BANKING ON ECONOMICS

EURO CRISIS EXPLAINED: SEVEN PARADOXES

2011-12-10T16:46:00.000-08:00

The Euro like many great but complicated projects has different storylines. There are the simple versions for general public consumption and what politicians find to be useful sound-bites that are difficult to challenge technically, and then there are the more complex deeper reasons that risk technical arguments beyond the capacity of most politicians to master and that are therefore deemed suspiciously suspect because they are above the capacity of the public to usefully (politically) understand. The consequence is policies promoted for misleading even spurious reasons.
The reasoning that led to creation of the Euro and its support system the Growth & Stability Pact (also known as The Maastricht Criteria) had a number of political motivations including closer integration picture-framed by a few simple practical ideas for the public to understand such as easier cross-border trade and savings for tourists on currency conversion costs. The most important reasoning however was really to create a currency too big to be played with to the extent of its credit being severely damaged by the markets, a currency that would not suffer the blackmail of the markets as in the case of Sweden and the Nordic currency crisis of 1991-3, The ERM crisis of 1992-3, the Sterling crisis (termed "Black Wednesday") of September 1992 (and of some importance the Latin American currency crises of the late '80s and Mexico in 1994-5 and East Asian in 1997-9).
The first paradox therefore is that clearly the money markets have in fact been able to discredit the Euro system to such an extent that like the earlier ERM with its narrow bands it is struggling to survive. If it falls apart, partly or wholly, market speculators have a golden opportunity to make short term large gains by shifting in and out of different Eurozone countries' equities, bonds and currency holdings.
When the Euro was created (January 1, 1999) and in the months leading up to this date the money markets lost 10 interest rates, currencies and bonds differentials to trade in and out of. A lot of markets liquidity was lost and investment banking gross trading profits of several hundred $billions a year. Money had been made by aggressive speculators in the ERM (also known as currency snake) years. The essential ingredient facilitating successful speculation (including short-selling)is a rigid system with transparent rules that can be easily tracked by the markets. The narrow bands within which currencies within the ERM were allowed to move were manna to the speculators.
The second paradox therefore is that in creating the Euro to be resistent to market speculators it was furnished with rigid transparent rules in terms of maximum ratios of budget deficits and of gross national (government) debt as a % in ratio to GDP. In the first years of the Euro a certain latitude was permitted including in the case of the largest economy of the Eurozone, Germany. Following a brief Eurozone technical recession in 2008 (a shock response to the international Credit Crunch) it was obvious that the next speculative opportunity would be loss of confidence in soverign debt as measured by the Euro's ratio rules. Such sovereign debt crises have always been triggered after a recession when governments increase their budget deficits and national debts in order to pull their economies out of recession.
That this should be especially a problem for the Eurozone and Euro system was easily predicted by many experts, though ignored and voted down at several IGCs. The Delors Plan and European Recovery Plan both of which advocated a trillion Euros to smoothe differences between economies netering the Euro was voted down by Germany, Netherlands and UK when supported by all others. Germany and UK especially were adamently opposed to brussels getting its hands on such a large spending reserve.
The markets speculators have merely had to wait for the Euro's first important recession to test its structure. The experts doubted how any currency could be sustained through and after a severe economy downturn if it is not directly supported by government finances. The Euro was only supported by the European Central Bank whose flexibility is constrained and whose ability to respond to some countries problems more than others is politically and constitutionally limited.
Brussels economists planning for the Euro in the mid-1990s told me privately that they believed The Maastricht Treaty was too simple and too inflexible. But because of the political drive behind the Euro it would be a disaster to drop the Euro plan, a disaster to delay it, and a disaster to proceed with it! The politicians and others had painted themselves into a tight and unsustainable corner. It was hoped that after five years of low growth and higher unemployment against trend caused by The Euro's introduction that lessons would be learned and a more sophisticated system introduced. Such a system should take better account of different GDP growth paths of each national economy, allowing for some that were growing based on heavy bank lending to property thereby causing trade deficits and those were growth was predicated mainly on export surpluses and therefore on banking lending to industry.
In the first decade Greece for example was praised year after year for contributing to Eurozone GDP groth much above its weighting in the Eurozone economy. It did not matter that Greece ran up the biggest trade deficit in the OECD relative to its GDP. Current account (external) payments balances were not part of the Maastricht Criteria. Ireland benefited to from excessive praise. While its GDP seems to be growing fast because of its massive trade surplus relative to GDP, the fact that it had huge current account payments deficits (uniquely so) was ignored! The system of rules was too simple.
When the ECB and other central banks set interest rates there are rules and obligations at work. But they are flexible; matters of judgement that make the interest rate decisions very difficult for the markets to predict and to successfully speculate against. This ambiguity in how decisions are arrived at and what they mean is a very useful policy tool that became evacuated from the Eurozone, especially so once Germany (with alongside other net exporters) was no longer in breach of the ratio rules.During the Credit Crunch (not yet over) banks and later governments that refinanced their banks using government bonds (not bills i.e. on-budget, not off-budget) the great anxiety was to bring down the cost and raise the certainty of supply of loans to banks (to recycle their funding gap finance) and to governments (to keep borrowing costs in line or below that of the rate of GDP growth and of government revenue growth).
German banks and the banks of net exporters (also called competitive economies) are heavily exposed to industry where lending margins are tightest and herefore their cost of borrowing is most critical to banks' profitability and solvency. As those competitive countries could appear so much "stronger" than deficit countries in the politics of the European Sovereign Debt Crisis their cost of borrowing would fall slightly as the deficit countries such as Greece especially found their cost of borrowing soaring. This is a vicious beggar-my-neighbour strategy. And this alone is enough to severely discredit the Euro Project and the prospects of its sustainability.The third paradox is therefore that a Euro system intended to integrate surplus and deficit countries works only when there is growth and appears to fall apart when there is recession! It is failing the essential solvency test that of surviving intact over a whole economic cycle.
With the Euro Sovereign Debt Crisis the European Central Bank that was created to be free of political interference has been displaced spectacularly by the central role in financial structuring taken by leading politicians, by the leaders of the "major powers" in Europe. This is a fourth paradox. It is linked to a sixth paradox that the European Union of equals regardless of size has morphed into a Union where the largest players dictate the economics of the smallest players. This in the case of Greece reminds us of the Munich Agreement of 1938 that dictated the dismemberment of Czechoslovakia without the Czechs at the bargaining table! The European Community, European Union and Eurozone predicated on European integration for the avoidance of war ever again is risking precisely again political disunity and potential for cross-border and civil war violence and possibly military or comparable dictatorships. This is the seventh paradox that financial and trade integration to make war (or near warlike disputes) impossible is now the single biggest factor in Europe's disunity.
In part it is the mindfulness of this that prompts Merkel and Sarkozy and others to seek tighter integration through fiscal unity and more rigid deficit and debt rules. They hope the amrkets are appeased by a rigid common order. But, we have plenty of experience to show us that transparant rigidities in the system encourage aggressive speculation.
It is repeated often that Germany above all fears currency collapse as in 1923. It has a practical fear certainly of a high Deutschmark destroying its trade surplus if the Euro system collapsed and the Eurozone members returned to each having a floating national currency. But, in 1923 the German currency was destroyed by short-selling speculators precisely because it was confined within a rigid system of enforced war reparations payments and dollar shortages. There was no flexibility allowed until it was too late. That the Merkel-Sarkozy proposals and the austerity measures enforced on Greece and Ireland and others are foolishly based on increasing the rigidity of the rules and that takes us further deeply into all the paradoxes above.
Aplying the rules will become even more severe and untenable if the crisis after Austria then more severely engulfs major economies Italy and Spain! The markets will not let up; they cannot so long as the liklihood of worsening crisis persists. It will do so for additional reasons. The Eurozone is in the early period of its normal recession, a recession only to expected that is on schedule to anyway regardless of the Euro Crisis as macro-economists can predict this merely based on past history!
Once Germany cannot politically sustain keeping within the bounds of the Maastricht budget deficit ratio perhaps only then will the Euro system be allowed to become more intelligent and more flexible! The sooner the better for all.It is a political problem of the first order in the wake of the Credit Crunch and Banking Crisis and the various austerity programmes for politicians to be seen advocating any solutions however sensible that sound like "funny money" or "painless" or gaming the system by allowing flexible responses. The mistrust of the voters and their cynicism and anxieties currently are boundless. It will take politicians of truly major statesmanlike stature to explain a truly Communitaire policy response and be believed involving cross-border trust and everyone sharing the blame, burdens, and the rewards according to financial need and not merely according to economic size. A relaxation of the rules and more flexibility in their interpretation plus more sophistication and complexity can supply a relatively painless solution for Europe and the world.

