Tuesday, 23 December 2014

The gullible economist

I think John Cochrane has lost his marbles. Or maybe his dispute with Paul Krugman has blown his brains. Anyway, he has written one of the worst op-eds I have ever seen.  He even quotes George Osborne as an authority on (the problems with) Keynesian economics. You couldn't make it up.

Cullen fisked about half the article but gave up in disgust when he encountered this little gem:
By Keynesian logic, fraud is good; thieves have notoriously high marginal propensities to consume.
Noah, who clearly has a stronger stomach, read all of it, understood most of it, and summed it up in one word.

But not being British, both Cullen and Noah missed the sheer idiocy of this statement (emphasis mine):
With the 2013 sequester, Keynesians warned that reduced spending and the end of 99-week unemployment benefits would drive the economy back to recession. Instead, unemployment came down faster than expected, and growth returned, albeit modestly. The story is similar in the U.K.
Oh no it isn't. These are the real GDP growth paths for the US, UK, Euro area and Japan since the Lehman shock, according to ONS:

The UK and the US don't look very similar in this chart, do they? By the way, the effect of the sequester is clearly visible on the US line. What had been rather good GDP growth suddenly fell. So much for Cochrane's claim that austerity caused "modest" growth to return.

This is UK employment versus GDP over the same period:


This chart shows that UK GDP was actually recovering until Q3 2010, when it started to tail off. From mid-2011 to mid-2012 it flatlined. Similarly, hours worked and employment were both increasing until Q3 2010, when they started to tail off. Both employment and hours worked actually fell in 2011. 

Well, ok, this is employment and hours worked. What about unemployment?


Well I never. Unemployment actually rose in 2011. It didn't really start to fall until 2013.

So it seems that the UK was recovering nicely until towards the end of 2010, when it was hit by some kind of shock that clobbered both growth and employment. It did not start to recover from this second shock until 2013.

There are a number of theories as to what this shock might have been. Monetary tightening by an angry Bank of England governor determined to discipline wayward banks, oil price shocks, and the crisis in the Eurozone have all been suggested as possible causes. And so has fiscal consolidation.

The Coalition government was elected in May 2010 on an austerity mandate driven by concerns about the size of the UK's deficit in the light of the growing crisis in Greece. The majority of the Coalition's spending cuts were actually made in the first half of 2011, though they were announced long before that: but what is not often reported is that the previous Labour government had already introduced consolidation measures. Austerity actually began in the middle of 2010.

The spike in unemployment in 2011 shown on the chart above is due to public sector job cuts and the entry to the workforce of single mothers and sick/disabled people due to benefit changes. Unlike the US, the participation rate in the UK has actually risen since 2008: this is evident from the fact that although unemployment is still above its 2008 level, both employment and hours worked are now ALSO above the 2008 level. There simply are more people working.

But despite a fairly substantial increase in the workforce, the UK's GDP growth remained well below its pre-crisis trend. This is due to the UK's dismal productivity. There may be lots more people in the workforce, but they aren't producing much. The reasons for this are unclear, but low business investment seems a likely cause, coupled with the fact that many of these new entrants to the workforce have poor skills and and an inflexible lifestyle.

The fact is that GDP flattened and unemployment rose in the UK as a direct consequence of fiscal consolidation by both Labour and Coalition governments. Yes, a DIRECT consequence. In March 2013, Robert Chote, the head of the OBR, confirmed in a letter to David Cameron that OBR calculations showed Government tax rises and benefit cuts had reduced GDP:
....applying these multipliers to the consolidation measures put in place by the previous and current governments would have been sufficient to reduce GDP in 2011-12 by 1.4%. 
Nor was the OBR particularly generous with its multipliers. Chote admits that IMF research showed multipliers could be much larger after a financial crisis, which would imply that the fall in GDP from premature fiscal consolidation might be even more.

Growth finally returned at the beginning of 2013. Exactly why is unclear. It seems likely that the Bank of England's Funding for Lending scheme kickstarted growth by stimulating mortgage lending. Dis-saving by the elderly and PPI windfalls may also have played a part. And the Chancellor's 2012 Autumn Statement announced plans to increase expenditure on infrastructure and provide support for housebuyers, which was followed up in the 2013 Budget with tax threshold rises, pension increases and the Help to Buy programme for first-time buyers. The 2014 Budget continued this theme: more tax reductions, pensions reform, extension of Help to Buy (now laughably known as Help to Buy Votes), promises of infrastructure investment.

Now, correct me if I am wrong, but infrastructure investment, tax cuts, pension increases and help for homebuyers are fiscal stimulus, are they not? And of course expectations matter. Austerity starts with its announcement, and so does stimulus. Just as fiscal consolidation was a cause of the UK's poor performance in 2011-12, so fiscal stimulus seems likely to be a cause of the UK's outstanding performance in 2013-14.

So the Chancellor whom Cochrane quotes approvingly as saying that Keynesians wanting fiscal stimulus were "wrong" has actually been doing, er, fiscal stimulus - though more for political than economic reasons. It's amazing what effect the growing proximity of an election has on economic policy. 

