerably, and legal eagles out there will no doubt say I've simplified far too much - bank lending agreements are far more complex and the distinction between committed and uncommitted lending is not always clear. But it will do as a general principle.

Banks aren't the only source of debt. Issuing bonds is a form of debt financing for large corporations and governments. Any individual or financial institution that purchases and holds bonds is in effect lending to the issuers of those bonds. I'm not in this post going to address how bond issuance and trading works, but corporate and government bonds make up a significant part of global debt. And they are important to ordinary people: anyone with a private or corporate pension almost certainly has significant holdings of government and blue-chip corporate debt.

Savings are deferred spending (deferred consumption). You don't need to spend all of your wages this month (lucky you), so you put some of it in the bank. Or you choose not to spend all of your wages in order to put money aside for spending at a later date - for example, when you are too old to work. You want to put your money somewhere that will earn you a return on your deferred spending, partly to compensate for the erosion of the value of those savings by inflation, and partly because by choosing not to spend that money now you are forgoing the pleasure you might receive from, for example, having a fantastic holiday.

There are many forms of saving. Bank deposit accounts (including current accounts) are one form. Others are pensions, ISAs, long-term savings plans (endowments), shares and bonds, gold and other precious metals, art, wine and property. The last of these - property - is particularly important because a high proportion of the UK's population have their savings principally tied up in the house they live in. Even if they have a mortgage, the difference between the present value of the house and the amount outstanding on the mortgage - their "equity" - is their savings. When house prices rise, existing home owners benefit because their savings increase. Conversely, new buyers have to take on more debt. The increase in debt among new home owners balances the increased savings of existing home owners.

Overall, the people of the UK now have far more savings outside bank deposit accounts than they have in them. That's why, if you only look at banks, it looks as if there is far more debt than savings. But when you take into account other forms of saving - including tax, which is government savings (tax extinguishes government debt obligations, which is equivalent to saving), and bank and corporate retained earnings, which are the savings of shareholders - it becomes evident that globally, debt=savings. That is why it is very wrong, and very dangerous, to suggest (as some have done) that debt is made of "imaginary money" which can simply be wiped out cost-free. No it isn't, and it can't. Wipe out debt, and you also wipe out savings.

Financial intermediation is the process by which borrowers obtain from savers the money they need to buy things. Or alternatively, the process by which savers obtain from borrowers the interest they need to maintain the value of their savings over time and compensate them for not spending that money themselves. Banks and other financial institutions act as financial intermediaries, lending to borrowers at interest and paying interest to savers. They make money by paying less to savers than they charge to borrowers - that is known as the "spread". And they accept and manage the risks inherent in lending to borrowers over a long period of time while allowing savers to remove their funds if they wish.

The money supply is the total amount of various types of money in circulation. "Money" in this case pretty much means anything that will be accepted by somebody as payment for a product or service. "Base money" is notes & coins plus bank reserve balances at the Bank of England (more on this later). "Broad money" is all other versions of money, including balances in bank deposit accounts and various types of commercial paper.

Fractional reserve banking
"Fractional reserve banking" is the process by which banks intermediate between borrowers and savers. It is commonly believed that banks "lend out" deposits. Banking and economic textbooks are full of descriptions of banks lending and re-lending fractions of deposits. Sadly those textbooks are wrong in one important respect: they assume that deposits precede lending. No, they don't.

What actually happens, as I've explained previously, is that banks lend, and then look for reserves to settle the drawdown of that lending. The accounting entries for a new bank loan for £10,000 are as follows:

Customer loan account: £10,000 DR
Customer deposit account: £10,000 CR

The loan account debit represents the customer's DEBT, which is the bank's ASSET.
The balancing customer deposit account credit is the actual money advanced by the bank, which is the bank's LIABILITY. It is usually a credit to a demand deposit account such as a current account, and can be drawn in cash or paid out by bank transfer or cheque in the same way as any other deposit. It is not possible to distinguish in any meaningful way between a deposit created from a bank loan and a deposit made by the customer.

Demand deposit account balances form part of bank reserves - not capital. This distinction is important, as I describe here. Bank reserves are required to settle deposit withdrawals, including loan settlement, but they are not referenced at the time the loan is granted. And demand deposit balances are included in the measures of "broad money" supply in the economy. So the creation of a new deposit without drawing on underlying reserves has the effect of increasing the amount of money in circulation - as Positive Money correctly claim. Therefore, in my example above, when these accounting entries are made "broad money" increases by the amount of the deposit.

That new deposit behaves in all respects like any other sort of deposit. You can draw it in cash or you can pay your car dealer by bank transfer or cheque. If you draw cash the bank must physically have cash to pay you – as with any other deposit withdrawal. Banks estimate their cash requirements on a daily basis based on withdrawal patterns across their customer base. Sometimes they do run out, of course. I’m sure you have all experienced trying to get money out of an ATM over a bank holiday weekend. And most banks require notice of large cash withdrawals.

If you pay your car dealer by bank transfer or cheque then no cash is involved. The accounting entries are as follows:

Your bank:
Customer deposit (current) account £10,000 DR
Interbank settlement account £10,000CR

Car dealer's bank:
Interbank settlement account £10,000 DR
Car dealer's deposit (current) account £10,000CR

BoE reserve account entries:
Your bank £10,000DR
Car dealer's bank £10,000CR

Your money advance has now become your car dealer's deposit. In the process your bank has drawn on its reserve account at the Bank of England (sort of like its current account) and is now running an overdraft. Conversely, your car dealer's bank now has excess reserves at the Bank of England.

Banks have to balance their Bank of England reserve accounts at the end of each day. If they have a negative balance (more money drawn than received) they borrow from other banks which have credit balances, or as a last resort directly from the central bank. It isn’t possible for a bank to run an overdraft overnight on their reserve accounts. They have to borrow the money from somewhere, and they pay interest on those loans.

Your bank could of course borrow your deposit back from your car dealer's bank to clear its reserve overdraft. It's sort of circular. And it gets even more circular if you and your car dealer bank at the same bank and you pay him by bank transfer, which clears during the day. In this case there is no impact on interbank settlement or BoE reserve accounts. Your loan is in effect funded by its own deposit. But the bank still pays interest on that funding - even current accounts attract interest, pitiful though it is.

The example I have given above is of a committed loan, of course. In uncommitted lending no deposit is created and the liability remains off balance sheet until it is drawn. On drawdown settlement funding applies as I have described. Whether or not drawdown of uncommitted facilities increases the money supply is a matter of debate: personally I think it does, because a new deposit is created in the recipient's bank for the amount of the drawdown.

I hope I have shown through the example above how lending creates new money that then inflates savings as well. Overall, household debt has increased by £10,000, small business savings have increased by £10,000, and broad money supply has increased by £10,000. But to argue, as some have done, that banks don't need to borrow to settle loans because they can invent the money, is simply wrong.

Reserve and capital constraints on lending
Since banks lend in advance of obtaining reserves for settlement, it's not in any way meaningful to regard bank lending as constrained by the availability of reserves. And because of the money creation involved in lending, there is NEVER a shortage of reserves for settlement provided banks are willing to lend to each other. If for any reason banks become unwilling to lend to each other - as we are seeing at the moment in the Eurozone - central banks provide settlement funding ("liquidity") at penalty rates.

Under the present system bank lending is capital constrained, not reserve constrained. How much credit a bank can create is governed by the ratio of shareholders’ funds and retained earnings (money it DOESN’T OWE TO ANYONE, which is its capital base) to what we call “risk weighted assets”, which are a way of valuing loans by their risk. Each new loan drains an amount of capital proportionate to its risk weighted amount. Banks can only lend within their capital ratios. In the run up to the 2007 crash the capital ratios were much lower than they are now and were widely ignored anyway. Now capital requirements are much higher, which limits lending, and hopefully regulators are being tougher about enforcing them. The problem with this is of course that calculating risk weightings is a bit of a black art, and risk classifications can be intrinsically wrong: e.g. sovereign debt is weighted at zero, which means banks can lend unlimited amounts to governments because their debt is assumed to be risk free – but we all know that’s not true, don’t we? So regulators are trying to move towards constraining leverage as well, which is the ratio of capital to deposits. As each loan creates an equal deposit, forcing banks to restrict their leverage would also have the effect of limiting lending.

Positive Money would like to change this, of course. In effect their proposal is to introduce reserve constraints on lending: they want banks to obtain reserves in advance of lending and only lend up to the limit of those reserves. They also want to force all banks to obtain reserves only from term deposits or from central bank liquidity: current accounts would be excluded, and banks would not be allowed to lend to each other. The MPC would be tasked with making sure the Bank of England created enough money to fund lending without increasing inflation. I know the MPC has a reputation for wizardry, but how on earth they are supposed to forecast lending needs versus inflationary pressures without resorting to clairvoyance is beyond me.

Conversely, the Independent Commission on Banking (ICB)'s proposal for bank reform envisages significantly increasing capital requirements, particularly for systemically-important banks with retail operations. The ICB (correctly, in my view) rejected Positive Money's proposals for bank reform on the grounds that they would be unnecessarily restrictive of credit. Instead, they proposed capital ratios for large banks that would go beyond the levels recommended by the Basel committee. Predictably, the banks have objected to the amount of capital they are being required to raise, on the grounds that it would hinder economic recovery.

There is no doubt that bank reform is necessary. There is also no doubt that it will be painful, not only for banks themselves but also for their customers, both borrowers and savers. Savers are receiving rubbish returns on their investments. Borrowers are finding it hard to get credit and are facing rising interest rates and charges. Whichever alternative is adopted - reserve-constrained lending, as Positive Money would like, or increased capital constraint, as the ICB proposes - the result will be that lending becomes more expensive and more difficult to obtain. The days of cheap and easy credit are gone - for now.

Austerity and the Eurozone

2011-11-07T21:43:00.001Z

There has been much discussion recently about the austerity measures being imposed on Greece, Italy and others in the Eurozone in the interests of returning their budgets to balance and implementing much needed structural reforms. The question is not whether these measures are necessary, but whether in the current economic situation they are achievable.

Firstly, some basic economics.

If a country runs a trade surplus it is a net exporter of goods & services and an equivalent net importer of capital. Conversely, if a country runs a trade deficit it is a net importer of goods & services and an equivalent net exporter of capital.

If a country runs a fiscal surplus it means that the government's income is greater than its spending. Conversely, if a country runs a fiscal deficit it means that government spending is greater than its income.

There is of course a relationship between trade surplus(deficit) and fiscal surplus(deficit). If the domestic private sector is balanced (neither spending overall nor saving overall), then a country with a trade surplus will also have a fiscal surplus, and a country with a trade deficit will also have a fiscal deficit. If the private sector is spending overall, then a country with a trade deficit may still have a fiscal surplus due to indirect taxation increases. Conversely, if the private sector is saving overall (or paying off debt), a country with a trade surplus may still have a fiscal deficit because of reduced tax income. The most poisonous mixture is a country with trade and fiscal deficits where the private sector is net saving, which makes for an economy dangerously close to recession. British readers will recognise this as the UK's problem....which I shall return to in another post.

The trade flows between countries net to zero. So within an economic area, such as the Eurozone, a trade surplus in one country must be balanced by trade deficits in one or more other countries. Everyone wants net exports, but not everyone can have them. Which is why the "exports are good, imports are bad" view that is so prevalent at the moment is economically nonsense.

Countries usually issue debt to cover their deficits, so the longer a country runs a fiscal deficit the deeper in debt it will be. If attempts are made to cut a fiscal deficit without also reducing the trade deficit, either by increasing exports or cutting imports, the deficit is in effect transferred to the private sector who are forced either to use existing savings or borrow to pay for goods and services previously paid for by government. If the private sector has no savings (or is unwilling to use them) and is unwilling or unable to borrow, then cutting a fiscal deficit without export growth causes recession. I hope this is clear.

How does all this stuff about trade and fiscal surpluses and deficits apply to the Eurozone?

Germany has a large trade surplus with its Eurozone partners. As Gavyn Davies points out, the excess of its exports to Eurozone countries over its imports from them just about balances the trade deficits of Greece, Italy, Portugal and Spain combined. These countries all have excessive public debt, and all except Italy have fiscal deficits - and Italy has only achieved primary balance this year. Basically, the four of them have imported from Germany more than they have exported to it, and they have funded those purchases by borrowing from, among others, German banks. Germany has therefore benefited from the debts taken on by those countries, not only because of the income generated by the exports themselves, but also because of the interest paid by those countries to German banks. It is fair to say therefore that Germany's trade surplus with the Eurozone is funded by the excessive debts taken on by those four countries, and that its fiscal surplus arises from taxes paid on income from exports and lending to those countries.

In the Eurozone, like everywhere else in the Western world, the private sector is already highly indebted and unwilling or unable to take on more debt. For deficit countries to reduce their fiscal deficits, therefore, their trade deficits must also reduce. One of the major issues that these countries face is that the locked exchange rate within the Eurozone makes their exports uncompetitive compared to Germany's. Making their exports competitive requires massive reduction in the cost of production, particularly labour costs, which is politically immensely difficult to do. It is highly unlikely therefore that their trade deficits will reduce due to increased exports. But if Germany's Eurozone trading partners reduce their trade deficits by cutting imports - which is already happening - then its trade surplus can’t possibly be sustained. Germany’s economy is heavily reliant on exports to the Eurozone. Balanced budget measures in other Eurocountries will therefore force the German economy to shrink unless it increases its exports outside the Eurozone. It is in fact doing this, but whether it can increase external exports enough to compensate for declining Eurozone exports is questionable. And this does of course undermine the whole purpose of the European Union, which was to promote trade between European countries.

Currently the issue of trade imbalances is being ignored by the Eurozone leadership, especially Germany's Merkel, and the insistance on fiscal austerity in deficit countries is not balanced by a requirement for fiscal loosening in surplus countries. They don’t seem to understand that since within a currency union the usual monetary tools such as interest rates and exchange rates can't be used to control trade flows, fiscal policy must substitute for these ON BOTH SIDES.

So why is the Eurozone leadership, against all sound economic advice, so wedded to the idea that austerity measures alone will achieve balanced budgets and growth in deficit countries without compensatory fiscal loosening in the surplus countries and redistribution of surpluses to the deficit countries?

Value judgements about government financing - deficit = "bad", surplus = "good" - skew government decision-making in favour of spending restriction that may not be the most appropriate course of action in the economic circumstances. So in the Eurozone, deficit countries ("bad", profligate) must reduce their spending and make structural reforms, but surplus countries ("good", prudent) are models of fiscal rectitude so need make no changes.

These value judgements are completely unhelpful. "Good" and "bad" depend on your point of view. Someone who is a thrifty net saver is likely to regard saving as "prudent" and spending as "profligate". Someone who has a less frugal lifestyle and spends instead of saving may well regard saving as "selfish", if it means others go without, and spending as "generous". Neither has any right to regard their viewpoint as better than the other, or to attempt to impose their values on others. But that is what is happening in the Eurozone. People in the countries that have net saved regard their way of doing things as "right" and don't see why they should pay to support countries who have spent instead of saving. They can't see that their saving has only been possible because of the debt-financed spending of the deficit countries. And conversely, people in the countries that have net spent don't see why they should pay to bail out the irresponsible lenders who have financed their spending, and why Germany shouldn't give back some of the money it has earned from its exports and lending. The result is that the dominant country, Germany, tries to impose austerity on countries who won't accept it and who adopt all manner of underhand ways of avoiding having to implement it. It's a standoff.

Now, some people believe that austerity-induced recessions are good because they "clear out" malinvestment and force structural reform. To some extent that is true. But the Eurozone is a special case. Austerity-induced recession only works as a reform strategy if the country concerned has control of interest and exchange rates, so that it can manipulate these to encourage business growth and exports. The Eurozone countries have no such control, and no politician who valued his job would seriously try to impose the wage cuts really required to restore competitiveness. Austerity-induced recession therefore cannot possibly be the brief painful clearout it is meant to be, because growth will be strangled at birth by counterproductive monetary policy and insufficient demand for exports. Without fiscal support from the surplus countries, the recession facing the deficit countries in the Eurozone will last for decades - if the people of those countries allow it to go on so long.

Which brings me to my final point. Structural reforms are indeed desperately needed in the deficit countries, but for the Euro to survive, structural reforms are needed in the surplus countries too. Germany and other countries in fiscal surplus need to relax their fiscal discipline to encourage domestic spending so that smaller Eurozone countries such as Greece have a fighting chance of exporting to them. And surplus countries must commit to reinvesting their trade surpluses within the Eurozone instead of outside it. To be fair, Sarkozy did comment that countries in fiscal surplus need to consume more, and the G20 communique contains a commitment to do something to increase demand in surplus countries. So maybe light is beginning to dawn. But it may be too late to save the Eurozone.

Unless the imbalances between Eurozone countries are addressed, the deep recession in Greece will spread to other countries too, eventually including Germany. It is already beginning to. And once recession takes hold in the entire Eurozone, people will start to see that their lives and their futures are being sacrificed on the altar of a political dream that is rapidly becoming a nightmare - and they will take action. We are already seeing political unrest in Greece, Spain and Portugal. As recession deepens, this unrest will worsen and may be violently repressed - a fertile ground for actual revolt and even war.

Is preserving the Euro in its current form really worth wrecking the lives of an entire generation of Europeans, and risking the end of over 60 years of peace in Western Europe? I think not.

Magical thinking in Euro Wonderland

2011-10-28T04:12:00.328+01:00

After a tense few days, EU leadership have finally come up with a draft proposal for easing Greece's debt problems, recapitalising banks and helping other debt distressed countries to finance their debt more easily. The full text of the EU leadership's statement is here (downloadable pdf).

The devil will be in the detail, of course, which is pretty sketchy at the moment. But my initial impression of the report is that it contains far too much magical thinking. External agents will apparently willingly provide money to distressed Eurocountries when the ECB won't; growth will somehow appear in highly-indebted countries despite severe spending cuts and lack of inward investment; countries with uncompetitive business sectors and large trade deficits will somehow balance their budgets. And financial conjuring tricks will create the amount of money the report says will be available. How these will work in practice remains to be seen.

Media interest in this report has focused on three areas:

- Greek debt restructuring
- bank recapitalisation
- the "big bazooka": use of the EFSF to provide financial assistance to debt-distressed Eurocountries and if necessary to provide capital to insolvent banks

According to Gavyn Davies in the FT, all three of these are inadequate. I'm afraid I have to agree.

1. Greek writedown.

Gavyn Davies says:

"The 50 per cent haircut on private debt passes the litmus test, but there has been no participation by the official sector. The effect is to reduce the Greek debt ratio from 152 per cent of GDP in 2020 to 120 per cent, assuming that all of the Greek fiscal restructuring can be implemented in the meantime (which seems highly improbable). These debt figures are higher than expected, and may well prove unsustainable once again. So the Greek headache has not been definitively solved, and probably will not be until there is a significant write-down of official debt."

The proposed Greek debt writedown involves private creditors only. Once again, public creditors - notably the ECB - have got off scot free. Quite apart from the fact that this is unfair to private creditors, it also means that the writedown is far smaller than it needs to be to make any significant dent in Greece's debt mountain. The ECB should now acknowledge that it must write down the value of its Greek collateral.

Greece is now in partial default and it remains to be seen whether ISDA will declare a credit event. So far it seems they won’t because banks did actually agree to the 50% haircut.

2. Bank recapitalisation

I've commented already that the 9% capital requirement might not be quite what it seems. Gavyn Davies is lukewarm:

The litmus test said that €300bn of recaps would be impressive, while €100bn would be skimpy. Predictably, the summit has chosen the skimpy end, at €106bn. This will only be enough if the rest of the package, designed to calm the sovereign debt markets, is highly successful. Clearly, European leaders were worried about the possible effects of making excessively onerous capital demands on the banks, given they were threatening to lever their loan books in order to hit the new capital ratios. Regulators have been told to ensure that this does not happen.