EURO SOVEREIGN CRISIS - CURRENT POLICY ISSUES?

2011-11-19T18:49:00.000-08:00

The Euro Area and the Euro System are in trouble as much from speculative attack by the money markets as from the natural difficulties of getting countries with very different growth stances of a mix of severe surpluses and deficits to share a common currency. It cannot expect all its legs to move at the same time together in the same way and in the same direction, not how any animal system walks or runs.
The EU needs a system of financial rebalancing that recognises the often extreme differences in each state's growth strategy and that accepts the inevitability of economic cycles. The Euro system rules are too simple and too rigid and offer the markets easy targets in the first recession testing of the Euro system.
The current system focuses on GDP only (not GNP) and fails to take account of payments external account and focuses on gross government debt (not net debt).
Greece and Italy are not the same problem except superficially. The EU and Euro Area are inevitably economies with opposing growth settings; export-led such as Germany (with banks focused 60% on lending to industry), deficit-led such as Greece and Spain (banks focused 70% on lending to property), or in rough external account balance such as France and Italy (where bank lending has been too conservative). Ireland is a unique mix of highest trade surplus and equally high payments deficit, which is bizarre? It has the highest trade surplus ratio to GDP and yet similarly high payments deficit. This shows it to be more a regional economy within the Uk than a truly national economy with its own domestic and national financial integrity.
Germany has a trade volume and export surplus equal to that of China. In the EU export surplus countries are equal to two times China. The rest of the bloc has to cope with this. Greece allowed itself to follow the examples of USA, UK, Ireland in growing GDP powerfully based on boom in mortgage lending. The banks were deaf to the entreaties of the Central Bank to stop that and lend more to industry.The central problem is not national debts and who these are owed to. Nor is it that the banks cannot be profitably financially helped by governments over time. It is certainly partly the banks' fault for the dysfunctional pattern within each country of their domestic lending bias. But the politicians are not aware how to address that or that they have the powers through EU laws based on Basel II to do so?
There are technical and definitional problems such as the simplistic Maastricht ratios. These should be termed funny money issues rather than levels of debt, which are well within the EU's financial resources to comfortably cope with over time.
The problem for all Euro Area governments is that when they provide financing loans to their commercial banks they have to do so on-budget and on-balance-sheet because their central banks no longer have treasury bill issuing rights. The USA and UK had no such problems and could insulate taxpayers from the refinancing of the banks.
When member states adopted the Euro it meant that T-bills (debt of 1 year or less maturity) that were previously issuable by central banks now gave up that power to the ECB. Today, countries in the Euro Area only issue T-bills from the Treasuries and debt management agencies and the debt therefore appears on budget (deficit) and on balance sheet (gross national debt). The UK and others can issue T-bills through their central banks where the debt is off-budget and off-balance sheet of the government. This provides immense flexibility to UK and others not in the Euro to provide financing to the banking system without directly embarrassing their budget deficits and national debt levels, a luxury denied to Euro Area governments.IS GERMANY AT FAULT? Merkel has in 2008 and in the years since including this year done and said no other than say Margaret Thatcher would have done and said in the same circumstances. One difference is the quality of Finance Minister and Schauble is not allowing himself to overstep a nationalist line. There is a concern to advertise Germany as safe, successful and superior so that German banks can continue to rely on getting cheapest funding, cheaper than other EU member states' banks. But those banks are heavily over-long on lending to exporting industry that is in severe pain to service its debts. Export surpluses, the principal source of Germany's GDP growth, are not won cheaply! There has come a point in time now when to ratchet down any further on the PIIGS ability to fly will rbound negatively, even catastrophically, on the German economy and the solvency of its banks. If Merkel and her team can see this danger they may start to give more credence publicly to reforms in the Euro system that permit less rigid adherence to simplistic fiscla rules. For the moment, however, the talk is of more rigidity not less and that means rich pickings for financial arbitrageurs and currency shorters, whose pay day is coming soon with the imminence of a full-blown Euro Area recession! Only when Germany has to loosen its own financial constraints it may agree for other member states to do the same? The present disparities will soon result in financial arterio-schlerosis spreading throughout the Euo Area system whereby many more states will find their wholesale finance cost rising and higher funding costs hitting all banks. A bout of recession will markedly worsen this and governments will then have to get together and realise that they have to act in concert and expand their spending and borrowing. Germany's economy appears to be externally strong (large export surplus as the main motor of GDP growth) but internally it is potentially weak. The banks are vulnerable by having loaned too much to industry (which is paying 10% of value added to service bank debt compared to only 10% of profit in case of UK industry, a nearly tenfold difference!).German banks are desperately in need of cheapest wholesale money (to support narrow margins and cash-flow based collateral) hence the hard attitude against deficit countries' fiscal problems - just a way of making Germany look good to wholesale finance providers relatively by comparison. If external trade shrinks and or becomes less profitable to exporters and if the Euro Area breaks up then Germany faces domestic economy meltdown (worst of all if it returns to a strong and soaring Deutschmark). The Euro Area is in any case now into its recession, a recession that follows as it usually always does 2 years after USA/UK recession. (EU/EA's brief recession in 2008 was not the real thing, only a shock from the financial bank crisis).EU politicians have to learn again to kiss their European frog and trust it will turn into a prince again. The USA (Tim Geithner etc.) has very right to criticise the Euro Area politicians for being too reluctant to act in the interest of the whole international community - but he may be foolish to do so publicly. The same may be said of the UK's David Cameron. The Fed, Bank of England and the ECB have a joint responsibility for world money markets and when these seize up they have to intervene jointly. Foreign politician's criticisms - brickbats flung across the Atlantic or across European borders - are usually for domestic political consumption. It is easy to make broad statements but they only make sense when there are concrete ideas to be shared of how best to resolve the problems practically.
It would be a reasonable accusation that the Euro Area fiscal rules are inflexible and simplistic. The Euro had its political supporters but technically was supposed to protect by sheer size against FX-money market speculators. The ECB was set up but placed in a constrained position and consequently fails to sufficiently compensate for the central bank powers that each Euro state gave up to the ECB.
Even the economists internally within the Euro planning teams in Brussels a decade ago foresaw this present disaster. But, back then, they hoped that after the first 5 years new more refined rules and better understanding of the technicalities would have evolved.
This didn't happen for various reasons most of which are political cowardice in face of global FX-money markets - mistakenly believed to be somehow most astute about economics and anyway ultimately all-powerful. The actual dysfunctional nature of information in these markets and their miserable irresponsible short term profit seeking etc. is all beyond the understanding of politicians and even of most political-economists, many of whom get little real-world model-building experience. The bankers also are afraid of economists and refuse to let them into the boardrooms where they fear that economists might take over - preferring instead to deal with the mathematical geeks whose understanding of risk cannot go further than market prices, rating agency ratings, and poorly cultured algorithms.Must a new Euro system be legislated? The default direction of travel here currently among EU politicians is to seek a tighter union and tighter rules with a fiscal policing agency. But, practical reality dictates that the EU and Euro Area need less rigidity not more. The Euro sovereign debt crisis is a product of rigid rules and crude definitions of national debt. It is the rigidity that makes it an easy target for shorting speculators.
The irony of the present situation is that the Euro was constructed to protect all members from money market speculators employing rumor-mongering of exaggerated insolvency scares. It is extremely damaging with incalculable repercussions worldwide in medium and long terms to undermine the credit-standing of OECD countries and to threaten the Euro system to generate investor panic for the sake of short term profits.
Any revised or new system must recognise if some EU members insist on maintaining large export surpluses then others must have sizeable external deficits. They cannot all aspire at the same time to export-led growth.
The Maastricht Rules should be elaborated to be made more intelligent, subtler and harder for the markets to analyse and play merry hell with! It does not follow that the answer is fiscal union or sameness within the Euro Area. And fiscal union should not mean aligning all tax and spending. It is not a sensible or workable basis for justifying cross-border financial guarantees. The proponents of more rigidity and fiscal alignment fail to see this course will require large fiscal transfers evey year between Euro Area member states. President Nicolas Sarkozy called up Hu Jintao recently to ask if China would care to invest in the European Financial Stability Facility (EFSF), the Eur750bn fund. Sarkozy and Kanzler Angela Merkel are imagining China's US$3+ trillion in foreign exhange reserves as a source of ready cash. Should China say yes?
Of course China should participate because it adds to its mystique as a most successful economic power that is impervious to the crisis elsewhere. This is however not the true case. China is extremely vulnerable. Its economy is considerably smaller than official figures suggest and its economy is starting to nosedive beginning with a property collapse. China's banks are teetering on insolvency caused by funding gap and growing poor and non-performing loans and are only sustained by massive deposits from China's foreign currency reserves. China's industry is massively over-borrowed and very vulnerable to fall in export volume and or profits, already accutely modest.
Europe should not seek China's involvement in contributing to Euro Area crisis funds, or from OPEC countries' dollar reserves either. Such a course would be giving foolish testimony to EU insolvency and internal failure, which is not at all the true state of EU or Euro Area financial resources, which exceed that of China plus OPEC many times over!
The reason China cannot loan a few $ trillion is because its reserves are mainly committed by over $4 trillions to supporting China's domestic banks' balance sheets. Chinese households cannot add much to current deposits and are only permitted to borrow a third back while two thirds of household deposits and all of corporate deposits are lent to industry. There is nearly $5 trillion in loans to China's industrial borrowers in support of which the government has deposited $2 trillion with China's commercial banks and loaned them $2.5 trillions Yes, China has extra pocket change (generated annually from the trade surplus) and could support its trade with Europe more assiduously and politically by directly buying Euro Area bonds including those of the EFSF and or IMF, but probably by no more than a % of its annual trade surplus with the EU totalling perhaps $40 billions in 2011. But, this is a trivial and unnecessary, and for Europe's self-confidence and global prestige hugely damaging - EU's politicians need a wake up call to understand the realities they are playing with.
For quite good succinct discussion on the background see:
http://en.wikipedia.org/wiki/European_sovereign_debt_crisis