And it's also amazing how gullible a Keynes-hating (or perhaps more accurately Krugman-hating) US economist can be. 

Related reading:

No, it's not party time yet

* There were also tax cuts in the 2012 budget, but these were offset by benefit cuts and other changes that left many people worse off. 



Sunday, 21 December 2014

One Bank To Rule Them All

http://www.jornaldoalgarve.pt/wp-content/uploads/2014/01/Jean-Claude-Trichet.jpg

The ECB has released this letter from its former President, Jean-Claude Trichet, to the Spanish Prime Minister in August 2011. It is excruciating reading.

The letter starts with a reminder about the Spanish government's responsibilities:
We recall that the Euro area Heads of State or Government summit of 21 July 2011 concluded that "all Euro countries solemnly affirm their inflexible commitment to honour fully their own individual sovereign signature....."
Well, ok, this letter is about the threat to the Euro caused by spiking Spanish bond yields and the fear of default and redenomination at that time, so it is probably reasonable of the ECB to ask for assurance that the Spanish government intends to honour its debt obligations. But that's not all:
"...and all their commitments to sustainable fiscal conditions and structural reforms."
And the letter then goes on to explain in some detail exactly what "structural reforms" the ECB expects Spain to undertake. There are three groups of changes:
  • changes to the labour market, including decentralising wage bargaining, ending indexation of wages and "reviewing other regulations" in order to make it easier for the unemployed to find jobs. Apparently making it cheaper for firms to sack people and eliminating restrictions on the rollover of temporary contracts makes it easier for the unemployed to find jobs. I am not quite sure how this logic works. 
  • additional "structural fiscal consolidation" (i.e. permanent spending cuts and/or tax rises) of 0.5% of GDP, apparently to "convince markets" that the 6% deficit target could be met. This was to be coupled with strict control of sub-sovereign budgets, new rules enforcing transparency in sub-sovereign accounts and a "spending rule" restricting spending increases to the trend growth of GDP.
  • product market reforms, mainly to improve competition in key sectors and promote housing rentals.
I am not in this post going to discuss the wisdom or otherwise of these proposals. I am interested in the fact that it was the ECB that made them. In what insane world is fiscal policy the responsibility of a central bank? Which EU treaty gives the ECB the right to dictate policy to a sovereign government, even one subject to the "excessive deficit procedure"? It is very hard not to conclude that the ECB strayed far beyond its mandate. But why did it do this?

The final paragraph gives the game away:
"Overall, we trust that the Spanish government is aware of its very high responsibility for the smooth functioning of the Euro area at the current juncture and will decisively undertake all necessary measures to regain market confidence in the sustainability of its policies again."
The impression that this gives is that restoring market confidence in the Euro was the responsibility of the Spanish government, not the ECB. An emasculated ECB was desperately trying to persuade the Spanish government to do whatever was necessary to prevent disorderly breakup of the Euro. Poor thing.

We now know that this is total nonsense. What markets really needed to restore confidence was not Spanish structural reforms or fiscal consolidation. It was a guarantee from the ECB that it would stand as "buyer of last resort" for Eurozone sovereign debt. And when the ECB finally gave that guarantee - though admittedly hedged around with conditions - calm was restored to the markets and bond yields fell to normal levels.

So it was not the Spanish government that needed to act. It was the ECB.

In this letter, the ECB attempted to evade its own responsibility for ensuring the stability of the Euro. Nor was this the first time it had tried this trick. The Irish letters also include instructions to the Irish government about "fiscal reforms", though not in such detail. But in the Irish case, the ECB threatened to withdraw liquidity from the Irish banking system if the Irish government did not comply. It is a total mystery to me why the Irish government did not call the ECB's bluff. There was no way the ECB could possibly have done any such thing. It would have brought down the European banking system and caused a disorderly breakup of the Euro.

The Spanish letter does not include overt threats. But the message is clear. The ECB believed it had the right to dictate fiscal policy to a sovereign government. Had the Spanish government resisted, no doubt threats would have followed. And once again, they would not have been credible - any more than the ECB's conditions for sovereign bond purchases are credible. The fact is that the ECB must do "whatever it takes" to prevent Euro breakup, even if that means buying every sovereign bond and bailing out every bank. Its threats are empty.
 
This must be the last time the ECB is allowed to usurp fiscal sovereignty from a member state government. By design, the Eurozone does not have a single fiscal authority. It may be that at some time in the future, member states will agree to create a supranational fiscal authority. But until then, the governments of member states remain sovereign. The ECB needs to be firmly put in its place. One Bank it may be, but it should never rule them all.

UPDATE: It seems Spain was not the only sovereign subjected to ECB fiscal diktat in 2011. Via Filippo da Fiume comes this letter sent by Trichet and Draghi to Berlusconi, which - as with Spain - details three groups of fiscal policy recommendations:
  • measures to improve growth
  • fiscal consolidation 
  • streamlining of public administration.