But there is a glimmer of light:

.....there appears to be an intention to introduce a new EMU-wide guarantee scheme which will help banks to secure unsecured medium term funding. This could be a very important step towards restoring confidence in the banks...."

3. The "big bazooka"

The supposed extra 1tn euros available to distressed sovereigns and undercapitalised banks through the EFSF facility is fictional. Gavyn Davies says:

"It is important to be clear that this does not involve bringing any new money from the eurozone itself to bear on the problem. At most, it involves a subsidy of about €200-250bn (which was already committed in existing EFSF guarantees) from the stronger members of the eurozone to attract new investors into the market for Italian and Spanish bonds......it amounts to 8 per cent of the outstanding debt of these two countries, which may not prove compelling. Talk of a trillion of new money, apparently conjured out of thin air by financial engineering, is inherently misleading....."

So the EFSF will be leveraged, not funded. Exactly how that will work is yet to be disclosed, but the idea seems to be that there will be some combination of taxpayer guarantees from member states to insure bondholders against default (some sort of CDS insurance, I suppose), plus hopefully some actual funds from external sources such as the IMF and China. The IMF probably will cooperate but it is unclear (to me, at any rate) what the incentive would be for China to provide money to the EFSF rather than investing directly in Eurozone countries. I wouldn't have thought that propping up distressed sovereigns without any real prospect of even recovering the investment any time soon would be particularly attractive to them.

It remains to be seen whether banks can raise the necessary capital from private sources. If not, then it seems the EFSF can be tapped for this as well. How far is 1 trillion euros expected to stretch?

At this point the media lose interest. But actually there is much more to this report, and the implications of it are far-reaching. These are the matters that the media are not discussing - and should be:

1. The provisions of the European Semester regarding economic coordination between member states are to be fully adopted. That means the European Commission will review national budgets before they are implemented to ensure compliance with the Stability and Growth Pact.

2. Despite the statement that the Eurozone is "committed to growth", there are no measures whatsoever to promote economic growth in the debt distressed countries. Instead, the Eurozone is still adhering to its ridiculous austerity agenda, which will only serve to drive those countries further into recession and eventually drag the rest of the Eurozone down too. Concerns have now been expressed about this from around the world. Because of this, reduction of Greek debt to 120% by 2020 looks extremely unlikely and further default and restructuring seems inevitable.

3. Countries in deficit reduction programmes will be supervised by the European Commission to ensure they comply with the economic (i.e. austerity) measures imposed on them as the price for their bailouts. This supervision is to be introduced immediately for Greece. But economic supervision of Greece is not accepted by its population and is likely to be fiercely resisted, especially as it is certain to involve even harsher cuts and austerity. There is no democratic mandate for this provision in the EU statement as far as I can see.

4, Legislative commitment to balanced budgets "in accordance with provisions of the Stability and Growth pact" is now required from all member states. But for deficit countries to achieve this they need inward investment and exports. Germany and the Netherlands therefore should invest invest their trade surpluses in their European neighbours and encourage domestic spending to attract imports. There is NO discussion of the large trade imbalances between the Eurozone countries and no commitment from either country to increase inward investment in deficit countries. And both Germany and the Netherlands have large fiscal surpluses. The Stability and Growth pact limits deficits to no more than 3% of GDP but imposes no limit on surpluses - so "balanced budget" doesn't quite mean that, does it? Are Germany and the Netherlands going to adopt expansionary fiscal policies to reduce those surpluses despite the lack of incentive to do so? Or are EU leaders so economically illiterate that they don't realise that fiscal tightening in deficit countries must be accompanied by fiscal expansion in the surplus countries or the whole area will end up in recession?

Financially, all this proposal does is kick the can down the road for a bit longer. But I’m very concerned by the authoritarian tone of many of the pronouncements in the report.

For me the really striking feature of this report was the evident intention to use the opportunity created by near-collapse of the Euro to push forward the "cause" of the single currency. New measures to promote fiscal convergence are principally aimed at further embedding the Euro, not sorting out the very real economic problems that Eurocountries face. The EU leadership are not really interested in fixing what is wrong with the Euro model as it is at present. They are buying themselves time to move the Eurozone further towards the model they really want - full political and economic union.

If you read the statement in this light, suddenly everything makes sense. Eurozone leaders believe that eventual political and economic union is not only possible, it is inevitable and will be achieved within a short timespan. Wave the magic wand of European unity and - hey presto - Wonderland will be restored.

So there is no need to provide adequate funding to the EFSF, no need for more than minimum Greek debt relief, no need to do anything to relieve the real economic tensions in the Eurozone. The only thing that matters is the austerity measures that they believe will turn all Eurocountries into mini-Germanys. And any country that can't or won't implement those measures obviously hasn't sufficiently bought into the Euro project so must be coerced with economic supervision and - eventually -with sanctions. Never mind the cost in economic ruin and human distress. Never mind whether the people of the country concerned support those measures. They will be imposed by an unelected, unaccountable outpost of the European Commission residing within the errant country and with carte blanche to override the elected government's decisions regarding the conduct of their economy. Furthermore, ALL countries in the Eurozone will now have to consult the Council of Ministers before implementing economic policies mandated by their electorates.

I don't oppose the aim of political and economic union in the Eurozone. Far from it. In my view full political and economic union is the only way the single currency can survive. But it must be achieved with the full knowledge and consent of the PEOPLE of the Eurozone. Using this crisis to force through far-reaching changes designed to move the Eurocountries towards such a union by undermining national democracy smacks of Shock Doctrine.

Behind the mask of economic aid to debt-distressed countries lies a very real attack on democracy. This statement is deeply disturbing and to me abhorrent.

That 9% bank capital requirement may not be quite what it seems

2011-10-26T21:31:00.000+01:00

From the FT this evening (26th October 2011):

Is the European bank recapitalisation a done deal? Not if you ask the Germans and Spanish. A broad agreement on raising the capital bar for banks has been announced this evening. But some technical details — that make a big difference to some banks – have been left open.

Berlin and Madrid are mounting a last-ditch bid to lower the bar by allowing a broader range of capital to be used as part of the “temporary buffer”. German and Spanish banks in particular will have a lot more work to do to reach the new, 9 per cent core tier one capital ratio if they are not allowed to count some hybrid forms of capital.

This is reopening a highly-charged (and tremendously technical) debate that overshadowed the European Banking Authority stress tests last summer. After a long fight, the EBA overruled the Germans and Spanish and imposed a relatively narrow definition of capital that excluded so-called convertible debt.

This time around, there is a chance there will be a little more leeway. European officials insist that the capital criteria will largely match that used in the summer stress test. But even some small tweaks could make a big difference. Some banks’ core tier one capital would rise by 1 or 2 per cent, if the hybrid capital were accepted. Morgan Stanley reckon that, under this scenario, the capital shortfall could be as low as €50bn-€90bn.

None of this was clarified in the European leaders’ statement this evening. But eventually the details will emerge. Will the market be impressed?

For those who don't know, so-called "hybrid instruments" are securities that have the characteristics of both debt and equity. Convertible instruments, probably the most common form, are debt securities (bonds) that have a provision in the terms of the contract that allow them to be converted into shares under certain circumstances, such as heavy losses or insolvency of the holder. This is important, because if a company or bank suffers serious losses shareholders' funds are first in line to take the hit after retained earnings. Bonds, which are in effect loans, have to be paid back if there are sufficient realisable assets. So if a company or bank fails, shareholders will lose their investment, whereas bondholders will expect to receive some or all of their money back.

Tier 1 capital, for banks, traditionally consists of shareholders' capital and retained earnings - so is the most loss-absorbent type of capital. The EU's definition of capital assigns convertibles to Tier 2, which is only called on if Tier 1 capital has been wiped out. This is what the debate is about. The 9% requirement is for Tier 1 capital only, but Germany and Spain allow convertibles to count in Tier 1 capital.

It all depends to what extent these hybrid instruments can be relied on to convert to equity and therefore absorb losses. And that hangs on the terms of the contracts. I foresee a lot of work for corporate lawyers sorting this one out.

The cold hard truth

2011-10-25T02:16:00.001+01:00

On Friday 21st October 2011, a group of economists working for the so-called Troika produced a devastating report. This report was leaked to the press, notably the FT, which promptly produced an article analysing it, and the BBC. Paul Mason, BBC Newsnight's economics editor, gave a 10-point analysis of the report on Twitter which I reproduce here. And the Telegraph released the full text of the report the following day.

European politicians have been fighting ever since. Germany's Merkel and France's Sarkozy had an argument loud enough to be heard in the EU concert hall. The Belgian finance minister left early and refused to attend the press conference. Merkel and Sarkozy jointly turned on Italy's Berlusconi, demanding that he implement fiscal reforms he has so far failed to deliver. And Sarkozy slapped down the UK's Cameron when he complained about the lack of any credible resolution plan for the Eurocrisis.

Entertaining though the politicians' antics are, they arise from a terrible truth. The bailout plan they came up with on July 21st was totally and completely inadequate. Everyone knew this, of course. But the politicians didn't want to admit it. Because actually they haven't the faintest idea what to do.

This crisis reminds me of the "bird within a bird within a bird" roasts that pretentious restaurants like to offer. On the face of it, it is a sovereign debt crisis in the poorer countries of the Eurozone, now extending to richer but highly indebted nations such as Italy. The ~~German~~ official story goes that these countries have borrowed far more than they can afford so must take the pain of massive reductions in their bloated public sectors in order to reduce their debt and return to competitiveness. This story, and its accompanying denigration of people in the debtor countries as "lazy" and "profligate" despite considerable evidence to the contrary, is now so widely believed that it is difficult to counter it. It has become an article of faith.

But cut through the sovereign debt crisis and you find a bird of a different feather. Regular readers of my blog will know that almost everything I write has banking in it somewhere, and this post is no exception. If Greek debt had been entirely held by its own banks, it could have defaulted long ago - nationalised its banks, wiped its debts, started again. But its debt was held by giant foreign banks, systemically interconnected, crucial to their countries' economies and seriously short of capital and liquidity. The countries to whom those banks "belong" have waged a systematic campaign of disinformation to prevent the world realising that the Greek (and Portuguese, and Spanish, and Italian) sovereign debt crisis is also (and has always been) a BANKING crisis and the main suspects are French and German banks.

Every cent that has gone to "bail out" Greece has been paid straight to banks. Greece has not been "bailed out" at all. Far from it - it has been asset-stripped and its people impoverished to enable it to make some contribution to meeting its creditors' demands. Furthermore, those creditors have demanded severe fiscal austerity as the price of this "bailout". I say "those creditors" because the principal agents of those demands are the French and German governments whose banks are at risk - plus the IMF, representing more distant financial interests. The Greek economy is now in deep recession. But the creditors are demanding even harsher austerity measures, despite the appalling consequences for the people of Greece .

Demanding severe austerity from a country in recession looks like madness, not only for the country itself but also for its creditors, since it makes it even less likely that it will be able to pay its debts. But there is a reason why the creditor nations have insisted on this apparently idiotic course of action. To them, there is no other choice.

Here's why. Were Greece a currency-issuing sovereign state, it could say "up yours" to its external creditors, default on its debts, nationalise its banks, devalue its currency and impose capital controls. The ensuing economic adjustment would be painful, but at least Greece would be controlling its own future. But it can't do this - because it is a member of the Euro. In effect it has adopted a foreign currency as its national currency. Yes, the Bank of Greece is one of the central banks that supports the European Central Bank (ECB), which is responsible for determining Eurozone monetary policy. But historically the ECB has pursued monetary policies that suit the larger, richer nations, particularly Germany, and are disastrous for the smaller, poorer nations. It is still doing so now: it raised interest rates despite mounting evidence of impending recession throughout the distressed debtor countries, thus making their problems worse. This would be fine if there was a commitment within the Eurozone that stronger countries would support weaker ones with fiscal transfers. But there is no such commitment - in fact it is specifically ruled out in the treaty directives. Nor have the convergence criteria defined in the European Stability and Growth pact ever been adhered to: the 60% debt limit was exceeded for several years by - France and Germany. Convergence criteria that are so widely flouted are pointless, and for creditor countries to blame Greece and others for failing to adhere to them is rank hypocrisy.

When a nation has no control of its currency, it has no control of monetary policy. The only means it has of solving economic problems are fiscal ones. If it is over-indebted, it must increase tax income and/or cut public spending. That means tax rises, sales of state-owned assets, wage cuts, benefit cuts, pension cuts, public sector job cuts. This is the "austerity" that is demanded of Greece and others. The reason why Eurozone creditor nations have demanded such austerity is that they see no other way that preserves the Euro. The only other alternative is for Greece to leave the Euro - and the fear is that other debt distressed nations would then follow.

But fiscal austerity in recession-hit countries doesn't work, does it? Greece's problems have got worse, not better. Its deficit is increasing, not decreasing. There is no prospect of it returning to economic health for at least a decade, if ever, if current policies continue. And this is the cold hard truth that Eurozone leaders are now facing. The policies they have pursued have turned a small sovereign default into a potential continent-wide debt crisis and banking collapse. And they have no other policies to offer.

So the politicians argue among themselves about exactly how much of a loss the private sector should "voluntarily" accept on Greek debt. Germany, whose taxpayers stand to take the biggest hit if Greece defaults, wants a 60% haircut. France, whose taxpayers will have to bail out its under-capitalised banks, ~~can't afford~~ won't accept anything more than 40%. Both of them are furious with (and terrified of) Italy, which owes far too much even for Germany to bail out. And the ever-so-virtuous UK is just seriously irritating. Why should Eurozone politicians care about the impact on them? They didn't join the Euro, after all, and they've scotched every bright idea that the Eurozone whizzkids have come up with for extracting more money from their bloated financial sector to help with the Euro blues.

It's all so much hot air. Every country is fighting for its own survival now. The figleaf of European union has finally fallen off and the fundamental misconception of the Euro project is evident for all the world to see. THERE IS NO UNITY. The only possible future for the Euro lay in fiscal and political union - the creation of a "United States of Europe". But there can be no political union while politicians pursue the interests of their own countries at the expense of the rest. And without political union there can be no fiscal union - given what has happened with monetary policy, is any Eurozone country really going to give up its tax raising powers to Brussels?

The Euro is doomed. Exactly how it will break up remains to be seen - perhaps Greece and other debtor nations will leave or be expelled, perhaps Germany will reinstate Deutschmarks, perhaps it will split along North-South lines (the so-called "2-speed Euro"). But break up it will, and really the sooner this happens the better for all concerned. Trying to preserve it at all costs has already wrecked Greece's economy and threatens to ruin the rest as well. I'm not pretending that a Euro breakup will be easy. It won't - it will be exceedingly painful and very, very messy. But I don't see how it can be avoided.

Greece's economic decline has gone too far now for an orderly default with maybe a 60% haircut to be sufficient. What is required is comprehensive debt forgiveness and economic aid, not more loans. It would be difficult enough for this to be achieved even within a more accommodating Eurozone. But in the present political climate I don't see how a sufficient aid package can be put together. The political will simply doesn't seem to be there. Eurozone politicians will no doubt kick around some numbers and come up with yet more ever-so-clever ways of leveraging fictional money to bail out banks and pay creditors without doing anything to relieve the debt burden or restore Greece's economy. It won't achieve anything and it won't fool anyone.

Greece is dying before our eyes and its only hope now is default, exit from the Euro and international economic aid. Others are queuing up to take its place as Eurozone basket case. Portugal, Spain, Italy.....even France is now on the hook for a possible credit rating downgrade because of the weakness of its banks. And Germany, that powerhouse economy, will soon feel the effects of the economic demise of the countries it has come to rely on as its main export market.

The Eurozone is heading into the mother of all recessions, and it will be entirely of its own making. But the consequences of its folly will be felt throughout the world.

Reality strikes the EU at last?

2011-10-25T01:19:00.000+01:00

Paul Mason's Twitter feed, Friday 21st October 2011

I am tweeting a series of quotes from the Troika Debt Sustainability Assessment. They say Greek debt peaks at 186% of GDP evn with 21 J deal

Troika report basically says current Greek debt dynamic entirely reliant on massive haircut AND total support from EU/IMF

Troika: "Making Greek debt sustainable requires an appropriate combination of new official support on generous terms and additional debt relief from private creditors

The Trokia's logic is to say: without help Greece gonna need E359bn bailout. With 50% haircut it needs E220bn - from p7 of Troika doc

Troika; however they also moot a 60% haircut - this brings official financing down to 216bn

OK to recap. Some insiders now saying my doc is not Troika but ECB+. However: debt dynamics only sustanable with haircut + further bailout.

Okay - now I have gotten thru the basics of the doc I will analyse and do an orderly twitter splurge. From 1 to 10

1) A debt analysis sent out to EU leaders says Greece may need 50-60% debt forgiveness (ie haircut) to maintain bailout as agreed...

2) Even with 50% haircut on Greek debt, says the doc, Greece going to need bigger bailout

3) It says debt to GDP could peak at 186% without a massive haircut, and remain unsustainable for a decade

4) It also models a very deep, frontloaded adjustment, with slump plus low privatisation receipts

5) Greece "a turn for the worse, with the economy adjusting through recession + related wage-price channels, rthr thn structural reform"

6) "Even with much stronger PSI, large official sector support would be needed for an extended period."

7) Some are saying this is a "positioning document" pinged late Friday into EU inboxes to freak them out. I would not know

8) It certainly places 50-60% haircut on agenda. That then impacts on bank solvency in N Europe

9) Bleakest part of DSA is its view that Greek economy is not undergoing structural impovement, just internal collapse

10) Hard to see the story standing up that Greece can grow its way out with 21% haircut, if this assessment is accepted.

Banks and bird food

2011-10-17T04:05:00.001+01:00

It seems appropriate that the "Occupy London" protest currently going on should base itself on the steps of St. Paul's Cathedral.

Devotees of Disney films will of course have watched the classic "Mary Poppins". Featured in that film is an old lady who sells bags of bird food on the steps of St. Paul's. Mary Poppins, nanny to the Banks children whose father works at a dusty old bank close to those steps, sings of the plight of the birds and their desperate need for food. At tuppence a bag, the food is just the right price for a rich but neglected child to buy with his pocket money.

I've long thought that it's not the birds that are hungry, but the old lady who is selling bird food in order to earn enough money to live. Juxtaposed in the film are ostentatious wealth, represented by the bank, and grinding poverty, represented by the bird lady. Michael Banks, the younger child, must choose what to do with his pocket money. Should he put it in the bank, or should he buy bird food?

In fact Michael's decision is taken out of his hands. The bank seizes his money against his will. When he protests, other customers of the bank misunderstand, and all start to remove their money, causing a run on the bank. But in the film there is no government to step in and rescue the bank. It is forced to close its doors and suspend business.

It seems to me that the dilemma that our government has faced, and still faces, is the same as that faced by Michael Banks. Do we concentrate our resources on supporting banks and financial markets? Or do we allow them to fail, and instead concentrate on supporting the poor and the needy?

So far government has opted to support banks while cutting support to the poor and needy. It has done so, in my opinion, because of a misguided belief that failing to provide money to banks would endanger the economy, and a second equally misguided belief that supporting the vulnerable costs money that the public purse cannot afford. Banks may not have physically seized government money - although some would argue that they have - but by talking up the dangers of bank failure and convincing politicians of their overriding need for support at all costs, they have ensured that they have first call on public money. The people of the UK get what is left over after the demands of banks and financial markets have been met. And even that is cut to the bone because financial markets actually don't like governments spending money to support the poor and needy. Never mind that the needs of people aren't met. Plentiful risk-free securities supported by AAA credit ratings are all that matters, it seems.