Property lending and rules to save banks from themselves

2011-04-20T03:32:00.000-07:00

Millions are frustrated because banks wll not lend them money to buy or develop property. Banks ascribe their lending restrictions to the new "Basel III" capital requirements (effective in 2012). This is not strictly a valid reason. Borrowers and others are given such simple reasons because the total picture is fraught with difficulties in striking the right balance between opposing demands, dogs and fire hydrants, rock and hard place etc. What is going on, or not?
Banks are shrinking their balance sheets and that inevitably means property lending (70% of UK and USA banks' customer loans - after exclusing loans to rest of finance sector which are also shrinking) and also hoping desperately to sell on bundles of property loans and foreclosed properties, if only they can find long term deep pockets to sell to without too steep a discount.
The retreat by banks from property is one reason why insurers and other institutional investors are getting into property lending, seeing an opportunity to do so without competition from banks and expecting higher returns than the banks can achieve.
The bankerspeak financial technicalities.
Basel III changes to higher capital reserves and more core capital of banks (higher amounts and higher loss-absorbing quality) are not genuine reasons for reducing the general loan exposure - it is really about narrowing the funding gap (between deposits & loans) that is filled by selling Medium Term Notes into the "wholesale interbank funding market" and banks are each fearful of when they next have to go to market to replace their MTNs on maturity (big amounts periodically every 3,6, 12, 18 months etc.).
"Internally generated capital" is recovery of monies loaned plus net interest income and other realised profits, and the banks are torn between using those gains to reduce their funding gaps or to increase their capital and liquidity reserves (as regulators under the name of "Basel III" require). They are also torn about how much they can allocate to bonuses rather than dividends. Hence, the banks blame Basel III for lower lending and want everyone to know that as part of their pressure on regulators and governments to soften or postpone Basel III and even on shareholders re. dividends and government and other pref bond holders to expect lower % coupons for longer - when actually it is really about narrowing their exposure to wholesale lenders i.e. to severely reduce their funding gaps, which UK banks have already halved from £1 trillion to £500bn, and falling, and that is a lot of balance sheet liquidated and internal capital generated.
The banks know the wholesale funders well and what is looked for an expected because they are also such funders in terms of their large loan exposures to other financial sector borrowers and have been liquidating cross-border interbank loans dramatically.
When (how soon) a bank has to next replace/refresh its "funding gap" finance will dictate its current openness to agreeing new loans; they are keen to say to their funders here is £5bn matured MTN repaid to you and we only want you to roll-over and buy £2.5bn of new MTNs back from us, which is supposed to sound good to the lenders and there should therefore be minimum fuss or embarassment (narrower spreads) that could leak out to market and damage the share price.
Property (development especially) is seen as riskier, and in addition UK banks are being warned by regulators to reduce the concentration of risk they hold in this one sector (property), especially while they are holding large amounts of receovered property collateral and seeking to sell on about 20% of their property loans (i.e. £260bn), probably with 15% haircuts = £40bn, some % of which could appear as paper loss relative to the outstanding loans, interest & charges that relate to the collateral recovered, perhaps £5-10bn (a wild guess).
The banks are in a bind partly of their own making insofar as the property market (asset prices) cannot recover until new property lending grows and yet until there is recovery they cannot sell their property exposures without risk of substantial loss, and without clearing out of a lot of property they cannot resume property lending.Therefore, if institutional investors (who are the major shareholders in bank other than governments) step in to make up the shortage in new property lending this, if on a large enough scale, could be important to breaking the logjam, and should be profitable to institutions in two ways (for themselves directly and via improved balance sheets of the banks), and given that property conditions are a major aspect of economic growth recovery.
But, when property lending is resumed by banks more assiduously the first port of call may be to refinance troubled loans rather than agree new loans to new borrowers, that is long term loans especially, while short term lending only looks relatively attractive to many banks. Medium to long term lending appears to have too many uncertainties i.e. the risks are very hard for them to compute.
The wider context includes policy that is torn between being seen to put in place measures that can be claimed to make sure the credit crunch recession never re-occurs, while also needing bank lending to stop shrinking and then to grow to generate more certainty of substantially higher economic growth. This facing in contradictory directions is why there is much fudging about the impoact of Basel III regulation including the Vickers Commmission recommendations that many outside UK as well as in UK hoped would provide a clear new line to follow and refresh the impetus of the G20 agenda of about 100 adjustments, policies and new institutions to protect the financial system from itself.
So-called "Basel III" rulings aim to increase banks’ tier 1 capital base from 2% to 4.5% (ratio to gross loans, or twice this to risk adjusted loans) to improve the resilience of banks. These discourage securitisation transactions, and there are four ways banks can increase their capital base to meet new ratios: raise more long term capital themselves (internally generated by cutting costs, bonuses, dividends and coupons), raise more in deposits, shrink loan balance sheets, commit less own capital to investment banking (market trading & derivatives), and reduce exposure (in economies where property dominates) to property and property loans.
There is the hope that interbank lending and funding gap finance and securitisation of loanbooks will sooner than later return as a reliable and substantial option, but only once the banks look safer bets i.e. the banks are strong enough to again dictate the loan spreads to those they borrow from. That is unlikely so long as the sovereign debt crisis reflects badly on banks and so long as Basel III looks hard for banks to comply with, even if these are very much parts of the banks own PR to shift the blame (playing up the sovereign debt crisis) and to soften new capital rules (foot-dragging on Basel III).
From the point of view of individual borrowers going to the banks with wonderful schemes of great quality all this bigger picture about future impacts reasons given for refusing loans is an immense frustration. It is actually the excat inverse of the pre-credit crunch past when banks ignored the bigger macro-economic and regulatory picture and approved any loans that passed merely microeconomic tests based on past high growth experience and not on forecasting future downturns. Yet, while the medium term future should be one of renewed growth and recovery, Basel III is ensuring future risks are assessed in terms of possible repeat of economic down turn (double-dip or another recession)!
In the case of seeking loans from banks that are underwritten or otherwise backed by government should ensure that banks can lend comfortably because the risk is low. But, low risk also means low net interest income when banks are anxious to raise their % net interest income, and given uncertainties about even government finance (subject to unexpected renewed cost-cutting at budget time) state-support may not of itself be sufficient to get the banks to lend. Institutional investors seeking to fill the gap also may not be attracted sufficiently by the low margins despite state guarantees. They are attracted by commercial property, not residential, and are not stepping into property lending because they are attracted by low margins of bank lending. Insurers are attracted by the higher interest income generated by commercial property loans compared with government bonds.
Over half a £/€trillion in commercial property loans are maturing in C.Europe over next 3 years and possibly a third of that additionally in the UK. Institutional investors will step in where banks fail to roll over what is of good quality and cannot be all repaid, and are already now financing about one quarter of comemrcial property lending.