Wednesday, 17 December 2014

Krugman, Bowman and the monetary financing of governments

Krugman says central banks can't create inflation. When interest rates are at zero, expanding the monetary base makes no difference.

This is, of course, anathema to dedicated believers in the omnipotence of central banks. But Krugman is in good company. I recently heard Richard Koo speak on lessons from Japan for the Eurozone. Koo questioned QE's effectiveness when the private sector is refusing to take on more debt because it is determined to deleverage.

Koo's and Krugman's scenarios are actually the same, though they attack the problem from different angles. In both cases, interest rates are zero, though Krugman explains this as an infinite demand for interest-free money (the liquidity trap), and Koo explains it as a lack of demand for borrowing. Both argue that central banks are unable to generate inflation when the private sector does not wish to spend. Both insist - though for different reasons - that when interest rates are zero, fiscal stimulus is needed to get the private sector to spend. 

Sam Bowman thinks this is absurd:

Let's test out Sam's theory. Imagine a country in which there is a fiat currency but no central bank. Money is directly created by government and paid to the population as a basic income via commercial bank accounts in a free banking system (Sam will like this!). People spend that money on goods and services, enabling businesses to flourish and creating jobs, which in turn enable people to top up their basic income with earnings. People get richer, and they spend more. The government keeps on printing money to provide the basic income, even though people are earning more and more from their jobs. Soon the place is awash with money. People can buy all they need and save as much as they want, and still have money left over. It's an earthly Paradise.

Except that it isn't. When everyone has everything they could possibly ever need, money is worthless. Money is only valuable to the extent that it is scarce relative to goods and services not only now, but for all time: as long as there is (relative) poverty, and therefore demand for money, money has value. Inequality is necessary if money is to maintain its value. This is why measures to reduce inequality, such as transfer payments from rich to poor, can be inflationary. But when the government prints more and more money, dishes it out as helicopter drops to everyone equally, and never taxes any of it away, goods and services become scarce relative to money, and therefore more valuable. If people start to believe that the supply of money is infinite, goods and services become infinitely valuable. Please note that this is NOT the same as Krugman's liquidity trap. In a liquidity trap, the demand for money is infinite, not the supply. What I am describing here is Zimbabwean hyperinflation. Central banks may not always be able to generate inflation, but governments can.

So to control inflation, the government needs a mechanism to drain money from the private sector. It could do what central banks do, namely sell assets. But what assets does it have? It might have some physical assets - schools, hospitals, roads, that sort of thing. But once it has sold those, what then? Well, it could issue bonds. We aren't used to thinking of government bond issuance as a monetary tool, but there is no reason why it should not be. If a government issues bonds but does not spend the money received - as researchers at the Bank for International Settlements have suggested - then money is drained from the private sector. Government bond issuance is monetary tightening. Private sector saving in the form of government deposits is also monetary tightening for the same reason.

In this scenario, there is no need for taxes. Government spends using newly-created money, then neutralises that spending by issuing bonds to the private sector. Interest rates are high enough to ensure that the private sector voluntarily buys enough of them to sterilise the Government's spending - though if the private sector's propensity to save is high, as in Koo's scenario, this could still mean interest rates at or close to zero. It's entirely circular and not inflationary. In theory, therefore, government spending could be entirely sterilised with bond issuance and/or private sector deposits (are you listening, Japan?). Note that spending comes first, just as bank lending precedes deposits. Governments really can act like banks.  

However, it is entirely possible that the private sector might refuse to buy the bonds. After all, they are only a promise that some future basket case government will redeem them by printing worthless money. Without something a bit more definite than "we really will pay you this money, honest", the private sector might balk.

This is where taxes come in. In a fiat currency system, taxes are a means of forcing people to return money to government. They are, if you like, the equivalent of required reserves for banks. Everyone must place a certain proportion of their income on deposit at government: the greater their income, the more they must place on deposit. People who refuse to maintain these "required reserves", or who divert them to other purposes, can be fined or jailed. In this way government ensures that it can always sterilise its spending.

In our mythical fiat-currency, free-banking, money-financed country, taxes - or at least the threat of taxes - would be necessary to control inflation. Just as a credible central bank standing ready to buy assets sets a floor under the price of those assets, maintaining their value, so a government that can credibly impose taxes on its population maintains the value of the currency, both now and in the future (this is why the power to tax also supports the price of government bonds). A defining feature of hyperinflationary episodes is that government loses the power to tax. It can print money, but it can't recall it. Central banks use interest rates as a proxy for taxes, but if the government loses its credibility then all too often the central bank does too - in which case interest rates lose their potency. In 1998, interest rates at 160% failed to restore the Russian currency or prevent government default.
 
The point of this rather fanciful example is that a credible government can in theory finance its own spending without a central bank. "Borrowing" and taxes are both ways of sterilising money financing of governments. Governments do not need central banks to control inflation. They can control it themselves.