In the film, the outcome of the bank's attempt to seize Michael's money is literally laughable. When the money is eventually donated to the now-broke bank along with a joke, the proprietor dies laughing, forcing a change in ownership and fundamental reform of management. We, too, need a change in ownership and fundamental reform of our banks. Some people see this being achieved through full nationalisation and state control. I would personally prefer to see it happen by allowing banks that have become too big and too rigid to fail, so that new forms of banking can develop in their place. It may be that some combination of nationalisation and bank failure will be required, depending on the size and significance of the bank. But even nationalised banks I think should suffer a sea-change - be broken up and sold on in bits to competitors and new entrants. And we should aim to remove all forms of government support from banks in the longer term.

The question of the bird lady remains unresolved. We don't know what happens to her. But really, she shouldn't exist. No elderly person should be forced to sell bird food (or anything else, for that matter) in order to survive. The diversion of political energy and public resources to the financial sector in the last few years, coupled with an unpleasant and illogical economic ideology, has meant that safety nets have been reduced, and we still do not have a satisfactory solution to the lack of funding of pensions, both state and private. It seems to me that supporting the poor, the sick and the old is the first duty of government in a civilised society, not the last. Let's get our priorities right.

In the film, Mary Poppins makes it very clear where her heart is, in her impassioned song "Feed the birds". I know where my heart is.

The fear that paralyses

2011-10-08T18:37:00.001+01:00

One evening back in June 2011, four people were discussing on Twitter the possibility of a second global financial crisis. They had been having similar conversations most evenings for several weeks. Now, anyone who knows Twitter will realise that tagging in three people to tweets all the time doesn't leave much room for comment. So those four people created a hashtag to enable them to discuss more easily using a TweetChat application. That hashtag is the now-famous #gfc2 - Global Financial Crisis 2.0

I was one of those four people. And in my post Black Thursday, on 5th August 2011, I told the world that the second Global Financial Crisis had started.

Since then, global markets have crashed again and again, banks and sovereigns have suffered ratings downgrades, yields on the debt of countries perceived as being "risky" have soared - together with CDS spreads. Countries have introduced a range of monetary and fiscal measures to attempt to stabilise the financial system and reduce the market perception of risk, often causing considerable pain to their own people in the process and wrecking any prospect of economic growth in the foreseeable future. The interbank markets are nearly frozen and banks have become dependent for funding on central bank liquidity. Investors have progressively moved funds to "safe havens" such as government-insured deposit accounts, government bonds from countries perceived as "safe", traditional "safe haven" currencies such as the Swiss franc and Japanese yen - and for those investors that are actually banks, the safest of all safe havens, central bank deposit accounts.

In the last week there has been the first failure of a major bank since 2008. Dexia's failure caused panic in the marketplace, and although the immediate announcement of a rescue package by France and Belgium did much to calm investor fears to start with, subsequent squabbling over the spoils spooked them again. This is against the background of an abject failure of European leadership to come up with any sensible plan for resolving the sovereign debt crisis that now threatens to bring down the entire European banking system and with it, possibly, the global financial system. That failure underlies last night's credit rating downgrades of Italy and Spain by the credit rating agency Fitch. Fitch raised concerns about Italy's debt level and the strength of its banks - but FT Alphaville and Zerohedge both pinned the reason for Italy's market woes on the ineptitude of its politicians, especially Berlusconi who seems to be becoming something of an international joke. The reason for Spain's downgrade is less clear, but Fitch's statement suggests that the main issues are the weakness of Spain's economy in the light of general failure of the Eurozone to sort out its problems.

The UK is not immune to political ineptitude either. On Monday the Chancellor, George Osborne, announced measures to improve corporate finance which in effect would reduce the Bank of England to the status of an SPV, enabling the Treasury to hide its largesse off balance sheet while keeping the notional risk. Not surprisingly the Bank was having none of it: when it recommenced Quantitative Easing on Thursday it adamantly refused to buy corporate bonds, leaving Osborne with only half a policy. Meanwhile the Prime Minister's speech had to be hastily rewritten after its suggestion that people should "pay off their credit cards" was leaked to the press. Economists everywhere pointed out that this would fatally undermine the government's austerity programme: unless there is a vast increase in exports, which is highly unlikely given that the imploding EU is still the UK's largest export market, concurrent public and private sector deleveraging makes growth impossible. "Is Cameron promoting zero growth?" they said. The trouble is, he was right - and everyone knows it. The private sector really is deleveraging - fast - and the government's austerity programme really is the wrong medicine now. Even the IMF - not known for its support of Keynsian stimulus programmes - has suggested that maybe fiscal consolidation needs to be done a little more gently. But Osborne has staked his political reputation on this austerity programme. However wrong it is, he isn't going to give it up easily.

Yesterday Moody's announced the downgrade of 12 UK banks and building societies, citing the removal or reduction of government support for banking following the publication of the Vickers report on bank reform. Immediately after the announcement there was panic among bank depositors evident in comments on, for example, the Guardian's comment pages. This was dangerous as it could have led to a run on these banks and building societies. Sudden uncontrolled bank runs are a sure-fire way of bringing down even well-run banks. Moody's was not suggesting that these banks were in danger of failure, or that depositors' funds were at risk: in fact five of the downgraded institutions actually had their "standalone" ratings - the real measure of their creditworthiness - upgraded as part of Moody's review. So there was NO reason for depositors to panic.

But according to some commentators, there was. At least one blog, and commentators on twitter, suggested that the government would not honour FSCS deposit insurance in the event of bank or building society failure. This is dangerous nonsense. Even in the event of catastrophic bank failure - and there is at present no reason to believe that is about to happen - the UK government can if necessary print the money to compensate depositors. I don't know if these commentators realised (or cared) that their words could spook depositors into removing their money from these financial institutions. The one I read has for some time been promoting the idea that all banks are about to fail, in support of his argument that total nationalisation of the entire banking system is the only solution. So maybe uncontrolled runs would suit him - after all, that would bring about the catastrophic bank failure he has been predicting.

If there is one lesson to be learned from the past four years, it is that the theory of "rational expectations" that underlies neoliberal economics does not fit the reality of people's behaviour. Investors, depositors, politicians, bankers - none of them are fully rational. Yes, when times are good and markets are behaving as expected, their decisions are probably close to rational. But when every day brings more bad news and disaster seems to loom, emotion governs decision-making at every level and panic reigns. This is where we are now. So we have depositors removing money from government-insured deposit accounts because they've read a scaremongering blog. We have investors removing money from funds domiciled in the EU even though the actual assets are invested worldwide. We have banks refusing to lend to each other. We have central banks providing money to investors who simply hoard it in safe havens instead of using it constructively to generate new business growth. And above all, we have politicians kicking difficult decisions down the road to the next election, knowing full well that after that it will be someone else's problem. The global financial crisis is in reality a global political crisis.

You see, people whose careers and livelihoods depend on promoting a particular set of policies, or a particular political line, don't make pragmatic decisions based on the best interests of the people they serve, if by doing so they have to admit they are wrong. People who are making money by managing other people's money, or manipulating opinion, don't always do so in the best interests of their customers, if their jobs are on the line. And above all, when people are scared, common sense goes out of the window and disaster scenarios abound. Fear stalks the streets and paralyses all constructive thinking and activity. Whole economies come to a standstill. Doom and gloom prophecies come to pass just because people have believed in them.

Fear is probably our biggest enemy at the moment. It prevents us solving problems and reinforces existing patterns of behaviour that make matters worse.

Yes, the economic prospects in most Western nations are dismal. Yes, the Eurozone is falling apart. Yes, the global financial system is at risk. Yes, some of our banks may well fail - although I personally don't think all of them will. But none of these are reasons to panic. We may well have a global financial crisis. We don't have a global disaster. Let's not create one.

Instead, let's call upon politicians to work together constructively to resolve this ghastly mess. Suspend party political differences, stop scoring points and be prepared to adjust policies to achieve workable solutions. Only this way can fear be conquered and the real economic difficulties we face be addressed.

Downgrade, what downgrade?

2011-10-07T08:56:00.002+01:00

This morning, the credit rating agency Moody's downgraded 12 UK banks and building societies. Understandably, people have been asking whether this means that these financial institutions are unsafe, and whether the overall credit rating for the UK is in danger - even though S&P, another credit rating agency, affirmed the UK's AAA rating only two days ago.

The statement from Moody's makes it clear that the reason for the downgrade is the expectation of less support from government for these financial institutions:

"...announcements made, as well as actions already taken by UK authorities have significantly reduced the predictability of support over the medium to long-term."

Moody's still expect some support from government for the large systemically-important banks such as Lloyds TSB and RBS, although they believe that even this may be withdrawn in the medium to long-term, so the ratings for these banks are on negative watch. But their view is that smaller institutions such as the Co-op Bank and smaller building societies would simply be allowed to fail in a crisis. I am slightly surprised by the two-notch downgrade of RBS, since it is 84% government-owned. Would the government really fail to provide support to a bank in which it has a controlling interest?

The driver for this downgrade must surely be the Independent Commission on Banking's report. As I've commented in a previous post, the aim of the recommendations in this report is to allow banks to fail safely. Personally I think that the recommendations actually fall short of meeting this objective. But the fact that the government has accepted those recommendations is a clear signal that support for banks can no longer be taken for granted. A further consideration would be the fact that the Government allowed Southsea Bank to fail in June 2011.

It is quite wrong to view this downgrade as in any way reflecting on the viability of these financial institutions. In fact even the term "downgrade" is misleading. What Moody's has done is assess the commercial creditworthiness of these institutions in the absence (or reduced level) of government support and assign an appropriate rating. It's an adjustment to a more realistic level, not a downgrade as such. It does not indicate any danger to these institutions - in fact their new commercial ratings are generally pretty good. Nor is there any danger to small depositors: deposits in all financial institutions are insured by the FSCS up to £85K.

What this adjustment will do, however, is raise the cost of capital and funding for these banks, which may find its way through into higher fees and charges, and possibly higher interest rates on lending. Not especially good news for bank customers.

Finally, this adjustment in no way reflects on the creditworthiness of the UK itself. In fact as Moody's now clearly believes the UK government is quite happy to throw smaller banks and building societies to the wolves instead of bailing them out, and may think twice before throwing money at larger banks too, it may be more willing to maintain the UK's AAA rating.

A new name for an old game

2011-09-30T01:10:00.001+01:00

This is Part 2 of a two-part post reviewing Finance for the Future's paper proposing so-called "Green Quantitative Easing (QE)".

PART 1 of the post, "A Doomed Assessment", reviews Finance for the Future's assessment of the Bank of England's Quantitative Easing programme in 2009-10.

PART 2 reviews Finance for the Future's proposal for government investment in the economy specifically to further green objectives as outlined in the New Economics Foundation (NEF)'s Green New Deal. I would like to make it clear that, as I am neither an economist nor an environmentalist, I am not concerned with the merits of the Green objectives themselves. I am merely commenting on the financing proposal. For a discussion of the Green objectives and their potential economic impact, I'd suggest you read Simon Cooke's blog.

BACKGROUND AND SUMMARY OF PART 1

Part 1 of this post can be found by following the link above. I admit it is pretty wonkish and therefore hard going, so if you want to skip the gory details, my conclusion is as follows:

"The authors' assessment of QE was doomed from the start because of their abject failure to understand what QE is and how it works. In particular, their confusion of central bank and government, and their evident lack of knowledge of the mechanics of fractional reserve banking, mean that this is a very seriously flawed analysis."

PART 2 - "Green" Quantitative Easing

The stated aims of "Green" QE, according to the authors, are as follows:

1. To provide the boost to the rest of the economy that the banks and financial services sector received from the first round of quantitative easing;

2. To finance a Green New Deal;

3. To promote new investment in productive capacity in the UK economy;

4. To refinance existing government related loans at low cost, so freeing public sector organisations and agencies to undertake new economic activity.

It is immediately apparent that these are much more diverse and wide-ranging aims than the stated aims of QE, and at least two are fiscal, not monetary, objectives. QE is a monetary policy tool used to substitute for interest rate policy when interest rates are close to zero. It is arguably not a suitable vehicle for delivering fiscal policy. These objectives are also, I would suggest, impossible to achieve through central bank money creation without compromising the independence of the BoE. Independence of the central bank carries a significant advantage in that monetary policy is not subject to political interference. Do we wish to return to a state-controlled central bank? Do we want the central bank involved in fiscal matters?

However, reading on it is quickly apparent that the authors are not talking about QE at all:

"In each and every case we are suggesting that the government spends the funds made available to the next likely round of quantitative easing to feed directly into the economy, and does not do so through the existing commercial, High Street and investment banks..." (my emphasis)

Now, in Part 1 I pointed out that government does not provide funds to the BoE for QE - the BoE creates the money out of thin air. If the government provides funds - presumably in the form of new government debt - then it is not QE. It's good old-fashioned direct investment by government. Calling it QE is just giving a new name to a very old game.

I looked through Part 2 of this paper to see if I could find any indication that the authors had any intention of funding their objectives with newly-created money by the central bank. If they had, then they could perhaps argue that QE is an appropriate descriptor. But I could find no reference anywhere to creating money to fund these activities. In fact throughout Part 2 there is repeated reference to public expenditure and borrowing, neither of which have anything to do with central bank money creation. On page 12, for example:

"Undertaking these activities would give the economy an immediate shot in the arm as well as providing infrastructure of lasting use which would more than repay any debt incurred in the course of its creation..."

"...We stress, what we propose is borrowing for investment, not borrowing for current spending. We are not alone in arguing this..."

"This is what we believe the programme we recommend would do and this is precisely why it is approapate to do it now when the cost of government borrowing is so low, a point Wolf and Skidelsky also make. This borrowing now to spend into the economy is the basis for the first stage of Green QE2 - and of the Green New Deal"

And on page 13:

"We recommend Green QE2 be used to deliver the funds that are needed for local authorities to draw on to take that risk. It should also provide the local capital that is needed to ensure the private sector joins them in delivering local green solutions. This will help create the employment we so badly need and in the process generate long term savings for the UK that will more than pay the cost of this debt...."

"That same low cost of borrowing does, however, bring us to the final issue we believe Green QE should address...."

Now, I'm not arguing that direct government investment in the economy is a bad thing. As I said at the start, in this post I am only commenting on the financing approach, not on the merits of the Green proposals. If a future government wishes to issue lots more debt to finance the aims of the Green New Deal, it can propose that to the electorate and obtain a democratic mandate to do so. But it should be called by its name - debt-financed government investment. It is emphatically not Quantitative Easing - of any colour.

And one final comment. I admit that I am really rather relieved that the authors have comprehensively misunderstood what QE is. If they had really been proposing creation of new money by the central bank to finance public works, I would be planning to emigrate. I don't want to live in Britain's version of the Weimar Republic. I know that various economists have suggested that government, not banks, should have control of the money supply. But I am by no means sanguine about that. Expansion of the money supply to fund spending into the economy is known to be inflationary. Sometimes that's a good thing, and yes, it's true that investment shouldn't be inflationary. But would politicians exercise sufficient caution in the use of such a powerful tool? I doubt it.

A doomed assessment

2011-09-30T00:27:00.002+01:00

This is part 1 of a two-part post reviewing Finance for the Future's paper proposing so-called "Green Quantitative Easing". The paper was produced in December 2010 (although I have only just seen it) but the ideas it contains are widely promoted, so I thought a critique would still be in order. I make no apology for the technical language I use in this review, as the concepts in the paper assume a fair understanding of finance and economics.

PART 1 of the report is an assessment of the Bank of England's Quantitative Easing programme in 2009-10. PART 2 is a proposal for government investment in the economy specifically to further green objectives as outlined in the New Economics Foundation (NEF)'s Green New Deal. I shall follow the same structure in this review.

I would like to state before I start that this review is in no way intended to be a criticism of the authors, Richard Murphy and Colin Jones. I would also like to issue a personal disclaimer. I am neither an economist nor an environmentalist, so will not comment here on the economic usefulness or otherwise of either Quantitative Easing or the Green New Deal. My comments will be concerned entirely with the financial process.

PART 1: Assessment of Quantitative Easing

What is Quantitative Easing?

The BoE has a handy layman's guide to QE as a PDF download from their website. As this is so easy to obtain, I am surprised that the paper does not refer to it, or even to the brief definition on the BoE's website. Instead, the appendix to the paper obtains a definition of QE from an article in the Financial Times (FT). The FT's definition is consistent with the BoE's but is not as comprehensive an explanation. Perhaps because the explanation is limited, the authors of the report have completely misunderstood it.

According to the authors of the report,

"Quantitative easing is......the Bank of England granting the Treasury an overdraft".

No it isn't. It's the central bank injecting newly-created money directly into the economy, bypassing government. Here's what the Bank of England (BoE) itself says about this (from its website):

"The MPC boosts the supply of money by purchasing assets like Government and corporate bonds – a policy often known as 'Quantitative Easing'. Instead of lowering Bank Rate to increase the amount of money in the economy, the Bank supplies extra money directly. This does not involve printing more banknotes. Instead the Bank pays for these assets by creating money electronically and crediting the accounts of the companies it bought the assets from."

The central bank is able to create new money itself and does not require permission from government to do this. Because this money is created "out of thin air", it is NOT borrowing and does not increase the government debt, unlike an overdraft. What it does do is increase the size of the BoE's balance sheet. It can of course be reversed by selling a sufficient quantity of securities to eliminate the amount of new money created - this may or may not be the same quantity or type of securities as the original purchases, of course, depending on movements in market prices since purchase. The BoE's money creation process for asset purchases has absolutely nothing to do with the issuance of new government debt in the form of gilt-edged securities, or "gilts".

What assets were purchased?

From the BoE's pamphlet:

"...in March 2009, it decided to buy two types of asset – UK government bonds (known as gilts) and high-quality debt issued by private companies. Making the majority of purchases in gilts allows the Bank to increase the quantity of money in the economy rapidly. Targeted purchases of private sector assets should make it easier and cheaper for companies to raise finance by improving conditions in corporate credit markets."

The reason why gilts were purchased was because the gilt market is highly liquid, so funds could be injected into the economy quickly and easily. For some reason the authors seem to think that the QE programme was "buying back" government debt. It wasn't. The BoE bought gilts, but they were not redeemed. Those gilts, along with corporate bonds purchased as part of the same asset-purchase programme, now form part of the BoE's balance sheet.

Where did the assets purchased come from?

According to the authors of the report, the assets came from banks. Here's how they think it works:

"...the Bank of England has been issuing bonds to High Street and investment banks, which they buy.....But because the Bank of England does not want to take money away from the banks....the Bank of England then buys back gilts from those same High Street and investment banks that have bought the gilts issued by the Treasury"

Well, yes, high street and investment banks do indeed buy gilts, although they are by no means the only purchasers of that debt - major holders of gilts are pension and other savings funds. But the BoE generally did not buy gilts back from banks. On page 9 of the BoE's pamphlet we find these statements:

"Direct injections of money into the economy, primarily by buying gilts, can have a number of effects. The sellers of the assets have more money, so may go out and spend it. That will help to boost growth. Or they may buy other assets instead, such as shares or company bonds. That will push up the prices of those assets, making the people who own them, either directly or through their pension funds, better off. So they may go out and spend more. And higher asset prices mean lower yields, which brings down the cost of borrowing for businesses and households. That should provide a further boost to spending.

"In addition, banks will find themselves holding more reserves. That might lead them to boost their lending to consumers and businesses. So, once again, borrowing increases and so does spending. That said, if banks are concerned about their financial health, they may prefer to hold the extra reserves without expanding lending. For that reason the Bank of England is buying most of the assets from the wider economy rather than the banks." (my emphasis)

In other words, because the BoE was concerned that High Street and investment banks might just sit on the money realised from asset sales instead of lending it out, it AVOIDED buying gilts or other securities from them.

What was the effect of this asset-buying programme?