Banks and Basel III: blackmail or chainmail?

2010-09-27T00:41:00.000-07:00

Will the various new so-called “Basel III” rules make the world safer from financial crises? There should not be a short answer to such a complex question – but my answer is yes, and no, not much either way, and, looking back, taking the metaphor of New Orleans sea defences and levees, higher equity in banks core capital reserves means the same as adding only inches to the height of ‘sea defences’. Protecting the financial system is a systemic challenge; individual breaches in flood defenses may be contained or lead to general failure.
Erecting barriers, by setting global prudential standards, to prevent calamity is the job of the Basel Committee on Banking Supervision (BCBS), to mitigate, prevent or postpone, another Credit Crunch, its job is to agree techniques, laws, rules and guidelines to resist a 1/25 tidal surge or the 1/100 that some say defined the Credit Crunch.
But, what do we think of bankers’ response to new safety rules? They sound like road drivers opposing lower speed limits.
The banks publicly resent being told to increase reserve ratios. It is the same reaction if government asked the private sector to build and pay for sea defenses. The banks’ lobbyists such as the BBA and IIF warn gloomily of a probable £1 trillion less lending in the UK alone over the next decade - maybe €7 trillion less lending across the EU.
Our inglorious banks have, it seems, regained a bold-faced confidence sufficiently to complain loudly about new prudential rules, as if these ingrates* have superior information to warn us not to kill the Golden Goose**, and as if everyone else will trust that judgement and believe the banks?
But, is it realistic to suppose that excessive fear of another financial crisis and mistrust of banks by regulators and taxpayers could lead to borrowers and the economy paying a big penalty for higher equity-capital reserve ratios?
Alongside the new capital rules, the Basel Committee also published two papers on economic impact that media commentators and banks’ lobbyists, appear not to have read? These assessments are more sanguine and define it as a (very) “conservative” view to assume all the impact of Basel III will be borne by higher customer borrowing costs and reduced lending.
The Committee agreed higher equity capital ratios (announced 12th September) to oblige banks to hold more to absorb the inevitable losses of a recession. The changes are intended to mitigate and or postpone the next “financial crisis”. More equity means shareholders will bear the losses, as they have done so already in the Credit Crunch?
Reserves are ratios to loans and investments net of collateral after risk adjustments. New rules require twice as much equity reserve as before, but with years to get there, by when the USA and UK will probably be in recession again? Higher “capital buffers” are also imposed, but only in the proportions that national supervisory regulators are already demanding.
Bankers’ bleat that capital hikes mean higher customer costs, less lending, and will only jeopardize recovery. But, by the time the ratios kick in we’ll be past recovery and into the next boom. Bankers, it seems, don’t want us to see the many ways they can generate more “own capital”, including via higher profit-retention and paying smaller bonuses!
The BIS paper on macro-impacts finds that for each 1% increase in the capital ratio loan costs could maximally rise by 13bp, and for every 1% higher liquidity reserves loan margins rise 25bp, assuming RWA is unchanged. This falls to 14bp or less if RWA falls by shifting the risk diversity to less risky assets without any fall in gross assets. If banks adjust their expected return on equity from 15% to 10%, then each 1% increase in capital ratio is recovered by a 7bp rise in loan margin, well within what can also be achieved by cost-cutting or other relatively painless measures.
BIS is very clear: “Banks have various options to adjust to changes in required capital and liquidity requirements other than increasing loan rates, including by reducing ROE, reducing operating expenses and increasing non-interest sources of income. Each of them could cut the costs of meeting the requirements. For example, on average across countries, a 4% reduction in operating expenses, or a 2 % fall in ROE, is sufficient to absorb a 1% increase in the capital/RWA ratio. In practice, banks are likely to follow a combination of strategies.”
Cost of borrowing by banks should reflect the riskiness of banks. If banks are safer because of new rules then the risk spread banks pay to borrow should fall. But, if bankers don’t rediscover prudence, alongside a humbler piece of the pie, as governments anxious to balance their budgets exit from bank-aid measures, then the banks will have to pay more to borrow funding gap finance and to attract and retain deposits.
Let’s not forget that the Credit Crunch was caused by funding gap finance cost (risk spreads) becoming uneconomic, too high to ensure positive corporate lending margins. Why, because banks lost credibility and it is not at all clear that they can presume to have that back now, not while ratings agencies keep so many banks on the bottom-most rungs of unsecured credit grades.
The rates borrowers are charged should be dictated more in future by competition and demand than by banks seeking again the super profits of the years before 2008, and in Europe especially if cross-border lending is to recover and grow? Banks may accommodate higher reserve ratios by requiring more collateral and by exercising other risk mitigations including diversifying better across all economic sectors and by changed business models. Banks in trade-deficit countries are biased to property lending and in export-surplus countries to industrial trade.
In the years up to 2007, banks grew faster than underlying economies, earning dispro-portionately high profits, 25% - 50% of all profits of publicly quoted companies, which should be unsustainable. Shouldn’t they adjust to more realistic or reasonable profit targets?
The new rules are a cornerstone of the G20 response, a global effort to ensure stable international banking. The rules redefine “core tier one capital”, a measure of a bank’s solvency, plus sufficient liquidity to survive a short-run crisis with less dependence on short-term borrowing. The new ratios would not have saved the banks that crashed in the credit crunch but are a step in that direction to take some pressure off future government budgets.