So why is money financing of government feared? It is feared precisely because it is far more likely to be inflationary than money creation by an independent central bank. Krugman is right. Central banks simply are not as effective at creating inflation as governments. If they were, we wouldn't entrust them with management of the money supply. After all, as both Russia and the Eurozone are demonstrating at the moment (though in different ways), central banks are only as independent as politicians allow them to be, and only as credible as the governments that back them. If government can't be trusted to manage the money supply without causing inflation, then neither can a central bank - unless it is simply unable to create significant inflation.

But why are central banks so much less effective at creating inflation than governments? I think it is largely due to the way in which the money they create is distributed.

Government spending and taxation directly affects the behaviour of ordinary citizens. Ordinary citizens are by-and-large financially constrained: they have shortages of money relative to their desire for goods and services, and they have limited borrowing capacity. Therefore, if a government creates money and pays it to ordinary citizens, the likelihood is that a fair number of those will spend it. Equally, if government increases taxes - or people expect that it will - many people will cut their spending. True, people might not adjust their spending if they think that tax and spending changes are temporary: but then banks and investors might not adjust their behaviour either if they think monetary expansion or contraction is temporary. Ricardian equivalence applies as much to central bank operations as it does to taxation. 

Clearly, if government money-financed spending is likely to flow through directly into increased consumption by ordinary citizens, it can very easily lead to consumer price rises. Tax changes can be too slow and unwieldy to counteract this inflationary effect - and they are unpopular. The real problem with money financing of government is that politicians depend on voters for their jobs, and giving money away is far more popular with voters than removing it, even if removing it is in those voters' best interests. But the same could be said of central banks. Removing the punchbowl when the party is in full swing is equally unpopular whether the party is on Wall Street or Main Street.

Central bank monetary operations depend for their effectiveness on banks and investors being willing to adjust their behaviour. Unlike ordinary citizens, banks and investors do not generally suffer from shortages of money. Their behaviour is driven by their appetite for risk and their desire for return. Monetary policy operations aim to influence their portfolio choices by adjusting yields on certain classes of asset. The main effect of central banks' activities is therefore seen  therefore primarily in asset prices, rather than consumer prices. There may be some impact on consumer prices via interest rate effects, wealth effects and the famous "hot potato effect", but it will be much less than the impact of an equivalent fiscal stimulus. It is, frankly, inefficient. To be sure, a central bank supporting asset prices by means of large-scale purchases can interrupt a deflationary spiral: but then a government supporting house prices by means of guarantees and tax breaks can ward off a property market collapse, which might prevent a deflationary spiral forming in the first place.

Ambrose Evans-Pritchard argues that central banks can always generate inflation if they try hard enough, and cites Friedman's famous "helicopter drop" as evidence. But central bank helicopter drops are fiscal policy, since the money goes directly to ordinary citizens rather than to the financial system. Why not simply unchain the fiscal authority so it can do money-financed deficit spending, rather than getting the central bank to do it and calling it monetary policy? When the economy is in a slump, no-one is spending and no-one wants to take any risk, does it really matter whether the central bank or the government reflates the economy? Where did this absurd idea come from that the only good stimulus is a "monetary" one?

Rather than using the loaded terms "monetary" and "fiscal", we should talk about "indirect" and "direct" stimulus. Put like this, Krugman is once again clearly right - as, incidentally, is Friedman. Direct stimulus is obviously far more effective than indirect. How on earth could we possibly think otherwise?

Related reading:

Fiscal pessimism - Pieria
Some incomplete monetarist arithmetic - Pieria
Structural destruction - Coppola Comment

Sunday, 14 December 2014

Broken windows, broken lives

This is a difficult post for me to write, and there will no doubt be people out there who will be horrified at what I am about to say. But I feel that the hard questions that I shall raise have to be addressed.

In August this year, my mother went into a nursing home. She now has twenty-four hour nursing by specialists in the care of dementia sufferers. It is eyewateringly expensive. And it is being paid for entirely by my father.

This is an appalling tragedy. It is worse than a bereavement. In effect, my father has lost his wife - but he is still paying for her care.

Now, please don't misunderstand. It is not a financial tragedy. My father reckons he can afford to pay for my mother's care for five years without having to sell the house that he still lives in. He observed sadly that the people who will pay are his children and grandchildren, who will inherit far less than he had hoped. But to me, it is only right and proper that the savings he accumulated during his working life should be used to support him and his wife. That money is not ours until they no longer need it - and if that means there is none left for us, so be it. Inheritance is a privilege, not a right.

The tragedy is what this situation has done to my family. My father now faces his first Christmas alone. He will go to see my mother, of course, though I know how hard he finds it to see the ruin of the woman that he loved. I, too, will go and see her, as will other members of my family. Indeed my father and I both go and see her about every couple of weeks: but it is difficult to make myself do this, knowing that we can no longer have the sort of conversations we used to have. She was highly intelligent, incredibly well-informed, and had opinions on everything from politics to gardening. All of that is gone: she can barely speak, her memory is shot to pieces and she is unable to concentrate on anything for more than a few seconds. She is also physically disabled, for reasons that I will explain shortly. The woman that we knew and loved is no longer there. But her crippled body, and the little that is left of her mind, live on, and must be cared for. 