As the authors correctly state (quoting Alistair Darling), we don't know whether QE did what was intended. The BoE, on page 13 of its pamphlet, provides a useful checklist to determine whether or not it was working. But the authors of the report produced their own checklist, so I shall use that.

Outcome 1: Recapitalising the banks

Recapitalising the banks was certainly not an aim of QE. The authors claim that "...public money has been used to reflate the banks with the benefit going to the existing shareholders and those receiving bonuses rather than reflating the broader economy to the benefit of the majority"

There are two errors here. Firstly, the money created by the BoE to purchase assets was not public money. The BoE, like all fractional reserve banks, has the capability to create new money without borrowing. The money it created had nothing to do with the government. Secondly, the money it created was not "used to reflate banks". Most of that money initially went to institutional investors. Yes, it then found its way into banks, because risk-averse investors chose to place the cash in deposit accounts rather than invest in riskier assets themselves or spend it, as the BoE hoped. And that cash did indeed inflate bank reserves. And banks may indeed have used that money placed on deposit with them to speculate on the international financial markets, from which they will have made profits which - if retained - improved their capital, or which may have been distributed in the form of bonuses and dividends.

So yes, the end result of this process may well have been that banks profited from QE. But that's not the same as using the money "to reflate the banks", is it? And if investors preferred to hoard the cash rather than spending it, well, they were only doing what in the report the authors identify as normal behaviour in a recession - saving. And if the banks speculated with that money, they were only doing what banks normally do with wholesale deposits. It was all perfectly normal behaviour. The only abnormal bit, really, was the lack of bank lending. I shall return to that.

Outcome 2: making funds available to business

From the authors:

"The stated aim of quantitative easing was to make funds from banks available to business so that they could meet the pressure on them arising as a consequence of the recession".

No it wasn't. There was no such stated aim. In fact the BoE avoided purchasing assets from banks because it was concerned that banks might not lend the funds out.

The stated aim of QE, according to the BoE's pamphlet, was to make it easier and cheaper for businesses to raise finance on the capital markets:

"Bank of England purchases of private sector debt can help to unblock corporate credit markets, by reassuring market participants that there is a ready buyer should they wish to sell. That should help bring down the cost of borrowing, making it easier and cheaper for companies to raise
finance which they can then invest in their business.

More generally, the Bank of England’s purchases of both government and corporate bonds also increase the total demand for those types of assets, pushing up their prices. This is another way in which the Bank’s actions will make it cheaper for companies to raise finance."

Outcome 3: a shortage of gilts for investment purposes

By reducing the availability of gilts, and therefore increasing the price, the BoE hoped to encourage investors - including pension funds - to move their portfolios more towards riskier assets such as corporate bonds and equities. What they actually did was place the funds on deposit at banks, which wasn't what the BoE wanted. But QE creating a shortage of gilts - yes, that was the point. It was supposed to.

So I'm a bit bemused by the authors bewailing the fact that there was a shortage of gilts for pension investment, as if QE wasn't supposed to have this effect. However, the key to this lies in the authors' observation that "...during a recession people save more". Indeed they do. But the point of QE was to encourage spending instead of saving. So obviously QE was going to make life difficult for savers, wasn't it? The shortage of gilts raised gilt prices and lowered yields, reducing returns to savers and therefore discouraging saving. In a recession, this is quite a sensible thing to do, surely?

Outcome 4: asset price inflation

"We suggest that is because excessive funds, being saved for the reasons noted above by both households and corporations have been moved by investment managers acting on their behalf into the UK stock exchange and other markets (such as those for commodities, including metals and foodstuffs) because those funds have not had sufficient access to the gilts market, because the government has not met the demand for gilts to be used for savings, and has instead been repurchasing gilts, so denying them to the savings market."

The authors, in that sentence, have summed up the entire purpose of QE. What a pity that they are using it to criticise QE's effect. If that has indeed happened then QE has done exactly what it was designed to do - forced investors to move funds to other types of asset.

Oh, and the confusion between central bank and government rears its ugly head again. No, the government has NOT been repurchasing gilts. The BoE has been purchasing them.

The authors then go on:

There are important consequences of this. First, a mini asset boom has been created, maybe inadvertently....(my emphasis)

No, not inadvertent at all. Absolutely what was intended.

Given the whole problem that gave rise to the financial crisis was asset price inflation, or booms, this replicates the whole financial failing of the pre-2008 era.

The authors are comparing apples and oranges again. Commercial banks leveraging assets to the skies with derivatives is hardly the same as partial replacement of certain classes of security with cash.

"Second, because many of the assets whose prices have been inflated, such as coffee which is at a thirteen year high, or palm oil, which is up 45% in price in a year, feed (almost literally) into consumer price inflation, this policy does result in inflation, but not as a consequence of the direct printing of money, which is what economists predicted."

Well, ok, commodity price inflation on international markets probably was an unintended effect. But QE is supposed to raise inflation. Yes, in the short term it depresses yields. But the aim of the spending boost is to raise inflation to the level where normal interest rate management can take over. The BoE's stated aim for QE was to get inflation back up to the target level of 2%.

Outcome 5: deflation has been avoided

Yup, by raising inflation. Which was the point.

Outcome 6: low interest rates

"Another policy objective of the Bank of England, the government, and the quantitative easing programme was the maintenance of low rates of interest within the UK economy with the objective of stimulating economic activity. The programme has clearly helped achieve this with regard to interest rates on government debt, and on rates of interest paid by banks on savings, but the impact on the cost of borrowing to business, in particular, has been marginal. As has been widely reported, businesses have continued to pay significant premiums over bank base rates. This is because banks say that the risk inherent in such loans has increased. As a result it is not clear that the programme has delivered the new economic activity via increased bank lending to business that was intended."

I do have to agree with the authors here, except for their assertion that increased bank lending to business was an intended outcome of QE. The costs of borrowing for both businesses and households has risen massively. Yes, cost of financing on capital markets has fallen. But most businesses don't have access to capital markets, and for them, bank lending has become expensive and difficult to get. This is not because of QE, but because of risk aversion on the part of both lenders and borrowers.

Summary of PART 1

The authors' assessment of QE was doomed from the start because of their abject failure to understand what QE is and how it works. In particular, their confusion of government and central bank, and their evident lack of knowledge of the mechanics of fractional reserve banking, mean that this is a very seriously flawed analysis. Let's see if Part 2 is any better.

You can find my review of Part 2 by following this link: "A new name for an old game".

The growth illusion

2011-09-28T03:25:00.003+01:00

Let's face it, we are in a mess. According to the BIS, the UK is the most heavily-indebted nation in the developed world, with total public and private debt amounting to something like 350% of GEP. Our economy is on the floor, unemployment is rising (particularly among young people) and would be even higher if it weren't for the fact that people are taking part-time jobs instead of the full-time ones they really want. Housing is still overvalued, first time buyers and young families can't afford to buy properties, and even if they could banks don't want to lend to them. Fuel costs are astronomical, food costs are rising, wages are flat. Businesses are going bust and individuals are going bankrupt.

Even worse is what's happening across the Channel. I, for one, am exceedingly glad that the UK did not join the Euro, which appears to be intent on blowing itself apart with an explosive mixture of market panic, economic mismanagement (by everyone, not just Greeks) and political inertia.

And then there's the US, with chronically high unemployment, welfare and healthcare systems that are very expensive and frankly unfit for purpose, a defunct housing market and debt that if stacked up could reach the moon - and a total lack of political will to deal effectively with any of this.

And then there's Japan....how long has that been bumping along the bottom now? Still paying the price for a housing bubble collapse and banking crisis two decades ago, not to mention recent natural disasters and an ongoing nuclear standoff.

And then there's China, which seems well-placed to become the overlord of the world - if it doesn't fall apart in a subprime crisis of its own first......

And then there's Switzerland, whose economy is being systematically crippled by scared investors moving their money to what they regard as a "safe haven". The SNB's attempt to deal with this by pegging the currency has effectively made tiny Switzerland the world's banker. Well, I suppose I can think of worse things for a country to be, but if and when they remove that peg, heaven help their economy....

I could go on, and on, and on....there are many, many more. The whole world is in an economic crisis.

On the face of it, the problems faced by all these countries look very different, don't they? But actually they all boil down to the same things. Political deadlocks, market panic, and above all - the dominance of economic theories that put the interests of international money ahead of the needs of ordinary people and ignore the real issues facing the world today.

Any economic theory that does not have the interests of PEOPLE at its heart is morally bankrupt. And by PEOPLE I don't mean the moneyed elite that play the international casinos. I mean ordinary people living ordinary lives, doing ordinary jobs for ordinary wages - bank clerks (yes, really), shop assistants, garage mechanics. I mean owners of very small businesses like mine, sole traders and little companies - corner shops, plumbers, peripatetic music teachers. I mean elderly people trying to live on a pension that diminishes day by day as inflation outstrips interest on savings. I mean single mothers trying to be both loving carer and adequate provider to their children as their benefits are cut and they are charged for trying to obtain maintenance from their runaway spouses. I mean young people leaving college in debt with little prospect of any decent job in the forseeable future.

I'm sure most readers of my blog would agree with me that we need an economic theory that really addresses the needs of these, and many other, people. The trouble is we don't agree on what that theory should contain. On one side we have those who believe that the way to prosperity is ramping up public debt (since interest rates are very low) to invest in public works, expanding the public sector hugely in order to develop essential infrastructure. On the other side we have those who believe that the way to prosperity is to cut the public sector brutally to allow the private sector into the gap that is left, because the private sector is a better source of innovation. I wish that both sides could see that they want the same thing, but they don't agree on how to get there - and they waste a lot of time and energy insulting each other rather than trying to achieve a compromise that honours the respective roles of both private and public sector.

For me, though - and I know I've said this before - if there are endless debates that degenerate into slanging matches and solve nothing, both sides are missing something important. Here's what I think the missing issue is: both sides anticipate a return to growth some time soon. But I think they are wrong.

We have lived for a century or more in the belief that prosperity comes through economic growth. And indeed, economic growth in the developed world has been astronomical in the last hundred years. We see the benefits in our comfortable lifestyles - and now, understandably, countries whose development has lagged behind want a piece of the action too. To support the lifestyle that we come to enjoy and enable other countries to have that too, the world economy has to grow - and maintain growth - at an unprecedented rate.

But the growth rates of the last century have been achieved through use of a finite resource. I mean oil, of course. And there is no doubt that we have nearly exhausted the known reserves of oil, but our global demand for oil is higher than ever before.

Now don't get me wrong. I am not playing the environmentalists' "economic catastrophe" card. I don't think the world running low on oil will mean all the lights will go out and we will return to living in caves. I am constantly amazed by the ingenuity of humans, and I have no doubt that solutions will be found to substitute for the crucial role that oil has hitherto played in the global economy. But it won't be quick, and it won't be cheap. And above all, it won't enable ANYONE for the foreseeable future to have the sort of economic growth that we have come to rely on.

So any economic plan that aims to restore the sort of economic growth we have had in the past is fundamentally flawed. And any political manifesto that claims that growth will sort out our financial and economic problems and restore the "good times" is dishonest. So I oppose "Keynsian" stimulus packages, whoever proposes them and whatever name they go under, if they involve more public borrowing. We cannot expect to have the sort of growth that will reduce that debt in the future, and although interest rates are very low at the present, there is no reason to suppose they will still be at that level in five years time. Yes, sovereign countries could print money instead of borrowing. But the relationship of money printing to inflation is well known, and although I suppose it is theoretically possible to manage the production of money so tightly that the inflation risk is minimal, I have no confidence in the ability of politicians to resist the temptation to interfere with this discipline in the interests of buying votes.

On the other hand, there is no doubt that people are suffering from our economic decline, and I don't see any prospect of this improving in the short term. I believe it is the job of government to support those who are the undeserving casualties of economic difficulties. Yet almost all the countries I have mentioned above are currently implementing spending cuts which hurt the most vulnerable in society. To me this is uncivilised. I don't want to live in a society that can't or won't help those who are unable to provide for themselves. And therefore, I don't support cuts in the public spending programmes that support the weakest. We are not so poor that we can't afford to care. Now, it is possible that providing people with the support they need to survive the next few years might require an increase in public spending in some areas, and that might involve additional borrowing. But I personally would regard that as money well spent.

What I DON'T want to see government doing is spending money - whether obtained through taxation, borrowing or printing - to prop up failed companies, build white elephants, host expensive flagship events, develop vast IT systems that are cancelled before they are implemented, or provide finance to high-risk small businesses that no commercial bank would lend money to (as Samuel Brittan suggested in the FT the other day). Or to set up a very expensive, monolithic and clunky state banking system, when all that is needed to provide essential banking services in the event of major clearing bank failure is a basic electronic payments facility and emergency lines of credit. And personally I don't even want government involvement in the development of green technology and replacements for oil - although I accept there is a role for government in financing R&D and very large infrastructure projects - because I think the private sector does that kind of innovative work much better. I'd rather government focused on providing essential services to support people. Because for me, that's what the public sector does best.

If I am right about the future facing us, then there are implications for our lifestyles. Will commuting become a thing of the past, replaced with homeworking, networking and electronic conferencing? Will schools and universities become centres of virtual learning, with students based at home (with homeworking parents?) and participating in on-line lessons delivered in real time? Will we see a return to shops within walking distance of people's homes and vibrant local high streets, replacing large out-of-town shopping centres only accessible by car?

Perhaps, when we can no longer rely on oil as we have done, it will force us to think more locally, to engage with our local communities and build prosperity through real economic activity from the grass roots up. And surely that is the best way of achieving a positive, prosperous future.

Trolling, cyberbullying and constructive debate

2011-09-24T04:11:00.000+01:00

There has been much discussion recently regarding the phenomenon known as internet "trolling", following the conviction of Sean Duffy for posting offensive messages on Facebook about young people who had died. The BBC's article on trolling to my mind confused it with cyberbullying, but I agree there is a considerable overlap: both cyberbullying and trolling involve deliberate, malicious attacks on an individual, and it is not clear at what point trolling metamorphoses into its far nastier and possibly illegal cousin.

Wikipedia defines "troll" thus:

"...someone who posts inflammatory, extraneous or off-topic messages in an online community, such as an online discussion forum, chat room or blog, with the primary intent of provoking readers into an emotional response or of otherwise disrupting normal on-topic discussion"

Urban Dictionary is subtly different:

"one who posts a deliberately provocative message to a newsgroup or message board with the intention of causing maximum disruption and argument"

And a pretty comprehensive definition of "trolling" comes from Know Your Meme:

"....refers to any behavior that is meant to intentionally anger or frustrate someone else. It is often associated with online discussions where users are subjected to offensive or superfluous posts and messages in order to provoke a response."

All these sources agree on one thing. It is not so much what is said but the INTENTION that defines whether someone is trolling. Online debates can become quite heated, tempers flare and language can become unprintable, but that doesn't necessarily mean that anyone is trolling. It is the deliberate DISRUPTION of debate that constitutes trolling.

This is in my view a very important distinction. In the comments on my recent post in Liberal Conspiracy, I was called a moron, an idiot and various other names by people who felt very strongly about what I had said and chose to show this by means of personal abuse rather than addressing the points they disagreed with. For me, anyone who resorts to personal abuse has already lost the argument. But that didn't mean these people were trolling. They simply felt strongly about something and expressed it in personal terms. As someone said to me recently, this could be seen as a good thing - at least they recognised me as a person!

But if someone maliciously attacks what another person has written with the intention of discrediting them, is that trolling, if the points they make are valid? This to my mind is a bit of a grey area, and I'd value comments from others on this. The definitions above are unclear: the Wiki definition suggests that this is not trolling, since the attacks are on-topic, but the other definitions do suggest that offensive posting IS trolling even if on-topic, because it is intended to anger and provoke rather than engage and debate. Deliberate attacks which seek to prevent reasoned discussion of the writing and aim to undermine the writer are hurtful and disruptive. But on the other hand it must be possible to disembowel a silly argument without being accused of trolling. The problem is, though, that what one person regards as reasonable fisking, another may regard as an unjustified and vitriolic attack.

To me the best strategy is to remain factual, address the points in a logical manner and refrain from emotive language or personal abuse - even if someone is using abusive language themselves. And don't attack just for the sake of it, for a laugh, or because you don't like the person: only take a post apart if you genuinely disagree with it. Stick to the topic, provide reliable evidence to support your points, and be polite to the writer while you are demolishing their arguments. They may still call you a troll, but the evidence will be against them.

Sometimes a particular individual is systematically targeted for abuse by others on social media. This is often called trolling, especially when it is associated with completely opposed political views. But in my view a sustained campaign of abuse of an individual on social media is not trolling, it is cyberbullying - even if the person concerned has been blocked so they cannot see what is being said about them. No block can completely prevent information reaching the target. I have been the target of such a campaign recently, and found it exceedingly distressing to discover that someone was deliberately spreading lies and misinformation about me in order to discredit me. However much you may disagree with someone, or believe they are a fraud and a sham, if you deliberately spread lies about them, misrepresent what they have said, or abuse them personally, you are a bully. You should engage them in constructive debate, not stab them in the back.

Sometimes the target of abuse - trolling or cyberbullying - exposes the abuse by writing about it, broadcasting it on social media, or confronting the abuser. I've done this myself and am in two minds as to whether or not this is a good idea. The advice from Twitter is to ignore abuse unless it involves threats of personal violence, in which case you should inform the police, of course. In many cases studiously ignoring abuse is sensible: "don't feed trolls" is generally good advice. It certainly stopped the abuse I was receiving. But cyberbullies may not be as easily put off as a troll who is getting off on your distress, and sustained hate campaigns involving personal abuse may therefore be better exposed. No-one should have to put up with this stuff, and exposure can be a powerful weapon. But if you do decide to expose abuse, be careful - make sure you release EXACTLY what the abuser has said and done, and keep copies of their postings as evidence. If you alter what they have said or done you may be guilty of trolling or cyberbullying yourself.

And finally, a warning about nasty jokes. Not all trolling is malicious attacks on serious posts or deliberate campaigns to discredit. Urban Dictionary gives a good example of "lighthearted" trolling:

Guy: "I just found the coolest ninja pencil in existence."
Other Guy: "I just found the most retarded thread in existence."

The "other guy" may well have meant this as a joke. But it was unpleasant, unnecessary and unrelated to the topic of the first remark, and therefore it was trolling. There is far too much of this stuff around on the internet and it would be a much nicer place if people would refrain from issuing gratuitous insults, even as "jokes". They aren't funny.

So in summary, play nice - even if the other person really is a prat!

On risk and safety

2011-09-21T23:09:00.000+01:00

At the Keynes vs Hayek debate at the LSE on 26th July, Shiv Malik (from the audience) asked a question which stopped the panel in their tracks. He commented that Hayek could be regarded as representing the desire of people in the 1930s for freedom, and Keynes as representing their need for security. And he asked whether people of today are looking for both freedom and security.

Needless to say, the panel did not answer his question - though many economic writers of today are indeed attempting to bridge this divide. But it reminded me of a song that some of my students sing, and the conversation I always have with them about the meaning of the song.

The song is "Dona, dona" by Sholom Secunda and was originally written in Yiddish. Only the verses are relevant and I reproduce them here in the translation recorded by Donovan in 1968.

On a wagon, bound for market, there's a calf with a mournful eye.
High above him there's a swallow, winging swiftly through the sky.

"Stop complaining", said the farmer, "who told you a calf to be?
Why don't you have wings to fly with, like the swallow, proud and free?"

Calves are easily bound and slaughtered, never knowing the reason why.
But whoever treasures freedom, like the swallow has learned to fly.

I learned this song when I was eight, and at the time thought it was about a calf called Donna - and was very puzzled by the calf's gender. I know better now.