Dame Angela Knight, chief executive and spokesperson of the BBA, was almost entirely negative about the announcements. She warned that banks have no choice except higher loan margins that will “suck money out of the economy” – by which she means the non-financial economy - as if banks’ profits, bonuses, and speculation can’t do that already. German banks made similar objections, and others too.
Three major UK banks have threatened to domicile themselves elsewhere if the UK government and its Banking Commission decide to split retail from investment banking - Paris and Frankfurt are offering lower tax to induce UK banks to move! Is this further evidence of a return to confident arrogance, of which resisting new capital ratios are shots across the bows of the regulators?
The threats are poor thanks for Government and Bank of England’s heroic roles as lenders of last resort in baling underwater banks. All banks were helped by state aid packages. Banks that did not require direct aid, or not as much as others, yet benefited massively from the help given to others. When Lehman Brothers collapsed, for example, among a host of emergency measures there was $2.5 trillion alone in temporary liquidity by the Fed, BoE and ECB to resolve failed money market trades.
Dame Angela (for the BBA) wants the new rules carefully handled to avoid “prolonging the downturn”. The banks got eight years, a long time in banking. She says, “The consequence is that inevitably the cost of credit – the price the borrower pays for money – will rise. The cheap money era is over.” Surely, a fun remark when the central bank rates continue negative in real terms. A lobbyist for bankers, the IIF used similarly dramatic language to persuade the Basel committee to dilute its reforms. Do bankers think we, politicians and taxpayers, learned nothing about how banks operate, or about how blinkered, self-serving, solipsic and short-termist their thinking can be?
The job of bank risk regulators can seem like herding cats!
The WSJ’s David Weidner wrote: “Judging by their hokey scare tactics, you'd think the act of raising capital requirements during an eight-year span was the final blow to capitalism. But it's not. Basel III is a compromise tilted toward an international banking community that's woefully undercapitalized and vulnerable to breakdowns.”
In truth, banks have far flexibility and head-room than their lobbyists want us to see. The public was not fond of banks before the crisis and now views them with mistrust, hatred, and derision. What other industry can prosper when so unpopular?
Banks do not have to make their customers pay; bankers can reduce their own bonus levels for a start, or perhaps regulators should do so – they now have that power! Banks’ pretence that certain people will only work for guaranteed bonuses, as for example for managers of ‘prime services’ to lend to hedge funds. Remarkably, it is so hard to lend them money this requires $5m guranteed bonuses?
Saving losses, what risk managers do, is never so generously incentivized, not remotely so? It is like paying football midfielders thirty times what the goalie gets, and strikers and team manager fifty times as much!
Privately, bankers, regulators, and most everyone else know that “incentivising” star players by handing them bonuses in excess of either group profit or loss damages credibility, solvency and shareholders. Fiduciary prudence is replaced by something else, poorly understood or defined except to call it ‘daylight bank robbery’ or ‘greed’. That is the dominant political and general voting public’s view. Are they wrong?
As someone who enjoys a spendthrift life on high-fees, I understand that heady culture that I am also part of, if better looking than Dick Fuld and freer than Bernie Madoff. Ah sure, wouldn’t we all be somewhat poorer for not having outrageously super-rich like us to gawk at, demonize and blame – but not if the consequence are distorted values that risk our whole economy! Martin Wolf in the FT wrote, “withdrawing incentives for reckless behaviour is not a cost to society; it is costly to the beneficiaries. The latter must not be confused with the former.”
Banks may reduce the capital they have committed to proprietary trading, to speculation, to profit from markets beyond lending to them. Banks may cash in realizable profits and sell non-core assets. Over the years banks can generate internal capital without upping borrowing costs of households and small firms. UK banks would do well to lend more to small firms who employ 40% of all jobs but only get 1.5% of non-financial loans – in the USA 10% and in Germany 19%. Banks can tap equity and bond markets for capital and retain more of net earnings before bonuses. When will they tell shareholders how much bonus is performance related or guaranteed?
The lobbying by IIF used the difficulties of Europe’s local savings banks such as in Germany and Spain, resulted in all banks getting a suspiciously long time to build new reserves, from 2013 to 2019. By then, all current top execs will have retired, rich, and we’ll be in the next recession when government again has to reflate the economy without help from banks!
Rather than scaremongering, bankers should grow up and recognise their priority is to rebuild moral authority and trust by customers, taxpayers and others, not least shareholders, show willingness to adapt their business models and pay themselves less. Scare-mongering fools no-one except the gullible of whom there are precious few left for banks to rely on for support today?
The banking lobbyists’ churlish failure to apologize or acknowledge that they must mend their ways and change how they do business and what is realistic and reasonable risk-based profit only does more damage to the recovery, not of the economy only, but that banks need to make to recover customer and taxpayer trust and loyalty, real self-belief and fiduciary responsibility, including in macro-prudential terms, i.e. real banking professionalism – or maybe I’m just old-fashioned, a grumpy old banker well past my sell-by-date?
______________________________________________
*Note: Ingrate, n. One who receives a benefit from another, or is otherwise an object of charity -Devil’s Dictionary.
**Note: Reminding us of, from “The madness of Crowds”, about the inventor of modern bonds, John Law, “he understood the monetary question better than any man of his day; and if his system fell with a crash so tremendous, it was not so much his fault as that of the people amongst whom he had erected it. He did not calculate upon the avaricious frenzy of a whole nation; he did not see that confidence, like mistrust, could be increased almost ad infinitum, and that hope was as extravagant as fear. How was he to foretell that the French people, like the man in the fable who killed in frantic eagerness the fine goose he bought to lay golden eggs?” (Charles Mackay writing in 1841)