And therein lies the conundrum. For my mother's care, and the care of elderly people like her, is a significant and growing contribution to GDP and gives employment to a lot of people. In effect, it is a transfer of wealth from the old to the young, though not the young my parents had intended.

While my (retired) father was her full-time carer, my mother's care contributed little to GDP: but once he had to admit that caring for a disabled and confused elderly woman was beyond him, her care became an economically productive activity. Prior to that, her care had been provided firstly by my father, out of love, and secondly by the NHS, out of taxation. We have no way of measuring love in GDP, and there are those who deny that public sector activity is "productive". Yet it is the same care.

The problem is that this care is fundamentally unproductive, regardless of who does it and whether or not it is counted in GDP. My mother will never be restored to health and activity. Her carers, and her family, are managing decline. Sometimes, when I see her, her mind seems a little better, and there are flashes of the woman I once knew - but this merely raises false hope. She is never coming back.

It could be argued that keeping my mother alive at such expense is a form of the "broken window" fallacy. This sounds harsh, but to explain why I say this in relation to my own mother I need to tell the story of her decline.

My mother has a range of long-standing health issues including heart failure and renal failure. She had been getting increasingly frail physically, though until August 2013 her mind was as sharp as ever. But in August 2013 she had a fall. She broke her hip and her wrist, and was rushed into Medway Hospital. There, they pinned her hip and her wrist back together. After the operation, they put her on a morphine drip for pain relief. My brother, who saw her not long after the operation, said she was well and cheerful. So the following day, I went to see her with my then 15-year-old daughter.

When we arrived, she was unconscious and fitting. The junior doctor on duty explained that she had a morphine overdose. Apparently they had not checked her notes before giving her a morphine drip....people with renal failure cannot clear morphine from their bodies, so it gradually builds up, resulting in an overdose. They gave her medicine to counteract the morphine, of course, but it was touch and go whether she would live or die: if her heart gave out, they would not resuscitate her.

She lived......but from then on, her mind started to deteriorate. Her concentration wandered: she, who had loved to read, started to find reading too tiring. Holding a conversation with her became increasingly difficult as her mind lost focus and her speech slurred. A CT scan done by the hospital revealed that she had had a stroke, but they didn't know when. She never learned to walk again.

Once she came home, she deteriorated fast. She couldn't move around, she couldn't communicate and her sleep was terribly disordered. She needed 24-hour care: my father, who was doing most of it, became increasingly tired and grumpy. Eventually, after best part of a year, he had to admit that he couldn't cope. She was taken into hospital until a nursing home place could be found.

We do not know whether her rapid decline was due to the morphine overdose or whether it would have happened anyway. But it does raise a question.....Arguably, it would have been better for everyone if she had died in August 2013. Yet the doctors did everything in their power to keep her alive and repair the damage that they had (possibly) caused themselves. And her nurses still do.

Our ability to prolong life far outstrips our ability to improve its quality, and an increasing proportion of our economic activity must therefore go towards caring for the frail elderly. But we have not addressed the ethics of keeping people alive for extended periods of time after their minds and personalities have disintegrated. In 2008, Baroness Warnock suggested that people with dementia had a "duty to die". Her remarks were greeted with horror: yet we do need to have this discussion. For in reacting with shock and horror to the very idea of ending someone's life, we are failing to see the human tragedy of dementia.

The tragedy is not so much for the person concerned, although in the early stages many dementia sufferers are fully aware of what is happening to them and some are horrified - as my mother was in the months after her operation, though she now seems happy. But the real, enduring tragedy is for the families: husband and wife torn apart, family relationships destroyed, and yet no closure, no funeral, no ability to say good-bye to the person that they loved, because even though that person is gone the shell is still alive, and must be cared for at increasing expense. We are caught in a trap of endless grief.

I do not want to see my mother die. But it might be better for everyone if she did. I fear for my father, if her life is prolonged: five years of this, and he loses his home. Is this what she would want for him? And what if he becomes ill or frail himself, and needs care? How would he - would WE - afford both her care and his? What of the children who are dependent on us? In diverting resources to such extended elderly care, are we crippling the development of the next generation? Do we have our priorities right?

The Hippocratic Oath that doctors take says "First, do no harm". But what is meant by "harm"? Is keeping someone alive when their mind is gone and they are physically disabled "doing no harm"? Is helping someone to die when they have no prospect of being restored to physical and mental health "harmful"? I do not know. But "harm" surely goes beyond the person being treated: is the cost to their  family of no consequence?

I am very aware of the possibility of abuse, which is why in this post I have raised the question of financial cost and inheritance. I suspect the majority of people would have the same view as me, namely that the correct use of savings is the care of the elderly: to dispose of an elderly person simply to ensure that his or her descendents could inherit would be an abomination. But there would no doubt be some for whom money talks. Could there be adequate safeguards against such abuse? I do not know. It is, I suspect, in large measure the reason why we have not so far faced up to the consequences of our ability to prolong life but not restore it.