This song exemplifies the very tension between desire for freedom and need for security that Shiv Malik identified, that different schools of economics portray and opposing political parties espouse. And I believe his point was really that human beings need both freedom and security, so our economic and political structures need to accommodate both of these - degrees of freedom so that calves can grow wings and fly if they wish, and degrees of support and protection for those who, for whatever reason, are not able to fend for themselves as swallows must. We are both calves and swallows. And the degree to which we are "calf" or "swallow" varies at different times in our lives and in different circumstances. In my own life I have been, generally, much more swallow than calf: the choices I have made have forced me in that direction, even when I would much rather have been a calf for a while. Equally I am sure that there are many people who have ended up as calves when they had hoped to be swallows.

In our society we generally aspire to "freedom", but we don't like the risks that attend it. In other societies, people like the protection that comes from conforming, except when that becomes oppressive - then they start clamouring for "freedom". And when times are good we resent government interference in our lives, but when times are difficult we call on government to rescue us. Being a swallow means accepting responsibility for our own lives, including the difficult bits. Being a calf means giving up some of our freedom in order to be cared for by our society.

So it is with business, with government, and with finance. When times are hard, and especially after high-profile fraud cases and financial crashes, we call for increased state control and intervention - "there should be a law against it". But when times are good we want the state to back off and let free enterprise rule. At the moment there are proposals for vastly increased regulation of banks, coupled with varying degrees of structural reform. There are even calls for a complete state takeover of banking. Yet only ten years ago the fashion was for deregulation, a hands-off approach by the state and freedom for financial enterprises to do whatever they wish.

We pay a heavy price for this pendulum swing from too much control to too little, and back again. How do we find, and stay with, the centre point, where free enterprise can operate freely within reasonable constraints set and enforced by the state? What constraints will we accept on our freedom to do whatever we want in the interests of financial stability?

I don't have a simple answer to this conundrum. But it seems to me that part of the issue is people's unwillingness to accept risk. We want to be swallows when we invest our money - after all, we like high returns, and those only come by taking risks, so we want to be able to choose where to put our money in order to achieve the best return. No-one wants to be forced to put their money into a state savings scheme when private schemes offer better returns, do they? But when the risks we have taken turn out to be bad ones and we face the prospect of losing our money, we suddenly become calves, scurrying to the safety of the government cowshed and crying "it's not fair!".

Is it time for us to understand the real risks we take with our money and take rational decisions as to whether safety or risk are more important to us at different times in our lives? Is it time we started to care about whether the companies we invest in are financially sound, economically useful and ethically acceptable? Some people already do. Maybe the rest of us should as well. And perhaps, if enough of us care about these things, the financial sector will start to provide the range of investment options from very risky to very safe that we really need, instead of pretending that investments are safe when they are not and conning us into accepting rubbish returns as a price for the illusion of safety.

Much of the problem in the last financial crisis arose from the fact that investments that had been regarded as "safe" turned out to be anything but. There is in my view an important role for government to ensure that real safety is available for those who need it, and real risk is available for those who want it, and both are clearly identifiable. Tinkering with organisational structures, pretending that some forms of banking are safer than others, fragmenting financial functions - none of these deliver the clarity and openness that we require in order to manage our money. What is needed is clear and accurate reporting and management of risk from end-to-end of the entire financial services industry. Only if there is complete transparency of reporting and accurate understanding of risk in financial services do people stand any real chance of being able to manage their need to be, at different times, both calves and swallows.

Trading losses and takeovers

2011-09-15T10:32:00.000+01:00

It appears UBS has lost some money - about $2bn - due to unauthorised and highly risky trading on financial markets. Not for the first time, either.

As a result of this, there are now even more strident calls for UK retail banking to be ring fenced to prevent these sort of losses from impacting on retail customers. This tweet from the BBC's Robert Peston is typical:

"UBS's $2bn rogue-trader loss has not come at a great time for those who argue investment banking and retail banking should remain integrated"

This is, of course, a particularly stupid comment. UBS doesn't have a UK retail banking operation so wouldn't be subject to the ring fencing proposals anyway. But does the UBS experience strengthen the case for the likes of Barclays to be required to ring fence their retail operations?

I had a quick scan down Wikipedia's list of banks that have made serious trading losses. Now, admittedly, Wiki themselves say this list is not complete, so it may be that another major UK retail bank is lurking in the shadows somewhere. But the only one reported on that list is NatWest's loss of $0.19bn on interest rate options in 1997.

Now the NatWest loss is very interesting. This loss occured after a series of acquisitions and investments in its capital markets banking business designed to reduce its reliance on traditional retail banking and enable it to manage the business cycle better. Instead it fatally weakened NatWest. After this loss it separated out its investment banking division and attempted to sell it. But the stock market was unimpressed and NatWest became a target for takeover, eventually succumbing to a hostile bid by the much smaller Royal Bank of Scotland (RBS).

A look at UBS's history reveals a similar pattern. In 1998 UBS made a loss of $0.55bn on equity derivatives trading. That loss, coupled with generally poor performance, led directly to its takeover by its fellow Swiss bank and competitor SBC Warburg.

You see, that's what normally happens to banks that make major trading losses. They get taken over.

And when the reasons for the losses are investigated, they always boil down to the same things - failure of internal management & control combined with an aggressive expansion strategy. It makes no difference whether the bank that is failing to manage its risks properly is an investment bank trading in exotic derivatives (UBS), an integrated bank so anxious to take over America that it fails to do due diligence on an acquisition (RBS), a household name going for broke in leveraged buyouts and private equity financing (HBOS), or a retail bank massively expanding its mortgage book by lending far too much to people who can't afford it (NR). The attitude is the same, and so is the result. A bank that is poorly managed doesn't deserve to survive as an independent entity.

But the fact is that the Wiki list indicates that only ONE UK high street bank has ever made investment banking losses large enough to impact retail banking - and that was nearly 15 years ago. If a ring fence was necessary, shouldn't it have been imposed then? And the UK didn't bail out ANY investment banks in the 2008 financial crisis. It bailed out three retail banks and a clearing bank. So what exactly are these risks that ring fencing retail banking is supposed to save us from?

Monetary Policy RIP

2011-09-09T23:04:00.000+01:00

So the markets were disappointed that Bernanke didn't announce Quantitative Easing (QE) round 3 for the US.

And the markets were disappointed that the Bank of England's Monetary Policy Committee (MPC) didn't announce a second round of QE for the UK.

Both Bernanke and the MPC have in effect said "monetary policy is dead in the water". Base lending rates are on the floor and neither has come up with any measures to reduce real interest rates further. Yes, Bernanke did suggest that there were some other measures the Federal Reserve could take to depress interest rates along the yield curve and so encourage investment. And neither the MPC nor the Fed have ruled out further QE at some point. But their reluctance to act suggests that they are now - belatedly - doubting the wisdom of throwing more money at the markets in the hope of stimulating demand in the real economy on either side of the Atlantic.

And about time. Business investment is low and consumer spending is on the floor. Those businesses that have cash aren't investing it - they are hoarding it instead because of worries about lack of sales. Those businesses that don't have cash are either paying down debt or avoiding borrowing for investment, again because of worries about lack of sales (different link!). Yes, there are of course some businesses that do want to borrow. But guess what - banks don't want to lend to them. Not because they don't have any money to lend. They do. But they would rather hang on to that money and park it safely at the central bank (which pays interest, of course) or invest it in nice safe assets such as government bonds. That's what they did with the money from the last round of QE. Which is why it didn't work.

As I've pointed out in a previous blogpost, QE only works as a domestic demand stimulus if banks are lending to businesses and individuals. But they aren't. It is therefore completely pointless.

Unfortunately those who work in financial markets can't tell the difference between the bubble they live in and the real economy. If there's more money around and bond yields are down, QE must be working, yes? No. QE does affect investor behaviour: it floods the market with cash and reduces the supply of safe long-dated securities, which is supposed to push investors towards investing in riskier assets such as equities. Trouble is, what they are actually doing is hoarding cash in insured deposit accounts and safe haven currencies. So arguably QE didn't work even for the markets. All it did was create loads of cash that is now sloshing around the world desperately seeking a refuge. Heaven alone knows why they want more. They can't find enough hiding places for the cash they've already got.

Monetary policy has nothing more to contribute. The only solution to the economic decline on both sides of the Atlantic lies in the fiscal realm. It is time that the politicians stepped up and accepted their responsibility for getting us out of this mess.

Where were you on 9/11?

2011-09-09T00:28:00.000+01:00

As we approach the 10th anniversary of the destruction of the Twin Towers, many people will be asking that question - where were you when the planes hit?

I'll tell you where I was. Just about to get into a taxi, heading for the airport. To get on a plane.

No, I wasn't in New York. I was in Edinburgh. At the time I was working on a project for RBS, designing and implementing a computer system to enable them to produce consolidated financial and regulatory reporting on something rather more robust and auditable than an Excel spreadsheet. I was dividing my time between London and Edinburgh, and on Tuesday September 11th 2001, I had been in Edinburgh for two days and was about to fly home. Just as I was leaving the office, someone said to me "have you heard the news?" I looked round, and on the Reuters screens were the images of the smoking twin towers.

I still got on that plane. It was the weirdest flight I have ever been on in my life. Everyone knew, of course - but no-one was saying anything. The only indication of anything being abnormal was cabin crew handing out double gin & tonics. That, and the atmosphere. You could cut it with a knife. I don't think I have ever been so scared, and I am certain I was not the only one who felt like that.

Our landing at Gatwick was uneventful, and there was no extra security as we went through to Arrivals. But in my taxi on the M25, we heard the news that Gatwick had been closed. Apparently mine was the last domestic flight to land before everything was grounded.

Why did I get on that plane? Well, I did toy with the idea of diverting to Waverley station and trying to get a train. But that would have caused a big problem. You see, I had to pick up the kids from the childminder at 6 pm.....

The events of 9/11 forced me to look hard at the life I was living. For the first time I realised how very tenuous my childcare arrangements were - that while my children were in school and nursery, I was four hundred miles away. And that happened nearly every week. They couldn't be ill, or unhappy, or short of some essential, because Mummy couldn't drop everything and run to the school or nursery at a moment's notice. And on 9/11, Mummy nearly didn't get home at all.

I felt that my children deserved a mother who had time for them, who could be there for them. Yes, I earned a good income. But the hours I worked, the travel, and the mental aggravation of senior-level banking meant that I was either physically not present or personally unavailable. That wasn't the sort of mum I wanted to be.

So when I completed the RBS project I looked for work that was more compatible with family life and the needs of my children - and my own need to be a decent mum. I set up my own business as a freelance singer and teacher, funded it from savings, and was afloat within three years from scratch. It is hardly the most lucrative profession in the world, and I am much poorer financially than I was before. But I have gained so much from having time with my children - and even more from discovering that I have a real talent for teaching and can help so many young and not-so-young people learn to enjoy singing, many for the first time.

I have no regrets at all that I left banking, and I do not plan to return. But that won't stop me talking about it, writing about it and trying to influence policy makers as they struggle to reform banking for the 21st Century. I worked in banking for a long time and I know it well. I have much to say.

Unholy alliance

2011-08-30T22:28:00.000+01:00

It appears that Angela Knight, head of the British Bankers' Association, thinks that now is not a good time for structural reform of the banks to make them less dangerous to life and liberty in the event of their failure.

It also appears that John Cridland, chairman of the Confederation of British Industry, thinks the same.

Knight argues that reforming the banks now, when the economy is dodgy, the stock market is volatile and the Eurozone is imploding, would delay economic recovery. She wants banks to concentrate on making money so that they can "pay taxpayers back". Implementing structural reform to reduce risk can come later, apparently.

That's bonkers. We are facing a banking crisis that could make Lehman look like a minor flurry. The imperative to reform banks to ensure that they can fail safely has never been stronger. Delay economic recovery? Disorderly failure of unreformed banks wouldn't just delay it, it would cancel it for a generation. And how come paying back taxpayers has suddenly become so important? It hasn't been exactly high on banks' agendas for the last three years.

Now, I am by no means convinced that the reforms proposed by the ICB will have the desired effect of making the banking system safer. I think they are half-baked, to be honest. I have written about this extensively, most recently here. But to leave things as they are is the worst possible option. The ICB's recommendations, weak and flawed as they are, are better than nothing.

Knight's opposition to reform is no surprise, really. She speaks for the banks. The banks don't really want to make any changes that mean they will make less money. So this is simply the latest in a long line of attempts to derail the process of reform.

What is more surprising is John Cridland's support for her views. According to the Guardian, he fears that introducing a retail ring-fence will "stem the flow of credit to businesses".

Amazing. So he fears that the banks won't be able to raise the extra capital they need to reduce the risk of catastrophic losses from dodgy lending, so will have to stop lending - not that they were doing much anyway. Maybe he thinks (hopes?) that bank lending isn't dodgy any more, so there's no need to make it safer. Or has he bought into bank scaremongering? They have argued from the start that retail ringfencing and higher capital requirements will reduce the availability of credit. I dispute this. I see no reason why ring-fencing should reduce lending - unless, of course, banks can't raise the extra capital required. Higher capital requirements do increase the cost, of course. But that's already happening: banks have already increased the spread between borrowing and lending rates to enable them to retain more profits without reducing shareholder dividends.

Whatever the reasons, Cridland's objections are as specious as Knight's. And there seems to be a distinct shortage of common sense around. Yes, the economy is fragile. But the risks to the banking system are the single greatest threat to economic recovery. Some sort of reform - even a half-baked one - is urgently needed. The Government should ignore both Knight and Cridland and get on with the job.

Two takes on the Tyranny of Democracy

2011-08-30T11:52:00.000+01:00

This morning, on twitter, I saw this blog from Richard Murphy: The Tyranny of Democracy.

And right next to it, in another column, I saw this blog from Tim Worstall: The Tyranny of Democracy.

Of course I had to read both of them, didn't I?

Fascinating. Tim Worstall's blog was, of course, a rebuttal of Richard Murphy's arguments. And I have to say that in general I agree with him on this one.

The Tyranny of Democracy is not purely concerned with taxation, as Richard Murphy suggests. As Tim Worstall says, it is to do with the tendency of majorities to impose upon, discriminate against and abuse minorities. To the extent that in our parliamentary democracy, the government is elected by the majority (and I'm aware that there are issues around that), minorities will always be at risk.

Imposition of draconian taxes on minorities has happened at various times in the past in the UK. Worstall gives a recent example of such a tax. I prefer to mention the continual milking of the Jews to fund military campaigns by successive kings in mediaeval times. Such taxes are as much an abuse of human rights as denial of voting rights, jobs, education, healthcare, benefits and liberty to minorities. Oh, and very often financial abuse goes along with systematic denial of other rights as well, particularly the right to argue and resist.

Now, I'm not arguing that wealthy people paying more tax is necessarily a denial of their human rights. But what if the top tax rate rose to 98% - as it did in the 1970s? At what point does tax policy stop being reasonable and become abusive? Wealthy people are unquestionably a minority, after all. If they weren't, we wouldn't be having this discussion, would we? Wealthy people need representation too. Otherwise it is all too easy for them to become a target for the envious poor.

I really don't think Murphy's argument - that libertarians fighting their corner amounts to an attack on democracy - stands up. They have a right to express their opinions and attempt to influence policy through debate and persuasion. We all have that right. Denying that right to someone because you don't like their politics, or their religion, or their gender, or their colour, or the amount of money they have - now THAT's an attack on democracy.

Oh, and I have no axe to grind here. I am not, and never have been, wealthy.

Setting up banks to fail: retail ring-fencing revisited

2011-08-29T22:35:00.000+01:00

In my quest for a blueprint for bank reform that would allow dinosaurs to die quietly without endangering people's lives and finances, I found myself re-reading the Independent Commission on Banking's (ICB) draft report yesterday. I always find it interesting to return to something I haven't read for a while, as I nearly always find something that I missed before. This was no exception.

In fact I don't know how I missed it before. On re-reading the report it is very evident that the ICB's recommendations for increased capital and retail ring-fencing have little to do with keeping banks running safely and efficiently. They are intended to make it easier and safer for them to fail.

And they don't mean just investment banks, either. The aim of the retail ring-fence is to enable government to take over the running of essential banking services (payments, access to deposits, lending facilities) for ordinary people and small businesses in the event of ANY bank failure, whatever the cause. You see, the problem with running an integrated retail & investment banking model is not that one funds the other, or that one increases the risk of the other. It is that you can't easily separate functions that are essential to the smooth running of our economy from those that are not, nor from those that have global rather than domestic impact. That is the real reason why the Government found it necessary to bail out banks rather than allowing them to fail.

On that basis, I applaud the ICB's efforts. But they don't go far enough, and there is - as I have noted before - a cost, both financially and in terms of increased risk, particularly to retail customers.

Let's look more closely at their recommendations and the reasons for them.

According to the ICB, "making the banking system safer requires a combined approach that:

••makes banks better able to absorb losses;••makes it easier and less costly to sort out banks that still get into trouble; and••curbs incentives for excessive risk taking."

And in recommending ring-fencing of retail banking as a solution, they say the following:

"Ring-fencing a bank’s UK retail banking activities could have several advantages. It would make it easier and less costly to sort out banks if they got into trouble, by allowing different parts of the bank to be treated in different ways. Vital retail operations could be kept running while commercial solutions – reorganisation or wind-down – were found for other operations. It would help shield UK retail activities from risks arising elsewhere within the bank or wider system, while preserving the possibility that they could be saved by the rest of the bank. And in combination with higher capital standards it could curtail taxpayer exposure and thereby sharpen commercial disciplines on risk taking."

See what I mean? Most of this is concerned with closing down failing banks. Only the reference to drawing on investment & wholesale banking to save retail operations, and the reduction of the taxpayers' guarantee to improve risk management, is about keeping them going.

Note that the above quotation mentioned the possibility of failing RETAIL operations being bailed out by wholesale and investment banking operations. This is not pie in the sky. Three of the four UK banks that failed did so because of serious losses in retail banking. It is essential that banks that have wholesale and investment operations can draw on them if necessary to support retail banking. One of the reasons for the ICB's opposition (and mine) to full legal separation is that that would make it very much harder for banks to do this, and there would consequently be increased risk to RETAIL customers.

It is unfortunate that the way in which this report has been represented in the media and by politicians gives the impression that it is a blueprint for protecting "safe" retail banking from "risky" wholesale and investment banking. It is nothing of the kind, and hysterical demands for full legal separation to "prevent bankers gambling with our retail deposits" are a million miles removed from the careful analysis and balanced arguments in this report. To quote the ICB again (my emphasis):

"...the Commission believes that there are practicable ways of distinguishing between retail banking and wholesale and investment banking. Both sorts of banking are risky and both are important, but they present somewhat different policy challenges."

I have previously written about the ICB's proposals for retail ring-fencing. As a model for banking in the future I still think it is seriously flawed, relying as it does on the integrity of bankers to keep risks manageable. The increased capital requirements overall and separate capital requirement for retail operations go some way towards mitigating this, but the fact remains that retail deposits will still be at risk. And the existence of deposit insurance backstopped by the taxpayer will still encourage bankers to take excessive risks in lending, knowing that if it all goes wrong the taxpayer will cough up.

However, as a model for ensuring that failed banks can be safely wound down and essential services maintained, I have to admit it has some merits. And since we are currently facing the possibility of a mammoth banking crisis due to sovereign debt writedown, imposition of a ring-fence in the short term would provide retail customers with some protection. But it doesn't go far enough. In particular, it is unacceptable that current accounts remain "at risk" in the same way as deposit accounts. As I have noted in another place, these accounts are the lifeblood of our economy and people need constant access to them. Nothing is proposed either to ensure that these accounts cannot fail under ANY circumstances or to compensate people for contingent losses arising from lack of access to these accounts. The FSCS scheme is utterly inadeqate as insurance for current accounts. I would prefer to see current accounts separately ringfenced and treated as custodian accounts (i.e. off balance sheet), so that banks cannot use them to support any commercial activity. And I would also like included in the ICB report discussion of appropriate measures to enable investment and wholesale operations to be safely resolved, losses mitigated and risks managed. After all, large amounts of our savings pass through these operations. Global failure of investment banking could wreck our pensions, our ISAs and our endowments.