MOODY'S BUGS CLEARED ON A TECHNICALITY

2010-09-01T06:19:00.000-07:00

Moody’s has avoided prosecution by SEC and others on a technicality, announced some three years after the SEC investigation began!
Sam Jones, wrote in FT’s Alphaville over two years ago about bugs in Moody’s model for rating securitization issues that mistakenly gave top ratings for bonds.
When re-rated after June 2007 using a model in which the bugs had been fixed tens of $billions of CDOS, RMBS, ABS bonds dropped in value by up to 17 risk grades, sometimes from Aaa straight to 'Junk'! Moody's between 2005 and 2007 risk rated about 10,000 Residential Mortgage Backed Securities (RMBS).
http://ftalphaville.ft.com/blog/2008/05/21/13198/ft-alphaville-exclusive-moodys-error-gavetopratings-todebtproducts/
This was based on a fuller account that appeared in a few blogs including my own. Moody’s awarded incorrect triple A ratings to tens of billions of dollars worth of a type of asset covered bonds. The FT wrote, “Internal Moody’s documents seen by the FT show that some senior staff within the credit agency knew early in 2007 that products rated the previous year had received top-notch triple A ratings and that, after a computer coding error was corrected, their ratings should have been up to four notches lower…” In 2007 moody's downgraded about one third of all RMBS. This was the mild form of the story.
It was not just about ratings in 2006; between 2000 and 2007, Moody's rated $4.7 trillion in RMBS! For some model descriptions: Moody’s used its Moody's Individual Loans Analysis (MILAN) model for collateral analysis with a cash flow model such as Moody’s Analyser of Residential Cash Flows (MARCO) or ABSROM. Moody’s analysis was intended to provide RMBS investors with a consistent and transparent system of gradation by which relative credit quality is expressed.
The lack of transparency issue has however been the leading criticism by regulators. The Moody’s objective was laudable - to assign the same ratings to all debt instruments exposed to equivalent credit risks over time, irrespective of the country of origin, the industry sector or the structure of the security. This aim is however subject to differences in law regarding the underlying rights of mortgage borrowers and how the property collateral may be recovered.
Moody's aim was that over the same period of time, portfolios of structured finance securities with the same ratings should sustain similar credit losses. But, the problem remained of not just the history of defaults in the models (or not if they failed to be updated and when the models appeared indifferent to default rates) but also the forecasting of defaults under various economic scenarios?What happened was that Moody’s modelers noted a speech by Ben Bernanke in January 2007 where he reported that default rates were below 2%, which seemed both counter-intuitive and contrary to other earlier reported figures of 4% and rising. Bernanke had taken his data from Freddy Mac and Fanny Mae, data that was actually post-adjustment after many mortgage deals had been restructured. The modelers decided to put progressively higher default data into their models only to find that every time they cranked the numbers the result was always triple-A or otherwise unchanged from before i.e. the bugs in the model meant they were indifferent to default rates – seriously flawed fundamental errors! And, then they discovered that the models in any case had not been updated for default rates for some years!
When Moody's announced on June 5, 2007 that it was introducing changes to its model, it did not reveal how fundamental this was. It said "Moody's Expands Loan Characteristics in Subprime RMBS Ratings Analysis - New York, June 05, 2007 -- Moody's Investors Service announced today that its analysis of securities backed
by pools of sub-prime residential mortgages closing after July 1, 2007 will be expanded to include a systematic assessment of certain variables described in the Special Report, "Moody's Revised US Mortgage Loan-by-Loan Data Fields," published April 3, 2007. In addition, Moody's will be modifying the way it incorporates some other factors into its analysis. The refinement of its rating methodology is part of Moody's continuing effort to incorporate the expanding range of loan and borrower characteristics now being captured by many mortgage originators as well as the
performance data that has been accumulated during the past few years in the rapidly growing and evolving sub-prime mortgage market. Moody's expects to continue to refine its methodology in the future as it continues to analyze the increasing amount of performance information that becomes available."
This made the changes seem merely benign, when in fact they heralded the bottom falling out of the interbank credit market. To those who need to know a little of the technicalities, it may be of interest to note that given limited historical data, Moody’s used three parameters to determine the "lognormal loss distribution": − expected loss (base case losses) of the portfolio − adjusted MILAN Credit Enhancement, and − average life of the portfolio.
Moody’s assessed the expected loss using historical default and recovery data "provided by the Originator" or "based on comparable portfolios and benchmarking". All very well, but range of possible loss data is surely the main feature that the ratings agency model should be bringing to the analysis, not merely using the issuer's own data?Moody’s used MILAN to determine the MILAN Credit Enhancement (CE), and, in order to derive the ratings of the Notes, Moody’s used a cash flow model, MARCO, which included "key structural elements". MILAN was a risk scoring model, which is not ideal; each loan compared and scored against a country-specific benchmark loan, then, based on certain assumptions (mainly loan to value ratios that are especially relevant in the US, but much less so elsewhere). The credit enhancement necessary to agree with the benchmark loan can be determined, then tagged to a specific rating level (somewhat circular). No mention is made in the Moody's literature I have seen of credit cycle or economic cycle or macro-economics at all!
Overriding accuracy issues for the ratings agencies was also competitive ones of how to win ratings of big issues when the issuers could shop around for who would produce milder or harsher ratings! The question remains unanswered as to whether the ratings models of Fitch and S&P were a lot better than Moody’s or not?
Several internal emails have come to light that show this. For example, a July, 2004 S&P email: "We are meeting with your group this week to discuss adjusting criteria for rating CDOs of real estate assets this week because of the ongoing threat of losing deals. . . ." [emphasis in original] A March, 2005 S&P email chain shows that agency was slow to roll out ratings model changes because the updated model produced harsher results. Parts of the chain: "When we first reviewed [model] 6.0 results **a year ago** we saw the sub-prime and Alt-A numbers going up and that was a major point of contention which led to all the model tweaking we've done since. Version 6.0 could've been released months ago and resources assigned elsewhere if we didn't have to massage the sub-prime and Alt-A numbers to preserve market share."
Emails at Moody's include in May, 2007: "Thanks again for your help (and Mark's) in getting Morgan Stanley up-to-speed with your new methodology. As we discussed last Friday, please find below a list of transactions with which Morgan Stanley is significantly engaged already. . . . We appreciate your willingness to grandfather these transactions [with regards to] Moody's old methodology." And also in August, 2007 Moody's email: "[E]ach of our current deals is in crisis mode. This is compounded by the fact that we have introduced new criteria for ABS [asset-backed securities] CDOs. Our changes are a response to the fact that we are already putting deals closed in the spring on watch for downgrade. This is unacceptable and we cannot rate the new deals in the same away [sic] we have done before. . . . bankers are under enormous pressure to turn their warehouses into CDO notes."
Such emails show considerable overlap between quality of models and competition for the business to the extent that could be deemed evidence of compromising fiduciary duty to investors etc.
See DailyFinance: http://www.dailyfinance.com/story/investing/more-hot-emails-put-new-heat-on-the-credit-rating-agencies/19452156/?icid=sphere_copyright
Moody's had several points in its modeling where results could be massaged. There was comparison of the specific loan, property and borrower characteristics underlying each loan with those of the benchmark loan. This, if fully true, must have involved massive computing, which I sense may not have been fully deployed.
This then leads to adjustments to necessary credit enhancements of each loan, which are then compared to the minimum credit enhancement determined for a country. Again, we may wonder at the resilience of the benchmark concept?
Once each loan was scored, the portfolio was compared with the country benchmark RMBS in terms of regional, borrower and loan concentrations. This led to additional adjustments on the credit enhancement and ultimately produced the MILAN Credit Enhancement for the portfolio, relating to a specific rating level.
All steps are analysed and discussed by a rating committee. After, and if, further quantitative and qualitative adjustments to the MILAN CE by the rating committee (resulting in the adjusted MILAN CE), then, given a lognormal loss distribution, MARCO is used as a cash flow model for how different features in the transaction impact the final ratings of the Notes (each of the tranches of the securitised bond issued by the SIV).
The model calculates the loss and the average life of the Notes resulting from each portfolio loss scenario of the lognormal curve. The model will then weight each loss and average life on the Notes with the corresponding probability of the loss scenario.
The result is the expected loss and the weighted average life for each tranche in the capital structure. With these two inputs, the ratings can be derived from Moody’s Idealised Expected Loss Table.