What I do know is that we have to have this debate. We divert ever greater resources to prolonging life, without considering the emotional cost to families or, indeed, the opportunity cost to society as a whole.  Is this what we really want? 





Tuesday, 9 December 2014

The Goldman touch

In my previous post, I cast doubt on the viability of Juncker's investment plan, pointing out that it involves no new money from either the EU or the EIB since it relies on a combination of non-sovereign guarantees and money diverted from other schemes, and questioning whether the private sector would be interested in investing in member state pet projects anyway. To put it bluntly, it appears to be a conjuring trick designed to give the impression that the European Commission is "doing something" about the appallingly low level of investment across the EU. I (somewhat impolitely) commented to a friend that this scheme looked like an attempt by Juncker to prove that he is not a total joke.

But in this extraordinary comment on my post, someone who identifies as "cig" exposes a dimension to Juncker's plan that I had missed:
There is an obvious trade here:

1. get bridge loan of say €100m
2. create SPV
3. have SPV buy €100m worth of senior tranche of EIB project
3. have SPV (alone or with mates) issue covered bond guaranteed on these (+ admin spread)
4. sell covered bond to ECB
5. goto 2 (you've just got your €100m back from the ECB)

No risk for the trader here, she just makes the admin spread and uses zero long term capital (once the 300B are exhausted she gives back the €100m to the bridge lender). In that scenario it makes sense that it's the EIB that decides what project gets done as after all it's the ECB's money we're spending. Technically there's no monetary financing that a normal electorate can notice.
And cig adds:
Now I'd like to know is whether this trade is the very point of the scheme and who understands that... Note that even if it's not, it may still work out that way anyway. 
When I saw this comment, suddenly everything became clear....Draghi's public support for Juncker's scheme in his Jackson Hole speech, followed by the ECB's surprise announcement in September that from November it would buy both ABS (as expected) AND covered bonds. The confidence of policymakers about the likelihood of private sector involvement in this scheme is indeed well-founded. The ECB is standing behind it - not directly, because as I pointed out in the post that would be monetary financing of governments, but indirectly in the name of "monetary policy". Never was falling inflation more opportune. The private sector's involvement in this scheme is completely risk-free, and whether the investment projects actually generate real returns is completely irrelevant.

If "cig" is right, then this scheme has two purposes: overtly, it is to increase investment across the EU - and covertly, it is to circumvent the treaties that prevent the ECB from financing sovereign investment. 

As far as I know, no commentator has spotted this - not even the redoubtable Bruegel. Though I think the Cypriot economist Alex Apostolides understood it. "Why is all this crap better than a treaty change?" he asked me on twitter. Indeed, avoiding treaty change is what it is all about.

No way did Juncker dream up a scheme of such Machiavellian brilliance. This is the Goldman touch. Super Mario is at work.

Related reading:

Draghi's debt trap



Sunday, 7 December 2014

Juncker's CDO

The new President of the European Commission has recently unveiled his second attempt at increasing European investment without raising public debt levels. His first attempt, which envisaged leveraging the ESM, was shot down by the Germans. This version leverages both the EIB and the EU's own budget. By committing 16bn EUR from the EU's budget and 5bn from the EIB, Juncker reckons that upwards of 315bn of new investment could flow into EU-wide projects, increasing jobs and improving infrastructure. It sounds wonderful, doesn't it?

But how would it work, exactly? Here is an explanation from the European Commission's factsheet:
The role of the Fund is to mobilise extra private finance in specific sectors and areas. The Fund is estimated to reach a multiplier effect of 1:15 in real investment in the economy. This is the result of the Fund's initial risk bearing capacity and is an estimated average calculated as follows: For every initial one euro of protection by the Fund, three euro of financing could be provided to a certain project in the form of subordinated debt. Given that this creates a safety buffer in that particular project, private investors can be expected to invest in the senior tranches of that same project. EIB and European Commission experience indicates that 1 euro of subordinated debt catalyses 5 euro in total investment: €1 in subordinated debt and on top of that 4 euro in senior debt. This means that €1 of protection by the fund generates €15 of private investment in the real economy, that would not have happened otherwise. This 1:15 multiplier effect is a prudent average, based on historical experience from EU programmes and the EIB.
I've drawn this up as a leveraged structure:

Note that the actual investment would be Mezzanine + Senior Debt, i.e. EIB subordinated lending plus private sector investment. The Equity portion is described in the factsheet as "protection". There is no actual money involved. It consists of public guarantees, not real money. In effect, the EU and EIB combined are providing insurance to private sector investors - accepting "first losses" of up to 21bn Euros. The EU's portion would guarantee the first 16bn Euros of longer-term infrastructure investment: the EIB would guarantee the first 5bn of capital investment in SMEs.