And finally....the ICB does not discuss funding of retail operations at all: it appears to assume that funds arise only from deposits, which is far from the truth. There are strident calls for retail banks to be denied access to external funding sources such as the interbank market and bond issuance: many of these calls arise from a mistaken belief that retail banking deposits fund investment banking, so retail banks can't be short of cash, can they? Oh yes, they can. Most retail banks require external funding on a daily basis. Liquidity crises are possibly the most serious threat to retail banking. How would liquidity be maintained in a ring-fenced model? As, despite my qualms, it seems likely that some form of ring fence will be imposed, I shall return to this in a subsequent post.

Regretful criticism

2011-08-28T04:06:00.000+01:00

I have never before written a blogpost in which I have severely criticised the writing of another person, and I do so now with a heavy heart. But I really can't let this nonsense pass.

In a blogpost a week ago, Richard Murphy called for nationalisation of the banks. He said:

"Of course we can save the banks, again. We can print money. We will have to.

But this time let’s get real. This time we don’t lend them that money. Or give it to them as quantitative easing."

There are two howlers in here, of course:

- We didn't "lend" banks money. We provided it to them in return for equity. As a consequence two banks were fully nationalised and we have substantial equity stakes in two more. As with all equity investments, there is no guarantee that we will ever get our money back - it depends entirely on the eventual sale price of the remnants of Northern Rock and our stakes in RBS and Lloyds TSB.

- Quantitative easing was not "given" to the banks. It was used to buy securities - which are now held by the Bank of England, increasing its asset base.

However, correcting Murphy's errors isn't the point of this blogpost. It's the appalling suggestion that the UK government should take over organisations whose collective assets total more than four times the UK's GDP.

When I pointed this out to Murphy he brushed it off, claiming that of course when you nationalise you only take on equity, and no compensation would be paid to shareholders. This is true. But when you nationalise you also take on the balance sheets of the organisations you buy. The UK would end up owning trillions of pounds worth of potentially toxic assets. After all, he is proposing nationalisation to prevent financial collapse, isn't he?

Yes, I know we could print lots of money to cover the inevitable losses on those assets. Or we could issue huge amounts of lovely new government debt. But if we're going to do that I would much rather it was spent on something useful. Something that really benefited the people of the UK. Not - absolutely not - on propping up failed institutions.

And the most bizarre part of Murphy's writing comes not in the post itself but in the comments.

I commented on his post:

"Yes, I can disagree. Nationalising banks would leave taxpayers owning $trillions of dodgy assets with no prospect of writedown in any way that doesn’t mean more taxpayers’ money going to the very rich. I for one don’t want any part in that."

He invoked the financial armageddon argument, of course, to justify his position, thereby ignoring the fact that there are other options that could be considered to avoid catastrophe. And he claimed that there's no such thing as taxpayers' money. Weird. But not as weird as the next bit.

I reproduce this in full for the amusement of my readers.

From another commenter called Stevo!!! in response to Murphy's reply to my comment:

"Write the debts down and turn them into equity! The debts are mostly commercial paper. Create enough money to buy them and replace the legitimate debt with cash or number money. All you would be doing is replacing these debts with the equivalent money value, therefore not creating any new money. Write any illegitimate debt off as unrecoverable."

This is odd enough. The commenter clearly doesn't know the difference between assets and liabilities where banks are concerned. But Murphy's response is priceless:

"Since debt is money your logic is sound".

Now, I did say "assets", didn't I? Bank assets are money it has LENT. If the people, companies or - most likely, in this case - countries can't pay the loans back, those assets become worthless and have to be written off. It is total nonsense to suggest that they can be "written down and turned into equity". Writing off bad debts is an immediate hit to profits, which if it results in an overall loss would have to be absorbed by reduction in shareholders' capital. In other words, we would be on the hook for potentially HUGE losses on our investment.

You'd think an accountant would understand that, wouldn't you?

I would like to think that Richard Murphy would take this criticism in good part. I do not mean it as a personal attack but as a genuine contribution to the debate that we need to have about the best way to deal with our dysfunctional financial system. But I am not hopeful, sadly.

Why are they doing it that way, anyway?

2011-08-27T11:51:00.000+01:00

In this blog I am stepping outside my comfort zone, so if I have made any glaring errors, please be kind! But in following the various horror stories, screams of outrage and complacent comments of "I told you so" arising from ATOS's assessments of fitness to work, one thing puzzles me. Why on earth has the Government engaged an external company to do this work, no doubt in return for handsome remuneration, when it already has a huge workforce that is more than capable of undertaking these assessments?

I refer, of course, to GPs.

GPs have access to patient medical records - which ATOS don't. For those claimants who are actually sick, their GP will be the person who manages their condition, refers them to consultants, deals with any aftercare following hospital admissions, sees them for repeat medical checks. Some of this work may well be done by practice nurses or health visitors, but the GP has ultimate responsibility. For those claimants who are disabled rather than sick, the GP is still likely to know them well. Why on earth weren't GPs given the responsibility of assessing claimants to determine what work they could do?

Could it be that our Government doesn't trust GPs to assess claimants accurately? Oh dear. Not a great endorsement of our medical system.

Or could it be that the aim of the Government in outsourcing ESA and DLA claim assessments was not to ensure that those who really are sick and disabled get the money they need to live on, but to eliminate as many claims as possible to reduce the bills and keep Daily Mail readers happy?

A look at the ATOS website (occupational health section) is informative. Yes, they are involved in healthcare assessments for private companies too, so they are obviously experienced in this area. But these assessments are aimed at keeping workforces healthy, reducing absence due to sickness and facilitating rehabilitation back to work. Well, well. It couldn't be that this is what attracted the Government, could it?

Helping people back to work is a reasonable thing to do. But the way they are going about it doesn't make any sense. How can a tick-box assessment by a doctor, nurse or physiotherapist who has never met the claimant before be a better judgement of someone's fitness to work than a GP's report?

The Work Capability Assessment process conducted by ATOS has been seriously criticised by the Parliamentary Select Committee on Work and Pensions. Maybe it's time to replace it with something that really works for both claimants and Government?

Lessons for GFC2 from GFC1

2011-08-24T15:10:00.000+01:00

The other day I read the National Audit Office's analysis of the events in the run-up to the nationalisation of Northern Rock. For a Government publication it's surprisingly readable and I strongly recommend it.

You may think this is ancient history. After all, Northern Rock collapsed over four years ago now. But I think there are still lessons to be learned from this and changes that need to be made to the way the Treasury does things. We still have not devised a method of managing bank failure that does not leave ordinary people - bank customers and taxpayers - on the hook for debts incurred by irresponsible bank management. And the banking sector is still desperately fragile. We urgently need a satisfactory way of dealing with banking collapse.

Lesson no. 1: The importance of planning
Northern Rock was the first of the major bank bailouts in the United Kingdom. It is very evident from the NAO's report that neither the Treasury nor the Bank of England were remotely prepared for this. The Bank of England at that time had no facility for extending emergency funding to banks suffering from lack of liquidity - which was initially all that was affecting Northern Rock. It had to get explicit permission from the Treasury to lend the money. And Northern Rock's handling of the media wa inept. Why on earth was the emergency loan disclosed to the public? They didn't need to know, and all it did was cause panic. The run on the bank was a direct consequence of the disclosure of that loan to the public.

Once the run on the bank began it was evident that the Treasury had no idea how to deal with it. Their kneejerk reaction was to guarantee all bank deposits - including, eventually, wholesale deposits that should NEVER be subject to taxpayer guarantee. The NAO's report makes it clear that the Treasury were winging it throughout, making decisions on the fly. Yet it appears that both the Treasury and the Bank of England had in fact been modelling disaster scenarios and considering emergency measures during the 6 months before the run on Northern Rock. But they hadn't put any of those measures in place. The necessary legislation to provide a stable rescue procedure for failing banks wasn't put in place until February 2009.

The lack of disaster planning for a business sector as key to the economy as banking was, and is, in my view negligent. Even now, we only have a legislated procedure for failure of individual banks. We have no plan for dealing with catastrophic collapse of the entire banking sector. Yet that is almost certainly what we face.

Lesson no. 2: Claim on your insurance!

One thing that struck me in the NAO's report was the fact that the Treasury appears to have totally ignored the existence of the Financial Services Compensation Scheme (FSCS), which already protected most deposits up to £50,000 (now extended to £85,000). This scheme was set up to protect savers and depositors following the near-collapse of Lloyds of London in 2000. Why did the Treasury choose to guarantee deposits and nationalise Northern Rock instead of informing depositors about the existence of this scheme and allowing Northern Rock to go into administration so that they could claim? Even now, bank depositors don't seem to know about the existence of this scheme. Banks don't tell them, and neither does the Government. What on earth is the point of having deposit insurance if no-one knows about it?

FSCS rules do say that a company must have ceased to trade in order for compensation to be paid. And the timescale is not immediate. But Northern Rock was not a clearing bank, so there was no risk to essential payments. What on earth was the tearing hurry in making funds available to depositors? And if there were people who would suffer from not having deposit account funds available to them for months, why couldn't emergency lines of credit for those individuals have been arranged with other banks to cover them for that period? If anyone has an answer to this, please let me know. It looks like a glaring omission to me.

Lesson no. 3: Stop the rot

The nationalisation of Northern Rock, and its separation into "good bank" and "bad bank" didn't happen straight away. During the time between its initial request for emergency funding and its nationalisation, Northern Rock received several infusions of taxpayers' money. But it carried on making bad loans during that period. The NAO's figures for the performance of TOGETHER loans are damning. Why on earth was Northern Rock allowed to continue making these loans? In fact, why did it continue lending at all? Surely if a retail bank is in sufficient difficulty to require continual funding transfusions, the first thing to do must be to stop it lending. After all, the main reason it requires funding is to settle lending.

The other reason it requires funding is to settle deposit withdrawals. I have already commented about Northern Rock's inept handling of its request for emergency funding. But would someone please explain to me why it didn't simply close its doors when the run began? Any commercial organisation can shut up shop for a day or two if it wants to. Of course, there may be some legal restriction specifically for banks that means they don't have this option available to them. If there is then for goodness'sake get rid of it. Banks must be able to close their doors.

I know that both of these measures - temporary closure and cancelling new lending - would have caused a massive loss of consumer confidence. But if depositors want to remove their money they should be allowed to - and if the bank goes down as a consequence, well, tough, really. All the closure should do is buy time for funding to be provided to meet depositors' demands. And Northern Rock's funding problems concealed a much deeper issue. It was very highly leveraged and a growing proportion of its assets were highly risky or actually in default. Why the FSA ever let it get into this state is a mystery, but allowing it to continue lending once this had come to light was ridiculous. Cancelling offers of new lending would have been tough for people trying to buy houses, but as a lot of this lending was to people who couldn't really afford it and for far more than houses were worth, it would have been better for them in the long run.

Lesson no. 4: Who is more important - depositors or taxpayers?

Once it became apparent that Northern Rock was not viable, the Treasury considered various options which are detailed in the report. The main driver behind the decision to nationalise appears to be the belief that depositors couldn't wait for their money. I've already commented on that above, so I won't address it again here. However, given that belief, the Treasury's analysis was reasonable and full nationalisation was indeed the best option for Northern Rock and its depositors. I question though whether it was the best option for taxpayers - and this question becomes even more serious when we look at the part nationalisations of RBS and Lloyds TSB.

For nationalised companies, the validity of the Treasury's assumptions about value to taxpayers depends on the market value of the company. This is unrealised, of course, until the company is sold or floated. At present banking shares are taking a beating: both RBS and Lloyds TSB shares are trading at well below their nationalisation value. If sold now both banks would deliver a loss to taxpayers. Recently the Chancellor actually proposed selling the "good" part of Northern Rock - which is currently making a loss. There is no way that this sale in the current climate would generate any kind of decent return for taxpayers. So at present the Treasury's assumptions about "best value" for taxpayers look very dodgy indeed. Nationalisation may prove to be a simply rotten deal for taxpayers.

Although the Treasury believed it was acting in the best interests of both depositors and taxpayers, therefore, in fact it placed the interests of depositors (and other creditors) ahead of the interests of taxpayers. This principle has applied in all the bailouts of banks worldwide. But is it reasonable? Should depositors (and other creditors) really be regarded as more important than taxpayers?

I don't think so. In fact I think this is a simply dreadful attitude. You see, taxes are paid by people who can't afford to save, as well as those who can. So in nationalising banks, the Government put the taxes paid by the poorest at risk. In effect, those who are too poor to save protected the savings of those who could afford to save. Nationalisation of banks to protect depositors (and other creditors) is therefore an INCREDIBLY regressive action. I am astounded that anyone on the Left regards this as a good thing to do.

Lesson 5: What do we REALLY need to protect?

From everything I have seen and read so far, the nationalisations of Northern Rock and Bradford & Bingley were driven by a misguided belief that depositors must be protected at all costs. I don't agree with this, and therefore I believe these nationalisations were both unnecessary and harmful to taxpayers.

But in the case of Lloyds TSB and RBS, current accounts were also at risk - and these are the lifeblood of our economy. Just about everyone in society has a current account now, even the very poorest. These are the accounts from which essential bills are paid and food is bought, and into which wages are paid. If people can't access their current accounts, they suffer - and the poorest people suffer the most, since they seldom have funds in other accounts. Protection of these accounts is therefore essential. But that's no reason to protect deposit accounts as well.

The problem is that in the banking world, all forms of bank deposits including current accounts are "at risk". You may not think your wages are lent to the bank when they are paid into your current account, but they are. And banks can lose that money through risky activity - particularly excessive lending, which is what caused the failure of Northern Rock, Bradford & Bingley and HBOS (Lloyds TSB). I believe this is wrong. I think that current account balances should be regarded as in safe custody and not available to banks for lending or speculation. And it is sensible in my view for government to guarantee current account balances up to a reasonable limit. Obviously if banks can't use current account balances for lending or speculation they won't make any money on them, so there would be no interest paid on current accounts and there may be fees. But the interest paid on current accounts is pathetic, and we are already beginning to see fee-based current accounts anyway.

So current accounts should be protected. But interest-bearing deposit accounts are a different matter. The FSCS is effectively backstopped by the taxpayer, and has the additional problem that it is funded by a levy on all financial institutions, which means that "good" institutions end up bailing out "bad". I would rather people understood that money placed in interest-bearing accounts is AT RISK, not in safe custody. If they want their money to be safe, safe custody could be made available - for a fee, and no interest would be paid on it. If they want interest then they either need to accept the risk that they will lose their investment, or pay for insurance to protect it. I am sure that private sector insurers would be very happy to offer voluntary insurance to those prepared to pay a premium to protect their cash....with protection against mis-selling, of course. This is how I think deposit-taking should operate in the future.

However, we have a banking crisis approaching in which large amounts of very dodgy debt will put everyone's money at risk. It is all very well saying that ideally people should manage their own risks and abandon banks they regard as taking unacceptable risks with their money. But that's in the future. The present situation is that savers - of all kinds - need protection from the approaching crisis. FSCS is essential, with backstop and if necessary top-up from government. By using FSCS, with additional emergency credit and if necessary payments facilities from the Bank of England, we can ensure that PEOPLE are protected in the coming storm, not the banks that need to be allowed to fail. For that was what went wrong in the first financial crisis. Instead of compensating depositors directly, government supported failing banks such as Northern Rock.

Lesson 6: What if it all goes pear shaped?

I don't know if the Treasury has done any planning for the possibility that the entire banking system may collapse. I hope it has. Because mass nationalisation of banks would be appalling for taxpayers. Not only would taxpayers end up owning a wonderful collection of zombie banks with no guarantee that they would ever come to life again, but they would also own all their assets. And if the banks collapse en masse due to, for example, sovereign debt defaults, quite a high proportion of these assets will be either highly risky or actually in default. Northern Rock on a simply gigantic scale.

There is a cautionary tale here. Ireland bailed out its entire banking sector when the property construction bubble burst. In so doing it bankrupted the country, destroyed the future of an entire generation and reduced its population to penury. It is now massively in debt and its banks are worthless. Do we want to go there? Surely not!

Let's develop plans NOW to allow all banks - including retail and clearing banks - to fail safely, while protecting taxpayers, current account holders and savers from the consequences. And let's work towards a more responsible attitude to lending by banks, creditors and depositors (who of course are also lenders). That way we may survive the coming banking crisis with our economy intact.

Debate with me, don't silence me

2011-08-22T13:50:00.001+01:00

Yesterday someone unfollowed me on Twitter. Well, this is no big deal, really - it happens all the time, and indeed the constant dynamic of following & unfollowing is one of the things that makes Twitter fun. But this one was different.

I was debating with someone who disagreed with something I wrote in my last blog. But instead of engaging with the argument, he complained that I didn't know what I was talking about, that I was "losing touch with reality", and finally sent me a direct message that he was dropping out of the argument. When I tried to reply to that message Twitter informed me that he was no longer following me.

Quite apart from the personal distress that this caused me, I find this behaviour very worrying. This is a person who influences people's thinking: he is a frequent writer and broadcaster, and has a considerable following on social media. And I am by no means the first person that he has unfollowed because of disagreement over politics or economics. If he will not debate, and will only engage with people who agree with him on these matters, then his influence is partisan. But the ability to debate, to disagree and in the end to agree to differ while remaining on good terms, is essential to the working of a mature democracy.

It is not only immature to close down debate because your opponents don't agree with you. It is dangerous. That's what happens in police states. You may think that unfollowing someone on twitter because you don't like their politics is hardly equivalent to banning political opposition and imprisoning those who don't agree with you. But it's the same mindset. The effect is to close down debate and silence your opponents.

I don't want to live in a society in which the only way to be heard is to agree with the prevailing view. It is the rich diversity of views that makes our society dynamic and interesting. And we all have the right to express our opinions, however extreme they may be, without being insulted or silenced. I hope this individual, and others like him, never get anywhere near political power. Heaven help us if they do.

Managing Collapse

2011-08-20T20:15:00.000+01:00

                      "Ah love, could thou and I with Fate conspire
                       To grasp this sorry scheme of things entire,
                       Would we not shatter it to bits, and then
                       Rebuild it closer to the heart's desire?"
                                                      Fitzgerald, Rubaiyat of Omar Khayyam

It seems to me that all the activity of the last three years by banks, governments and supra-national organisations such as the IMF has been aimed at one thing only - preventing the collapse of the international financial system. To prevent that collapse governments have wrecked their economies and sacrificed the future of an entire generation. Yet as I write, the financial system seems to be in no better shape than it was three years ago. In fact if anything it is worse.

I have been arguing for some time now that propping up failed institutions only makes matters worse. If an institution is not viable, it will fail eventually whatever steps are taken to prop it up. The problem is that when it does fail, it brings a lot of others down with it. The larger and more interconnected the failing institutions, the greater the risk they pose to the world economy - and the louder the cries of people who depend on those institutions that governments should act to prevent their failure.

If the international financial system is so fragile that it can only survive with constant infusion of mammoth amounts of public money, then IT IS ALREADY IN A STATE OF COLLAPSE. And as any mining engineer knows, propping it up is not only expensive, it is dangerous.

I would like to suggest that the international financial system should be ALLOWED to collapse. That doesn't mean that governments should abandon their responsibility to protect the people affected and as far as possible prevent long-term damage to the economy. On the contrary, governments should be actively involved in managing the collapse of the current unsustainable system and the building of a new system that meets our needs better.