That sounds simple actually, simply a way of getting the securities to comply with a standard ratings table. That is, until it is discovered in January 2007 that the models did not actually respond to different default or expected loss rates and that loss rates, presumably for the benchmark loans, had not been updated for several years before 2007!
Former Moody’s Executive Brian Clarkson described the approach as “you start with a rating and build a deal around a rating”.
While it certainly does exist, rating shopping appears to be a more significant issue in single-issuer debt ratings than in structured ratings. Given that single issuers exist prior to their rating and it is more difficult to change their existing businesses, balance sheets, income statements or structures in anticipation of review, rating shopping is a justified concern.
In structured securities, the SIV corporation (trust) does not exist prior to the rating, the structure to be achieved in order to garner a desired rating is defined by the rating agencies. As a result rating shopping is less a concern than is the pre-rating back and forth negotiations and substitution of underlying collateral which allows issuers to work with the rating agency until they create the structure that achieves the desired rating.
Working backwards and using feedback adjustments to get to a desired ratings is one thing, but operating models that are indifferent to default rates is another. Moody's modelers in January 2007 fixed these latter calamitously major bugs in the models and then found that the bonds or notes when reprocessed dropped by up to 17 risk grades! This they reported upstairs to a shocked board, who must have seen instantly that their company was now at major risk, and perhaps they might have also seen that the whole banking market was also at major risk.
The modelers were told to unfix the fixes and sit on this until it was decided how to handle this; how to tell the world? That thought-leadership process took 6 months, during which time other mind-focusing events occurred such as Bear Stearns securitisation collateral seized and sold at fire-sale prices by Citicorp's back office, triggering Bear's eventual collapse and US Treasury assisted fire-sale to JP Morgan Chase, and then UBS and Citicorp's own structured products exposures were subject to large writedown losses!
Yet, Moody's did not publicly mea culpa or publicly revamp its model until mid-year.
It made an announcement of a new model in June 2007. The news was not considered of fundamental importance to any but perhaps a few.
Then, from June 2007, using a newly fixed model. Moody's regraded securitization issues, mainly RMBS (of which Moody’s had graded more than half of all issues, or $4.7 trillions), that when cranked through the valuation model (a process like Chinese water torture on the interbank credit markets) with day after day, week after week, bank-issued (via SIVs) asset backed bonds and SIV notes (tranches) being severely downgraded that forced banks and eventually other investors to announce major writedown losses! For example on just one perhaps typical day, Moody's Credit Research Announcement 10 JUL 2007 "Moody's downgrades 399 subprime RMBS issued in 2006; 32 additional securities placed on review for possible downgrade". $ billions of RMBS were being downgraded every day.
Confidence in banks’ securities progressively collapsed and the Credit Crunch wreaked havoc on banks’ share values as well as on their ability to finance their funding gaps.
An SEC investigation followed the FT’s exclusive, EU authorities too, not least DG McCreevy when head of Ecofin, were extremely angry at the damage caused and considered suing the ratings agencies in court. Reforming credit ratings agencies became an important part of the G20 agenda. In various parts of the world including Europe various measures were considered and are being introduced to reduce reliance of the US credit ratings agencies. But, this is very difficult to do! It was obvious that when the ratings were re-run by Moody’s through new models in the second half of 2007, every week more downgrades, that coincided with full onset of the Credit Crunch.
It is reasonable to ask therefore if the securitization issues been properly, accurately, assessed, could the worst of the Credit crunch have been avoided? That is a big question, a big issue!
Similar criticisms of the ratings agencies followed in the wake of the Enron scandal but SEC legal action was not followed through with and was dropped. Enron's rating remained at investment grade until four days before the company collapsed. Similar failures were repeated in the cases of Bear Stearns and Lehman Brothers, and other firms. The ratings agencies failed in the case of Enron to notice that financial trusts linked to Enron made financial commitments largely based on Enron’s share price!
There were regulatory reforms in the US credit rating industry, the Credit Rating Agency Reform Act of 2006, and that put them in the context of the Sarbanes–Oxley Act of 2002. The SEC committed to improve the quality and integrity of the credit rating industry, but instead of focusing on detail resorted to broad reforms such as increasing competition between credit rating agencies including through new market entrants. That the SEC has in the case of Moody’s dropped further investigation on a technicality may have something to do with its own culpability. The SEC has been equipped with enforcement measures, which include the suspension and revocation of NRSRO status, and that may be used, for example, when a credit rating agency does not comply with procedures regarding the prevention of the misuse of material non-public information, conflicts of interest, and other abusive practices. Credit rating agencies are subject to (onsite) examination by SEC and extensive documentation retention and management programmes. It will be a long time before new competition can have a desired effect of improving the quality and integrity of the global US credit rating firms (the big three).
Arguably, the credit rating agencies are more powerful than the regulators in determining the creditworthiness of banks and their bonds. They also have a major responsibility and impact influence on sovereign ratings of governments. Given the influence of credit rating agencies in the capital markets and their regulatory responsibility as private-sector watchdogs, increased oversight of the credit rating industry is most laudable, but also most intimidating for regulators however backed by governments to undertake. Credit rating agencies currently remain prominently in the spotlight of national, federal, and international securities regulators, but appear let off the hook by the SEC, but only on a technicality. They remain subject to possible other agencies including private class actions slowly moving through the courts such as by CALPERS http://online.wsj.com/public/resources/documents/calpers.pdf
Three years on, on Tuesday, 31 August 2010, the SEC released this: “The Securities and Exchange Commission today issued a report cautioning credit rating agencies about deceptive ratings conduct and the importance of sufficient internal controls over the policies, procedures, and methodologies the firms use to determine credit ratings.”
The FT commented that the SEC’s Report of Investigation stems from an Enforcement Division inquiry into whether Moody’s Investors Service, Inc. (MIS) — the credit rating business segment of Moody’s Corporation — violated the registration provisions or the antifraud provisions of the federal securities laws. The Report says that “because of uncertainty regarding a jurisdictional nexus between the United States and the relevant ratings conduct, the Commission declined to pursue a fraud enforcement action in this matter…”
So, Moody’s has escaped prosecution for “fraud” because the relevant American legislation was defective – a shortcoming, the SEC notes has been expressly addressed in the newly-minted Dodd-Frank Wall Street Reform and Consumer Protection Act.
You can read the report at http://www.sec.gov/litigation/investreport/34-62802.htm
On May 20, 2008, the Financial Times published on its Web site an article that disclosed the coding error, citing internal Moody’s documents that showed the error had been discovered by MIS over a year earlier, and alleged that MIS had incorrectly awarded Aaa credit ratings to CPDO notes because of the error.
When Moody’s was contacted by reporters gathering information for the story, the company began an internal investigation into the coding error and the CPDO rating committee conduct. On July 1, 2008, a year and a half after the coding error had been discovered, and over a year after the European rating committee had declined to downgrade the credit ratings, Moody’s issued a press release discussing the investigation results and stating that “some committee members considered factors inappropriate to the rating process when reviewing CPDO ratings following the discovery of the model error.” Thereafter, MIS took personnel action with respect to management of the CPDO group and members of the committee, including termination of the Group Managing Director and two Team Managing Directors…
…Further, we conclude that, in early 2007, members of the European rating committee believed they could violate MIS’s procedures without detection, and in fact the conduct did not come to light until the Financial Times contacted MIS about the error in the CPDO model and an investigation ensued…
Note that today Moody's re-ratings actions based on improving or continued deterioration of subprime securitisations, or in conjunction with distressed or improving house price and rising or falling unemployment, will run each individual pool of mortgage loans through a number of stress scenarios to assess the rating implications of updated loss expectations. The scenarios include 96 different combinations within six loss levels, four timing curves and four prepayment curves.
For much more on all of this, I wrote about it in October 2008
http://bankingeconomics.blogspot.com/2008/10/risk-rating-smoking-gun.html
Also see:
http://newsroom-magazine.com/2010/governance/financial-crisis-governance/moodys-internal-corruption-detailed/
http://www.fcic.gov/reports/pdfs/2010-0602-Credit-Ratings.pdf