In fact, let us be completely clear. NONE of this money exists. Not a single Euro of it. This is a synthetic structure based entirely upon insurance, not actual funds.

The key to this is in the footnote of this diagram:




The EU's guarantee of 16bn Euros is only backed 50% by actual funds. If losses exceed 8bn Euros, the EU will have to find new money from somewhere. But worse than that, every euro of the 8bn actually backing this guarantee is already committed to other initiatives. 3.3bn Euros comes from Connecting Europe Facility (which is developing pan-European digital technology and broadband), 2.7bn Euros comes from Horizon 2020 (the EC's framework programme for research & innovation) and the remaining 2bn Euros directly from the existing EU budget. The EU is providing no new money to this initiative whatsoever, apart from the leveraged lending it expects the EIB to provide. All it is doing is placing both its existing investment programmes and the future budgets of member states at risk in the hopes of encouraging increased private sector investment in European projects.

The risk mitigation for the EU lies in the "second pillar" of Juncker's proposal. There would be a new facility in which EU bureaucrats would pick projects for presentation to the private sector as investment opportunities and provide "technical assistance" to investors to help them choose which projects to adopt. According to the EC's press release, projects would be recommended by Member States according to the following criteria:
  • EU value-added projects in support of EU objectives
  • Economic viability and value – prioritising projects with high socio-economic returns
  • Projects that can start at latest within the next three years, i.e. a reasonable expectation for capital expenditure in the 2015-17 period.
Why on earth would the private sector want to invest in projects chosen according to these criteria? Since when have either high socio-economic returns or EU objectives been of interest to private investors? What attracts private investors is returns on their investment - but there is no mention of the need to generate real financial returns. Reducing private sector risk is not enough to encourage investment. After all, investors who don't want risk can buy German bunds.

And it gets worse. These are the sorts of project that the new proposal wishes to encourage:
The new Fund will support strategic investments in infrastructure, notably broadband and energy networks, transport in industrial centres, as well as education, R&D, renewable energy and energy efficiency.
Looks good, yes? But as I noted above, the EU already has initiatives addressing broadband networks and research &innovation, which it is proposing to rob in order to provide guarantees for this new scheme. And that's not all.

It already has numerous energy initiatives - indeed one criticism that could reasonably be levelled at the EU is that it has lots of initiatives but no coherent energy policy. Unless the new funding would go to the existing initiatives, which seems unlikely, this is simply going to create confusion and duplication - as well as creating a golden opportunity for bureaucrats both in member states and in the EU itself to promote their pet projects. Transport in industrial centres looks like a good investment - but if it is so inadequate at the moment, why do private sector investors need public guarantees to encourage them to invest? After all, we assume, the principal beneficiaries of transport in industrial centres are industries. And as for education, it is notoriously difficult to demonstrate tangible benefits from educational programmes. If the programmes directly benefit industries, in that they provide workers with the skills those industries need, surely it would be reasonable to expect the private sector to accept the risk of investment? And if the programmes don't directly benefit industry, why would the private sector invest at all, even with public sector guarantees?

In short, there is a huge amount of muddled thinking going on in this proposal.

On the face of it, the EIB's involvement seems more sensible. Channelling investment funds to SMEs is clearly a good idea, given the paucity of bank lending in much of the Eurozone at the moment. But hang on a minute. Isn't this what the EIB already does? This is what its website says:
Smaller businesses face particular difficulties in accessing finance, particularly since the crisis. Our support has increased substantially since 2008, boosting our already significant long-term commitment. Countries particularly badly affected have received additional assistance. Our support has added impact by encouraging other private banks to on-lend and pass on advantages to businesses.
And these are the forms the EIB's existing support takes:
Loans
All types of investment by smaller businesses are eligible for favourable EIB loans. Support is channelled through our partner network.
Innovative financing options
We use a range of financial techniques to increase the impact of funding from the EIB, the European Commission and others.
Research, development and innovation support
We help with access to debt financing for research, development and innovation projects.
Capital injection & development advice
We invest in venture capital or private equity funds which then help growth.
Microfinance in the EU
Micro-businesses in the EU receive financial and technical assistance from our microfinance programme.
Energy efficiency investment
Green Initiative: energy efficiency for SMEs in new Member States and pre-accession countries. Funded by EIB loans and European Commission grants.
So the 5bn Euros of capital from the EIB isn't quite what it seems, either. It's simply capital the EIB already uses as backing for SME lending. 

In fact the new fund is to be a trust fund within the EIB. But the EIB is getting no new capital to support it, just a bunch of EU guarantees partially backed by money already committed to other things, and it is expected to divert part of its existing capital to support the new fund - which will of course reduce its current lending capability. On the basis of this faux capital, it is supposed to provide 63bn Euros of new subordinated debt. So this, too, is not quite what it seems: it is partly a diversion of lending from the EIB's existing SME support facilities.