But that requires a mindset change on the part of global leadership, and particularly central banks and the IMF. At present they think only of maintaining the status quo. And while they continue to think and behave only in terms of keeping the ship afloat, the greater the risk to the world economy. When the inevitable collapse happens, they will not be prepared for it and the world economy could indeed suffer serious damage. But that's not necessary. Planning for and managing the inevitable demise of an outmoded form of banking has to be the best way forward.

Why do I say it is outmoded? Consider this.

1. The lifeblood of our economy is payments. But there is no particular reason why payments should be made only via banks. Mobile phone companies have the technology to perform electronic funds transfers and are beginning to do so in a limited way. As we move away from paper-based transactions such as cheques, the need for back-office banking diminishes and the front end increasingly becomes electronic. And even paper-based transactions don't have to be handled by banks, anyway. A friend of mine runs an independent cheque processing company. At present the actual payments side can only be done through a clearing bank, but why shouldn't his company have direct access to BACS, CHAPS and the like?

2. The other key financial component of our economy is lending. Without bank lending, nothing moves. Banks have a complete stranglehold on the economy because they alone create the money that we use to buy goods and services. And because our economy is so dependent on bank lending it is prone to credit bubbles and credit crunches. When banks are feeling good about things, they lend - far too much, at too low a rate to the wrong people. The result is a credit bubble. Credit bubbles cause overspending in the economy, consequent overproduction (or importing) and eventually inflation. Then banks realise they have overstretched themselves - some of them get into trouble and have to be bailed out by governments - so they stop lending to ANYONE except those who don't need it. The result is a credit crunch. Credit crunches cause rapid deflation and recession. All of it is caused by the propensity of banks to over-lend in good times and under-lend in bad times. And in the background are governments which have no real control of their economies. Do we really want our lives controlled by banks? Surely there must be ways in which people and companies can borrow the money they need without messing up the economy?

3. But, people argue, banks can't possibly over-lend because they only lend out an agreed multiple of what they receive in deposits, don't they? Wrong. Banks don't actually need deposits in order to lend, so they don't seek to attract them and they don't offer a good deal to savers. Banks can obtain the money they need to settle lending by borrowing from other banks (particularly investment banks), issuing securities or borrowing from the central bank. Deposits are an optional extra. So the whole premise of "fractional reserve banking", that banks lend out a multiple of the deposits they receive, is fundamentally wrong. Modern bank lending doesn't rely on deposits at all. Which is just as well, because....

4. Bank deposit and savings accounts no longer hold people's life savings. Most savings are invested through managed funds in the investment banking sector. Retail banks simply act as a "front end" for selling those products to the customer. Yes, people still deposit funds in bank accounts, but generally those are EXCESS savings which people put aside for a short period of time and draw down as and when needed. The level of savings in bank accounts, as opposed to pensions, endowments and other forms of long-term investment, has dropped catastrophically since the 1960s. Loan to deposit ratios in retail banks are at an all time low. Do we really need traditional bank deposit accounts at all, any more? And if we do, how do we make them sufficiently important to banks for banks to offer a decent rate of return?

5. Conversely, the investment banking sector is awash with funds - and contrary to popular opinion these are NOT provided by retail depositors but largely by pension and endowment investors.  The volumes traded on international financial markets are HUGE and the frequency of trading is approaching warp speed. No longer are investors buying newly-issued securities and holding them long-term, generating returns from coupon payments and dividends. No, these days it's all about short-term returns. The "search for yield" - higher and higher rates of return for investors - was the key driver of Wall Street's excessive risk taking in the run-up to the global financial crisis. Very little of this activity gives real benefit to people through economic growth or decent returns on their investment: most of the return ends up in the pockets of the very rich.

6. There is a toxic link between retail lending and financial markets. Securitization allows over-extended retail banks to move loans they have already made off their balance sheets so that they can lend some more. They do this by packaging those loans up as securities and selling them on into the international financial marketplace. This would be fine if the risk of those loans was low. But it isn't. Securitization is routinely used in Japan and the US to remove non-performing loans from bank balance sheets. The reason these loans are non-performing is because the debtor is in trouble. They are risky by definition. Additionally, there is evidence that securitization encourages riskier lending. After all, if you can get rid of the loans, you don't have to worry about the risk, do you? But when sufficient numbers of securitized loans go bad, the result is DISASTROUS. The Global Financial Crisis of 2008 was primarily caused by failure of securitized retail loans.

I do want to make it clear that securitization itself is NOT the problem. Indeed, because capital markets are better able to price and manage risk than retail lenders, judicious use of securitization can enable lending to groups that otherwise might struggle to obtain finance. The problem is the moral hazard that that creates for lenders, and the fact that when lending is securitized large amounts of high-risk lending endangers the global financial system. I have written on this in another place.

7. And finally, there are practices in the investment banking sector that would be illegal if done anywhere else - insuring assets you don't own, pledging someone else's property as collateral for lending, ponzi schemes, mispricing and mis-selling. Complex maths and big words are used to hide the reality of what is really going on. If an investment banking practice or product is described in words of more than three syllables or priced using formulae containing Greek letters it's almost certainly dodgy.

I could go on to discuss the role of big banks in money laundering and international crime, the various scams that banks have inflicted on their customers (PPI, for example), the price fixing and cosy cartels, the advertising doublespeak that convinces people they are getting a good deal when they are really being scammed. But you've probably heard enough already. Do we REALLY want to preserve this? It's rotten to the core. Wouldn't we do better to allow the whole thing to implode? It is no longer working in the best interests of its customers - it is entirely self-serving, rapacious and greedy, bleeding people, companies and countries dry while it becomes ever more bloated and its main protagonists ever richer.

But how to manage the collapse of this monstrosity? First, we must stop feeding it. Ideally there should be NO MORE injections of public money. At present we are hearing demands for governments to provide liquidity (cash), increase bank capital (shares), and provide funds to countries to enable them to meet debt interest and refinancing obligations to banks. I agree that in order to manage collapse in such a way as to create a soft landing, it will probably be necessary to continue to provide some funding in the short-term. But the aim should be to withdraw all public financial support from the banking system, and it should be made clear to banks that if they get into difficulties because of the withdrawal of public funding - including debt payments - they will not be bailed out.

Secondly, there should be a programme of debt forgiveness for countries that have got themselves into serious trouble. Playing the blame game ("it's their fault, so they should suffer") doesn't help the people of those countries to rebuild their lives and revitalise their economies - which in the end is MUCH more important than paying off banks. Banks can and should take the hit for their irresponsible lending. After all, they received the returns on that lending in the good times.

Thirdly, it should be made plain to people and banks that deposit insurance is for PEOPLE not banks. Government should put in place through existing insurance schemes (and possibly new private insurance) measures to ensure that people's life savings, especially their pensions, are ADEQUATELY covered. And government should have ready emergency measures to enable payments to continue to be made in the event of failure of a major clearing bank, and to provide short-term financial support to people and companies whose money is temporarily inaccessible. Failing banks should go through a form of financial administration in which assets are sold and creditors paid off with the proceeds as far as possible. And if all our banks end up in landfill - well, we need replacements, don't we?

I don't think we need to worry about what would replace the present system. There are already businesses waiting in the wings for an opportunity to enter the financial marketplace - as this blog from Simon Cooke describes - who are being denied that opportunity by the dominance of the dinosaur banks. For the moment the dinosaurs are being kept alive by more and more artificial intervention to preserve their habitat. But when the asteroid of public debt default finally hits the dinosaurs will be wiped out, and a new breed of financial institutions will take their place.  And this is what goverments should be planning for, not preservation of a corrupt and outdated system. The economic adjustment will be painful, and it is the job of government to protect the people who will be hurt and support the development of new forms of banking. But the result should be a more efficient, more stable and more effective financial system. It would be well worth it.

Black Thursday

2011-08-05T04:32:00.000+01:00

As I write, it is four in the morning and I am watching the Asian stock markets falling. Yesterday both the FTSE100 and the Dow Jones crashed, and further falls are expected today. No-one seems to have any real idea why stock markets are collapsing around the world. But on one thing everyone is agreed - we have a worldwide financial crisis. Global Financial Crisis Two (GFC2) has landed.

The seeds of this crisis were sown in the Global Financial Crisis of 2008 (GFC1). In fact you could say that that crisis never really ended, it just calmed down for a while. We have been in the eye of the storm, but now the winds are lashing us again.

The reason why it has all blown up again is very clear. We didn't actually fix the problems that caused the 2008 GFC. All we did was move the problems to countries instead. Which makes things worse.

In 2008 many major banks, and one huge insurance company, failed due to assets turning out to be worthless, and massive uninsured liabilities. Other banks failed because interbank markets froze and there was, at the time, no other major source of cheap funds. Our solution to these problems was to take the debts of these banks on to national balance sheets, and to provide more low-risk liquid assets to markets to prevent them freezing again. This was the biggest transfer of private debt to the public sector in history. Now let's be clear about what this really means: it was the transfer of INSTITUTIONAL DEBT to INDIVIDUALS. It was not governments that bailed out the banks. It was taxpayers.

The result is that many countries that bailed out their banks are heavily indebted - yes, obviously there are assets (shares) offsetting those debts, but those are unrealised and after yesterday worth a lot less than a few days ago. Furthermore, the collapse of the banking system sparked a deep recession during which national debts around the world rose enormously as tax receipts fell and benefit payments increased. Now, it is normal for public debt to increase in a recession, and this should sort itself out once the economy starts to grow again. But our economies haven't grown, and the debt levels in many countries have become unaffordable. The result is that we now have a sovereign debt crisis. Whereas in GFC1 the failing institutions were banks, in GFC2 they are countries.

This is appalling. When a major bank fails, depositors lose money, borrowers may have loans foreclosed, and if the bank is a clearer essential payments may not be made. That's bad enough, and it is easy to see why governments believed that these problems were serious enough to warrant using taxpayers' money to prevent banks failing. But what we now have is a thousand times worse. Bankruptcy for a country means years and years of poverty; it may mean forced asset sales, massive unemployment levels, demolition of welfare and withdrawal of benefits. It may even mean that salaries aren't paid, sometimes for years, that power and transport systems fail, and that food becomes unobtainable or unaffordable. We have seen all of these happen in various countries in the last few years, notably in sub-saharan Africa, in Latin America and in Eastern Europe. But nobody ever thought this could happen in the rich Western World.

Well, it is happening, right now. And we don't know what to do about it. The recent US debt ceiling farce arose because there is no political agreement on the best course of action to manage the US's humungous debt. The EU has come up with one scheme after another to provide funds to Greece to enable it to pay its debts, all of which have foundered on a rock called "default". Meanwhile other EU nations are also experiencing debt distress, which the EU so far has simply refused to acknowledge. The UK is standing on the sidelines looking virtuous while slipping further and further into economic decline. No-one is fooled.

There is a leadership vacuum in the Western world. Since the US debt ceiling debacle and the abject failure of all the EU's silly schemes for bailing out ~~German and French banks~~ Greece, not one political leader now has the credibility to take the lead and decide what to do. Lagarde, the new IMF head, looked promising - for about five minutes: then she was tarnished by a possible corruption scandal and that was the end of her as a credible political leader for this ghastly mess.

So is it really so surprising that markets are collapsing? We have an unstable, highly indebted financial system, unstable, highly indebted corporations, and unstable, highly indebted countries. And we have no-one capable, it seems, of sorting it out.

It seems to me that we have ignored some very fundamental principles in our handling of the GFCs. The first one, for me, is that IT IS NECESSARY FOR FAILING INSTITUTIONS TO FAIL. It may seem less painful to prop them up, bail them out, throw money at them, change their management teams, load them with heaps of regulation, even break them up into smaller bits. But we've seen all this before, notably with the big nationalised industries of the 1970s. All the support they received from the taxpayer wasn't enough to stop their eventual closure. It just cost lots more and hurt lots more people. Isn't that exactly what we are doing with our zombie banks - keeping them going at taxpayers' expense? For how long can we realistically maintain the illusion of a healthy, well-functioning banking system? It isn't anything of the kind. Without taxpayer support it would collapse. Please, let it fail. Then maybe from its ashes a new financial system will arise, which would genuinely operate as the public service it should be.

The second principle in handling the GFCs is this: PEOPLE NEED TO BE PROTECTED FROM THE CONSEQUENCES OF INSTITUTIONAL FAILURE. And here's where we went wrong in GFC1. We confused protecting people with propping up failing institutions. Yes, if a major clearing bank fails, depositors need to be protected from losses, borrowers need to be protected from sudden foreclosure, and emergency measures are needed to ensure that essential payments can be made. But that doesn't mean the INSTITUTION should be bailed out. It should be allowed to fail.

Had the indebted banks from GFC1 been allowed to fail, the US and UK public debt levels would not be the size they are (and we wouldn't be losing shedloads on share value writedowns). The only major expense arising from supporting people is depositor cover, and much of that was already covered by insurance anyway. Emergency arrangements could have been made with other banks to cover payments, and lending portfolios could have been resold by administrators - including, in my view, toxic assets. There's always a market, even for risky debt.

But what about Europe? The debt levels in the European periphery don't come from bank bailouts, except in the case of Ireland, which absolutely shouldn't have bailed out its banks and I for one am appalled that it did. They come from overspending.

Well, that's true. But it is still about bank bailouts, really. None of the money that has been lent to Greece by the ECB has gone to supporting people so that they can rebuild their lives and revitalise the Greek economy. Had it done so, in the short term banks (mainly French and German ones) would take a loss, but in the longer term Greece would be able to pay them off because economic growth would give it the means to do so. But instead, the money that has been lent to Greece has gone to pay French and German banks. In other words, German and French taxpayers have bailed out their banks - again. Greece was just an intermediary, though it was asset-stripped in the process mainly so that German taxpayers didn't realise they were being scammed. Were they fooled? Maybe. But we're about to repeat the same mistakes with Portugal, Spain, Italy - and that's where the German taxpayers (I hope) dig their heels in and shout "NEIN!". No way should taxpayers be on the hook for the consequences of stupid lending by their banks. Peripheral Eurozone countries aren't going to pay their debts. Those banks' assets are toxic. Let them fail.

The way we handled GFC1 was a big disaster, and because of that we now have an even bigger disaster. Will we get this one right? It's not looking good at the moment.

Flannel and ostriches

2011-07-16T13:58:00.000+01:00

Yesterday the European Banking Authority (EBA) published the results of its "stress tests" on European banks. The full report is here for those with time on their hands!

The "stress tests" were designed to test the ability of European banks to withstand economic problems such as recession. Losses arising from difficult economic conditions should be absorbed by shareholders' equity (common stock) and retained earnings - what is known as "Core Tier 1 capital" (see my blog explaining this, Reserve Confusion).

Banks have historically held very little Core Tier 1 (CT1) capital, so in the financial crisis they had little ability to absorb losses, and taxpayers were forced to provide funds to many banks to prevent creditors (bond holders and retail depositors) losing their money. Financial regulators around the world have since required banks to hold a higher percentage of risk capital, particularly CT1, against risk weighted assets. The European stress tests demonstrated that only 8 European banks have less than 5% CT1 against risk weighted assets and a further 16 have less than 6%. Out of 90 banks tested, that isn't too bad, is it?

Actually it's flannel. The Basel committee recently recommended that internationally-active banks should have CT1 of 7% of risk weighted assets, and systemically-important banks should hold an additional 2.5%. Now, not all of the banks tested are internationally active - the Spanish Cajas, for example, are domestic banks. But a lot are, and some are systemically important. So the EU test has actually set a low bar for CT1 and applied it equally to all banks, whatever their size and significance. Reuters produced a useful little calculator yesterday which shows how many banks fail if the capital requirement is raised to higher levels. Apart from being great fun to play with, this calculator shows - worryingly - that if the EU had used the base Basel requirement of 7%, 41 banks would have failed. And at 8% 53 banks fail. Highest on the list - i.e. needing to raise the most actual capital in monetary terms - are some banks that without question are systemically important, such as RBS, Deutsche Bank and Societe Generale. There isn't a snowball's chance in hell that they will meet the enhanced Basel requirement of 9.5% CT1 in any reasonable timeframe.

That's bad enough. But the EU test is also structurally inadequate. It ignores the biggest risk to European banks at the moment - the risk that there will be sovereign debt default in more than one country. Yes, the tests show that overall the European banking system can withstand Greek default, although Greek banks would fail. But withstanding default by Ireland, Portugal and maybe Spain and Italy too - on only 6-7% CT1, which is what most EU banks have? I don't think so.

Pity the EU taxpayers, especially German ones. The main thing the stress tests have proven is that if there is a string of defaults, they will have to stump up. And that will be inevitably followed by recession and austerity in the whole EU, not just the countries defaulting.

The structural inadequacy of the EU test, and the low capital requirement, arise from the fact that at the moment no EU leader is prepared to admit that multiple sovereign default is even a serious risk, let alone likely to happen soon. I am reminded of the last line of Flanders & Swann's The Ostrich: "Here in this nuclear testing ground/ Is no place to bury your head!". Let's hope the EU leaders get their heads out of the sand and come up with a sensible plan for dealing with excessive debt burdens in peripheral countries before the Eurozone blows up in their faces.

Trust in danger

2011-07-10T14:08:00.000+01:00

Hot on the heels of Johann Hari's exposure as a plagiarist - and comments from many that "he's not the only one" - comes the disorderly demise of the News of The World amid allegations of phone hacking. And again, comments from many that "they're not the only ones".

Think back a few years. Do you remember the MPs expenses scandal? The initial belief from Conservatives that "it wasn't any of us" only to discover that yes, it was some of them as well? Suddenly policitians could not be trusted with the nation's finances. Corruption was exposed.

Now look at the financial crisis of 2008. I know I keep singing this tune, but what was exposed was excessive risk-taking and fraud in retail banking. Traditional, safe retail banks suddenly could not be trusted with our money. Admittedly considerable attempts have been made to blame investment banking for the crisis, because that's always been a bit dodgy, hasn't it? But the reality, that people know in their hearts, is that high street banks are not trustworthy.

The three professions of journalist, politician and banker all depend upon trust. Investigative journalists need to be believable or no-one will take their output seriously, and they need to be trustworthy or no-one will tell them anything. Politicians depend on trust for their mandate to govern - once the trust of voters is broken, the next election is lost. And banks need people to lend them their money, trusting that the banks will look after it properly.

Not only do these professions depend on trust, people need to be able to trust them. The media hold immense power over opinion and can massively influence behaviour simply by presenting researched facts and coherent opinion. Even if those facts are wrong people still believe them if they have been reported in a quality newspaper - as I discovered when I corrected the Guardian over the reporting of Barclays 2009 results. As a nation we need to be able to trust that the people we elect to represent us in the Mother of Parliaments, and by extension the people we appoint to govern us, will act fairly, honourably and in our best interests. And as individuals we need to trust that our financial institutions will treat our money with respect and honour their obligations to us.

We have in the last few years had our trust in all three professions shattered. And we are deeply shocked. Confidence in the electoral process, in party politics and in government is at an all-time low. Politicians are seen as looking after their own interests and those of their rich friends, rather than the interests of the people they serve. Bankers are seen as ripping us off to make huge amounts in bonuses: these days, even used car salesmen and estate agents are regarded as more trustworthy than bankers. And journalists are seen as amoral sensationalists, who will stoop to the lowest depths to spin a story and if necessary fabricate it, caring not at all about the cost to the lives and reputations of the people involved.

Isolated instances of bad (even criminal) behaviour by a member of a profession don't cause this deep-seated malaise. Dr. Harold Shipman, the worst serial killer in UK history, was able to kill so many people because his profession as a GP meant that people trusted him. But his conviction for murder didn't destroy people's trust in the medical profession. Similarly, the few examples there have been of teachers prosecuted for child abuse haven't resulted in huge numbers of people refusing to trust teachers with their children - but a much larger number of child abuse cases among Roman Catholic priests has resulted in a massive loss of trust in the priesthood. Even if they are not paedophiles, priests are treated as if they might be.