Juncker's scheme is a highly-leveraged, complex funding structure reminiscent of a synthetic CDO. And just like the synthetic CDOs that contributed to the financial crisis, it is a clever piece of smoke and mirrors. It is intended to fool people into believing that investments can be guaranteed by the public sector without cost. This is dangerous nonsense. The first losses would go to the EU and the EIB, which ultimately would mean sovereigns coughing up more money, although not at this stage a huge amount. But the next losses would ALSO fall to the EIB, creating further claims on EU sovereigns (since they are the EIB's shareholders). The combined EU sovereigns stand to lose a total of £84bn Euros before the private sector takes any losses at all. 

This strikes me as considerable public sector risk for very little return. Though to my mind the investment opportunity is nowhere near adequate anyway: the criteria make no sense from an investment point of view. I suspect the scheme may begin and end with leveraged lending from the EIB. This would be a viable approach - indeed a lot more EIB lending could be supported - if the EIB's subordinated loans could be packaged up and sold to the ECB. But no-one is going to agree to this, even to support pan-European projects. Monetary financing of all sovereigns is as bad as monetary financing of one, apparently. It's a weird take on "All for one, one for all".

Juncker's claim that this scheme will create at least 315bn Euros of new investment may or may not be true. But one thing is completely clear. Describing this scheme as funded with new investment capital from the EU is wrong. The EU's capital investment in this scheme is zero.

Related reading:

Austria's folly and Juncker's madness - Pieria
The Juncker fund will not revive the Eurozone - Wolfgang Munchau, FT



Friday, 5 December 2014

Lies, damned lies, and the War Loan

http://www.iwm.org.uk/sites/default/files/iwm_solr_field/large/Art.IWM%20PST%2010628.jpg


Back in October, Toby Nangle, head of multi asset allocation and co-head of global asset allocation at Threadneedle Investments, a UK-based fund manager, wrote a guest post on FT Alphaville in which he argued that the Chancellor should call in the UK's War Loan. The War Loan was issued by HM Treasury in 1932 and is one of the oldest bonds in the market today.

"The UK Government could reduce its debt and save the taxpayer £300m by exercising its right to call the ‘War Loan’ and refinance it with new perpetuals with the same coupon but a thirty-year non-call period or new long-dated bonds.", said Nangle.

The Chancellor took his advice. As part of the Autumn Statement, he has announced that the Government will call in not only the War Loan, but other historic gilts too. From HM Treasury's Press Release:
The Chancellor of the Exchequer, George Osborne is today (Wednesday 3 December) announcing that the government will repay all the nation’s First World War debt.
 The Chancellor also announced that the government will adopt a strategy to remove the other remaining undated gilts in the portfolio, some of which have origins going back to the eighteenth century, where it is deemed value for money to do so.
The 1932 War Loan - itself a lower-rate refinancing of a previous War Loan - will be called on March 5th 2015. Other historic gilts will be called in due course.

But HMT's press release includes the following extraordinary statement from the Chancellor:
This is a moment for Britain to be proud of. We can, at last, pay off the debts Britain incurred to fight the First World War. It is a sign of our fiscal credibility and it’s a good deal for this generation of taxpayers. It’s also another fitting way to remember that extraordinary sacrifice of the past.
 "Pay off the debts"? No, George, just no. If I refinance the mortgage on my house to take advantage of today's lower rates, I have not "paid off" my mortgage. I have paid off the old mortgage, yes, but I have taken out a new one for the same amount. I still owe the money.

In fact HMT's press release makes it very clear that the debt is being refinanced, not paid off:
The government will now be able to refinance this debt with new bonds benefiting from today’s very low interest rate environment....
So Osborne's claim that this debt is being "paid off" is simply wrong. It is, in short, an outright lie designed to impress voters.

And there is another lie here, too. The second part of that sentence  reads:
....which in part reflects confidence in the plan the government has put in place to cut borrowing and create a resilient economy.
 Low interest rates are a sign of confidence, are they? Then why are Italian and Spanish government bonds trading at lower interest rates than the UK's? These days, low interest rates don't indicate confidence - they are a forecast of poor growth and low returns. They are a sign of weakness, not strength.

In fact it is hard to argue that there is any confidence at all in the plan the government has put forward to cut borrowing. Osborne has failed to deliver on the plans he set out at the start of this parliament: the deficit is still above 5% of GDP despite recent encouraging growth. And the plans in the Autumn Statement to eliminate the deficit have failed to convince anyone.

UK gilts remain attractive to investors because the UK economy is currently performing well, not because anyone believes anything George says. That is the reason why UK borrowing costs, far from being low, are actually quite high relative to the rates paid by many other developed countries at the moment. And we do not want rates to be any lower. We would like them to be higher, really - that would indicate that the economy is really on the road to recovery. But the government's plan is if anything likely to ensure that they remain very low for a very long time. Spending cuts on the scale envisaged in the Autumn Statement would knock the stuffing out of the economy - again.

Refinancing the War Loan and other long-standing gilts while rates remain low by historic standards is eminently sensible. But the Chancellor's claim that being able to refinance the War Loan at lower rates indicates confidence in government plans is not just a lie, it's a damned lie.