So if journalists, politicians and bankers now are not trusted it is not because of individual bad behaviour by the likes of Johann Hari, Elliott Morley and Fred Goodwin. It is because there have, over a period of time, been sufficient examples of immoral or criminal behaviour by members of these professions to make people suspect that such behaviour is not exceptional but is the norm.

Loss of trust in such powerful professions is terrible. All three have really important roles to play in our society, though the power they wield has gone to their heads and they seem to have forgotten that their first priority is to serve the people of the country with honesty and integrity. All three are now discovering that they have no future without the trust of the people they serve.

And now it appears that the police, too, are part of the general malaise. Senior police officers have routinely failed to investigate possible criminal activity by newspapers and banks in the interests of "maintaining good relationships". Cover-ups are the order of the day. Yes, Sir Paul Stephenson has done the decent thing and resigned - but Mark Reckless's blog today points out that he has got out just in time to avoid the dirt hitting him: in 2009 he failed to investigate major News of the World phone hacking allegations properly. And Yates, of course, is still hanging on in there. Trust in the police - already undermined in some sectors of society by heavy-handed police tactics in UK Uncut marches - is sliding downhill at a rate of knots.

What can members of these professions do to regain our trust? What can be done to shift the public perception that there is a cosy elite who rub each other's backs? Cameron's statement that "we're all in it together" looks more like "they're all in it together".

I don't have any easy answers. Honesty and transparency would help, though that looks like it's in short supply these days. But public servants - which is what all these people are, even those who ostensibly work for commercial organisations - must recognise that their first duty is to the people of the country. Behaviour that hurts ordinary people in the interests of selling more newspapers, making more money or getting more votes is unacceptable. Those who are shown to be indulging in such behaviour should be called to account.

Pulling off the plaster

2011-07-06T02:39:00.000+01:00

On my blogpost "There's no more money" I stated that one reason for the Bank of England's QE programme was to stave off deflation. There has been one comment in response:

"Why is deflation bad?"

It's an amazing question.

My immediate reaction was "well, obviously it is". And then I thought, "well, actually it's not obvious at all, and I don't know the answer". So I did some research to find out what economists say about whether deflation is a good or bad thing. I found Krugman's article on this, and several others as well. As I expected, Krugman's article was accurate in description but uniformly negative in opinion about deflation. But the others were more balanced. And one, ElliotWave, pointed out that deflation was not bad unless you were unprepared for it.

Now, according to ElliotWave's description, the UK is pretty unprepared for a period of deflation. Households, businesses and government are all carrying exceptionally high levels of debt. Government debt is heading for 70% of GDP. Individual debt is over 100% of GDP. And corporate debt is higher still. But deflation seems to be what everyone wants. The Government is putting in place measures designed to reduce the rate at which government debt is growing, which generally reduce the amount of money available, to households in particular. Banks are not lending anything like the amounts they were prior to the financial crisis. And individuals and businesses are choosing to pay down debt rather than spend money. All of this adds up to a severe and rapid contraction. Deflation is not just a risk, it is inevitable.

But my questioner wants to know whether deflation is a bad thing. And after reading all those articles and papers, I don't know any more than I did before, except that this is another subject on which economists don't agree. But of one thing I am certain. Whether deflation is a bad thing depends on the circumstances. And in the present economic circumstances I don't think it is a bad thing at all. I think it is essential. The only debate should be over how fast the economy should deflate.

Let me explain my thinking.

The prosperity of the ten years to the financial crash in 2008 was built upon a credit bubble, not on real economic growth. There was no sound economic foundation to this prosperity. In effect, the UK was living beyond its means. As a consequence of this, many businesses and individuals are carrying historically unprecedented and unsustainable levels of debt. This debt is now much more expensive than it was a few years back, and tighter lending conditions mean refinancing it is no longer an option for most people and businesses. The only other option is to reduce it, and that is what people and businesses are doing.

Debt reduction causes shrinkage in the money supply, which increases the value of monetary units and therefore tends to reduce prices. This is deflation. Under normal circumstances this shrinkage would be offset by expansion in the money supply due to new bank lending. But at present the banks aren't lending at anything like the levels required to offset private sector debt repayment. Nor should they be. After all, the private sector wants to reduce its debt, not take on more. So deflation is necessary if the private sector debt burden is to be reduced - unless, of course, the reduction in private sector debt is offset by increases in public debt.

Officially, we don't have deflation as such at the moment - we have inflation, mainly due to a VAT increase coupled with rising world prices for fuel and food prices. But the pattern of behaviour in the domestic economy is definitely deflationary. House prices, which have been inflated due to the credit bubble, are falling, and the retail sector is turning in awful results. People and businesses are reducing their spending across the board, and rising prices in some sectors are simply encouraging people to make even deeper cuts. Were this not the case, external factors would mean that inflation might well be quite a bit higher than it is at present.

Government policy so far has ignored the drive to deleveraging in the private sector and concentrated on controlling public sector spending while stimulating the economy in various ways to promote growth. These measures include a failed attempt at demand stimulus through quantitative easing; corporate tax reduction; measures to improve lending to businesses, both through the banks and directly from government; light-touch regulation of tax avoidance measures such as offshoring. All of these are bound to be ineffective if the private sector prefers to pay its debts and sit on its cash, which is what is happening. Near-zero economic growth is here to stay while the private sector isn't spending.

The question is, do we really need to push for economic growth at the moment? Or should we accept that the UK economy is rebalancing itself, deflating the unsustainable credit bubble and returning to a more stable, if smaller, base? If we interfere with this so as to slow down the rate of contraction or delay its effects - for example by encouraging more bank lending to businesses, or increasing debt-financed public spending - do we make the necessary adjustment easier to bear, or do we simply turn an excruciating but mercifully short adjustment into a long-drawn-out agony?

I don't know the answer to this. But I know how I prefer to take off sticking plaster.

Sausage factories

2011-07-04T04:53:00.000+01:00

I'm aware that most of my posts so far have talked mainly about the way the UK retail banking system works and its role in the financial crisis of 2008. It has not escaped my notice that the US retail banking system is very different, but I must admit that until a recent twitter conversation with Cate Long I hadn't realised just HOW different it is. In particular, the US mortgage market operates in a fundamentally different way from the mortgage market in any other country - and that very different model was at the heart of the financial crisis not only in the US but throughout the Western world.

I'm also aware that some of my blogs get quite technical and they aren't always jargon-free. And the way the US mortgage market works is complex and hard to get your head round without illustration. So I thought I would describe it in terms of something much more familiar. I'm going to talk about sausages.

Imagine there are a hundred small farms all producing various varieties of meat - chicken, lamb, beef, pork. They sell some of their meat locally, but most of it is bought up by two huge processing plants. These processing plants dump all the meat, irrespective of its type, into huge vats, where it is boned, skinned and minced. It is then processed into sausages, which are packed up and sold on to domestic supermarkets and exporters. The exporters repackage the sausages under their own labels, taking some of them apart and creating new sausage-based products such as tins of baked beans with sausages in, tinned sausage stews and frozen sausage pies. Many of these repackaged sausages are exported, particularly to the UK and European countries where sausages and sausage-based products are popular because they are cheap and tasty.

Sounds like a really good, sound international industry, doesn't it? What could go wrong?

The meat that is produced is of course inspected by meat inspectors to make sure it is fit for human consumption before it is sold. And in the past the standards were high and quite a lot of meat didn't pass the test. This annoyed the farmers, because they couldn't get rich from farming, and it annoyed the factories, because they couldn't get enough meat to satisfy their international customers.

One day an enterprising farmer had a moan at the meat inspector about the meat standards and the fact that so much of his meat was only fit for pet food. To his surprise he discovered that the meat inspector agreed with him. So between them they came up with a scheme whereby some of the meat that should be condemned would actually be marked as "fit for human consumption" and sold at the higher price. Not all of it, of course - too much and questions would be asked. But enough to give a nice little boost to farm profits. The meat inspector got a cut of the proceeds, of course.

The farmer told his (equally frustrated) farmer friends about his friendly meat inspector. And the meat inspector told those of his colleagues he knew held similar views to him on the stupidity of meat standards. And before long, several farms were working with helpful meat inspectors to pass on some meat as "fit for human consumption" when it should have been condemned.

Well, the inevitable happened, of course. There was a massive outbreak of E Coli, initially in the UK and then in the US and various European countries. Hundreds died, and thousands more were very ill. Hospitals were unable to cope with the influx of sick people, and nurses and doctors worked around the clock but were still unable to treat everyone. Stocks of medicines ran out. Businesses lost money and many went bankrupt because so many of the workforce were ill. Governments declared national emergencies and asked unaffected countries for financial and medical assistance. It was a major global disasater. But no-one could work out where it had come from.

The obvious culprits initially seemed to be the export firms. After all, they were doing major repackaging and reprocessing operations: maybe some of their practices were a bit dodgy. And investigations discovered that that was indeed the case. Some of the export firms were adding potentially lethal substances to their products to make them look more attractive to housewives. And consumer watchdogs, noticing the pretty packaging, attractive colour and pleasant smell, were giving them top-notch approval ratings, which encouraged more consumers to buy the products. But if that was the only cause, how come people in the US were dropping like flies when all they had bought was sausages?

All the way down the line, companies involved in meat reprocessing were going bust. People just weren't buying sausages and sausage-related products any more. The export market collapsed. It was a major disaster for the industry. So the government stepped in to provide financial support to these companies so that they could find alternative suppliers and rebuild their shattered reputations. The largest amount of support went to the two giant factories.

Government investigators soon realised that although the export companies were making matters worse by their use of toxic substances in reprocessed products, they weren't the source of the E Coli outbreak. So they looked at the two sausage factories. Everything looked alright there - the factories were clean and hygiene standards were good. So they started to look at the farms themselves. And it soon became apparent that all was not well. Some of these farms had poor hygiene and animal welfare standards, others had untreated TB in cattle and there was an outbreak of swine fever in one area. All of these should have reduced or stopped the sales of meat from those farms - but it hadn't. Eventually, after much snooping and undercover work, the investigators started to expose the collusion of some farmers and meat inspectors. Prosecutions followed, of course. Interestingly, in the course of one of those prosecutions it emerged that both the factories had known about the public health risk and turned a blind eye.....they were only too happy to have the additional meat so they could produce more sausages.

The underlying problem was, of course, fraud. But had the meat that should have been condemned only been sold in local markets and not passed on to the factories, there would have been small local outbreaks of E Coli which would have been easily contained and the culprits identified and prosecuted quickly. Because it was sold on to the factories, which mixed it up with good quality meat and repackaged it, it went EVERYWHERE. Every sausage produced by the sausage factories was potentially a public health risk. And there were millions of them, and they were sold all round the world. So what started as a small-scale scam by a few disgruntled farmers and unscrupulous meat inspectors became a global public health disaster. It took years for the economies of the countries affected to recover. And the people who lost loved ones, or who were scarred by their illness, will never recover.

It's a horrible story, isn't it? Fortunately it has not happened. Or has it? Try substituting "mortgage" for "meat", "RBMS" for "sausage" and "financial" for "public health" in the above tale and see what happens.....

There is no more money!

2011-07-04T00:51:00.002+01:00

Yesterday I had a conversation with several people who believed that the purpose of Quantitative Easing (QE) in the UK and the US was to provide cash to banks so that they could lend more. They called it "printing money" and insisted that it would cause inflation and therefore lead to interest rate rises, which is a bad thing, of course, isn't it?

They have missed the point completely.

QE is an interest rate management tool. Nominal interest rates (base lending rates) in both the US and UK have been nearly zero for a long time now. Low interest rates would normally encourage spending - which is needed to stimulate economies - but both these economies were in such a poor state after the financial crisis and ensuing deep recession that near-zero rates made little difference and there was a serious risk of deflation. It was not possible to cut nominal rates further as this would make them negative, which would mean central banks were paying commercial banks to borrow money. However, real interest rates in the form of bond yields needed to fall further to encourage financial divestment and spending.

Both the Fed and the Bank of England therefore initiated asset purchase programmes. They bought up corporate bonds and equities, along with their own debt instruments, in return for short-dated Treasury Bills. These Treasury Bills were new issues (i.e. invented money) - which is where the accusation of "printing money" comes from.

The effect of these asset purchases was to reduce the supply of corporate and government bonds and equities in the financial marketplace, which raised their prices and depressed bond interest rates (yields). That's what QE was supposed to do - and it did work to some extent. Real interest rates did indeed fall and deflation has (so far) been avoided.

There was a secondary effect, which was to increase the amount of liquidity in the financial system. Treasury Bills have to be intermediated into currency by banks, so all purchases of assets under the QE programme resulted in increases in bank deposits at least on a short-term basis. In effect, financial institutions sold long-term investments for cash, and temporarily parked that cash at commercial banks, increasing their cash reserves. Now banks could indeed have lent this out to commercial borrowers - if they wanted to. But they didn't have to, and the evidence is that all they did was lend it to each other or (mainly) back to the central banks. So QE did NOTHING to encourage bank lending. Nor was it intended to. The Bank of England itself says that although the extra cash reserves could be lent out, banks might not choose to do that when they are trying to repair their balance sheets. Contrary to popular belief, QE does not increase bank capital - and it is capital that banks need if they are to lend more.

My friends also thought that QE inflated commercial banks' balance sheets with extra cash reserves paid for by the taxpayer. This is nonsense. Firstly, the new issues of Treasury Bills were NOT paid for by the taxpayer - they were simply created "from thin air" by crediting recipient deposit accounts. Secondly, the newly-created Treasury Bills were then used to buy an equivalent quantity of longer-dated financial assets, mostly from institutional investors rather than banks. So if there has been an influx of cash reserves in commercial bank balance sheets, it is because institutional investors have chosen to park their money there rather than spending it on other investments. Since banks generally are not increasing their lending portfolios, the increased deposit balances would be offset by a reduction in other forms of bank borrowing, so would not make any difference at all to the size of bank balance sheets. Bank balance sheets are no bigger than they were before. The only banks that DO have bigger balance sheets as a consequence of QE are, of course, the Fed and the Bank of England, who now hold large stocks of corporate bonds, equities and government bonds. These will be sold in due course once the economy improves.

And now to the inflation question.

My friends believed that the newly-issued money actually made its way into circulation, increasing the amount of money in the economy and therefore debasing its value, which causes inflation. This again is nonsense. The only way money can get into the economy is through bank lending and corporate bond issuance, and as I have already noted, banks weren't lending (and still aren't) and businesses are not investing. Even if they were, part of the reason for the poor performance of both US and UK economies is people and businesses in the private sector paying off debt, which reduces the amount of money in circulation. So although QE did increase the cash reserves available to banks, there is no evidence that much of it got into the real economy, and whatever did reach the real economy simply offset the money being destroyed by deleveraging. There is NO more money in the economy as a result of QE.

However, they were right about QE causing inflation. That was the purpose of the QE programme. A small amount of inflation is necessary in a healthy economy: zero inflation indicates stagnation, and negative inflation is deflation. Near-zero inflation rates in a demand-depressed economy are very bad news because they can signal the start of a deflationary spiral. In the UK the Government sets an inflation target and the Bank of England is responsible for taking the measures necessary to keep inflation around that target. Dropping too far below the target is just as bad as exceeding it. So the purpose of QE was to raise the inflation rate to around the Government's target by stimulating demand in the economy.

And yes, this should then lead to interest rate rises. Near-zero interest rates over the long term are indicative of an economy in very bad shape - as Japan's experience shows. A healthy economy not only needs some inflation, it needs positive interest rates. QE was intended to raise inflation by stimulating demand so that nominal interest rates could be increased to a more normal level.

So yes, QE would increase inflation, and this should eventually lead to interest rate rises. However, it doesn't seem to have been very effective, at least in the UK. Inflation is now well above the government's target, but interest rates are still near-zero and there is a serious demand slump in the domestic economy. Now if the inflation in the economy were due to QE, demand would have improved, wouldn't it? So it can't be due to that. In fact the inflation we are now seeing is due to external factors, especially high global prices for essential commodities and oil, coupled with consumption tax increases.

In fact QE has been a spectacular failure. And my friends were right about one thing - the lack of bank lending is the reason why it hasn't worked. QE requires banks to be lending normally and businesses to be investing normally in order for the additional liquidity to find its way into the real economy, which is where the demand stimulus is needed. But they aren't, and no amount of extra cash will persuade them to do so if they don't want to.

So the prevailing beliefs about QE, peddled by journalists who don't know anything and don't bother to do their research properly, are totally, utterly and completely wrong. Unfortunately a lot of people believe them. Which is why I wrote this blog. SOMEONE has to explain how it really works!

Asking the wrong question

2011-06-30T15:40:00.000+01:00

Today on BBC Radio 4, Francis Maude made the mistake of discussing the "affordability" of public sector pensions with the formidable Mark Serwotka. He lost the argument - massively - and various left-wing publications have been making political capital out of it ever since.

He should never have got into the argument at all. Of course public sector pensions are affordable. Any public sector expenditure of any kind is always affordable in a sovereign country that issues its own currency and its own debt, and whose debt and currency are freely traded on international markets (pace the Modern Monetary Theory folk, I'm not going down the "debt is an illusion" route in this post!).

The question should be, of course - do we WANT to spend the amount on public sector pensions that will be required to maintain them in their present form?

Public sector workers say "of course we do".  Generous pensions are a part of their pay package. They are being asked to take a pay cut, in effect.
On the other side of the argument, thousands of private sector workers, who either have no company pension or whose company pension is nowhere near as generous as public sector pensions, think it's unfair that public sector workers should receive better pensions than they do. They think the money could be better spent on other things, such as uprating general pension provision for the elderly.

Public sector workers argue that their pensions are paid for through their contributions, not from general taxation, so this is an unfair comparison. I disagree. Every penny a public sector worker receives in pay - including pension contributions made both by themselves and their employers - comes from general taxation. Public sector workers are net beneficiaries of taxation in financial terms. Their pension contributions are paid out of general taxation. Furthermore, as their pension funds are "unfunded" (i.e. current contributions go to pay current pensions rather than being invested for future pension payouts), in practice their actual pensions are also paid out of general taxation. So to ask whether maintaining the existing defined-benefit schemes is a good use of public money is a perfectly reasonable question.

I don't buy the argument that someone put forward on BBC Breakfast this morning that because the private sector benefits from public sector functions such as education, therefore the private sector should fund better pensions for public sector workers than they provide for their own workforce. Education is paid for out of general taxation. In other words, the private sector already pays the wages of teachers as well as the private sector workforce.  It is hard to justify the private sector providing better pensions for one set of workers over others purely because the first set are nominally employed by the state.

Of course, the private sector does provide better pensions for some people over others - notably corporate elites. It does so because it considers the work they do to be of greater value than that done by others. I'm not going to argue here whether corporate executives really justify their gold-plated pensions, but the "work value" argument is the one that is used in both private and public sectors to justify high pay and benefits. It comes down therefore, once again, to the value that we place on public sector work. Do we consider the work that public sector workers do to be of greater value than that done by private sector workers? Is the work that I do, as a freelance peripatetic singing teacher, worth less to society than the work done by my state-employed classroom colleagues? Or is it equally valuable, but remunerated less simply because it is in the private sector? And is that because the private sector underpays or the public sector overpays?

In the end these comparisons of private and public sector remuneration are as irrelevant as the affordability question.  The real issue is the priorities given to different calls on public money, and the role of government in ensuring the welfare of its people. Is the remuneration of public sector workers, provision of adequate state pension provision, and protection of private sector workers from exploitation, of lower priority than paying the IMF to bail out yet more banks, fighting wars in Libya and Afghanistan, or hosting the Olympics (hat-tip to my brother Matthew Cooke for some of these questions)? Government can always find money to do whatever it wants to do. But the twin smokescreens of "affordability" and "unfairness" mean that people end up fighting with each other rather than holding government to account for its decisions.