CEO Letter to my Rain-makers

2010-08-24T06:58:00.000-07:00

Dear Rain-makers, friends & colleagues,
You have been asking how exactly our 2009 bonuses will be structured and paid? As some of you will know 2008 bonuses were the same as in 2004, and all paid in cash!
2004 (28 April) was also when the USA's SEC relaxed leverage ratios on investment banks; following which we all in the UK followed suit, mainly by upping our % bonus pool to profit ratio by a fifth.
FSA's Financial Stability Report in 2009 found that if Britain's troubled banks had retained 20% of remuneration bonuses & shareholder dividends (£75bn or $120bn) instead of paying these out based on short termism (so-called) that actually exceeded what was needed subsequently (in 2008 and 2009) in government and central bank supplied capital support (in preference share equity) to the same excessive bonus-paying banks. This I will show is a false correlation, what some culture experts might call a "post-modern relativism", usefully summed up by the following cartoon that I urge all non-bankers to take to heart as we bankers do.The years from 2004 on were also those when bonus pools exceeded profits, which only appears absurd at first sight, but not when we look at the matter more profoundly. This is for the excellent reason that our human capital is our most valuable asset, and what else is to be done when everyone else (other banks, especially US ones) do this, pay over the odds. All banks are in firm agreement about the deservedly high return necessarily payable to human capital compared to the return to passive shareholders or that old saw of "internally generated capital build-up", which we know would have just gone up in flames with nominal losses - far better to be retained by our staff and productively invested, I should think?The equation of bonus pool to government funding support is false, because we would have simply used the retained profit to narrow our funding gap by 8% or less (and depending on whether our share cap would have fallen further on lower dividends) and that £75bn (in the case of UK banks) is dwarfed by the £500bn in asset swaps to shrink our funding gaps by getting all that off balance sheet via SIVs in return for Bank of England treasuries and deposit balances. What choice did the SEC have (Paul Atkins, Cynthia Glassman, William H. Donaldson, Harvey J. Goldschmid and Roel C. Campos, SEC commissioners, pictured above, along with Christopher Cox, SEC Chairman, and Annette L. Nazareth, SEC dir. market regs.) when faced by a joint motion for relaxation of reserve ratio (leverage) requirements by Goldman Sachs, Lehman Brothers, Merrill-Lynch, Bear Stearns and Morgan-Stanley. SEC did not have models capable of predicting any outcomes of that decision; they therefore should not be blamed for the severe embarrassments that all of the above banks faced as a result of their over-leveraged trading books and unsustainable bonus pool growth.
The plain fact is that high bonuses are market-dictated with the weight of an immemorial tradition, socialised via top-dollar real estate prices. We are not "banksters"; we pay our taxes eventually. Furthermore, it is quite clear that leverage variance is simply what we need to do to maintain stable return on equity ratios and why bonuses are genuinely just that, bonuses! Who should begrudge anyone for legitimately striking it rich? There should be no limit to opportunity. What right has government to restrict incomes in any selected profession; that would be an attack on basic human rights or free market rights?Some bankers have sabre-rattled that severe cuts to bonuses will entice us to move our headquarters to Paris or Frankfurt or Hong Kong, who are offering us low tax inducements to move there. But, we don't go along with that shallow selfishness; where else will we find a central bank with the creative flexibility of the Bank of England, with the deep treasury pockets in money market operations to see us through stressful turbulent times?
US media comment has reported London bankers saying they would crash their own country’s economy by departing for foreign parts unknown if that's what it takes to defend bonuses. We have no part in that and know of no reputable British banks who think that is a realistic option.
Some calculations of government support to "bail out" us banks have supposed this to be a cost to all citizens. That is a false premiss. Governments have merely stepped in to fill a gap that opened up when the private sector failed to maintain inter-bank liquidity (funding gap financing). The bail-outs are not net costs but have valuable assets that will profitably reward taxpayers and the economies eventually. In my view therefore all of the supposed loss in wealth per citizen as shown in the graphic below will be restored and added to by at least half as much again over the medium term. Hence our bonuses need not be attacked, surely?It is altogether fair, however, that because of recent experience, shareholders and others ask why we pay bonuses in cash (out of profit or loss) and not as shares (or share options)? Apart from conflicts of fiduciary responsibility to alternative investment customers, and the net interest differentials between stock-shorting and interest bearing assets like cash (note that we never countenance any insider dealing type arbitrage or shareholder dilutions or trading to peddle our own share value upwards against a falling market), nein, n'immer, keineswegs, kommt nie im Frage, non, pas de tout, au contraire!
We paid bonuses as cash and not in shares or prefs for good prudential reasons, to safeguard against the temptation to create false markets in our stock, when annual bonuses can be 10-20% of capital or even 10-20% of capitalisation! When US investment banks' leverage restraints were loosened, US commercial banks and UK banks immediately ratcheted up their leverage ratios. These were years when risk management was considered anti-enterprise, anti-profit, anti-growth. We banks all used higher leverage to increase our own-portfolio trading rather than use the leverage to increase customer lending, which was facilitated by selling off parts of loan-books via securitised bonds. Kneejerk regulatory responses, so-called Basel III and CRD III, following the credit crunch experience, by making us increase our regulatory capital reserves and economic capital buffers to include liquidity risk and counter-party risk reserves - these are forcing us to shrink our own portfolio trading somewhat faster than we were doing anyway (to shrink our funding gaps and to focus better on only the most profitable net interest income sources).
Less capital for own trading when markets are volatile and there are rich pickings for clever arbitrageurs has hit our bonus pool. But I take comfort in the poor performance of hedge funds including macro-funds. Our fee income is up in part from stricter credit conditions, but mainly from restructuring customers' debts. This revenue stream is declining, but it looks like M&A and MBO activity is surging again. All in all, with net interest income stabilised, there is modest optimism about our return on human capital, our bonus pool growth, which we calculate based on a weighted peer-group algorithm that includes Goldman-Sachs and JP Morgan-Chase. What is now to change is how we are paid our bonuses and over what period of time. We are moving towards less cash and a medium term roll-over, what some of our sovereign debt traders are dubbing Euro-billions roll-over, an ugly expression I do not want to hear again!
Bankers are the elite of the business world. Our remuneration levels track the art market and have recently overtaken it. As someone with a collection of superior quality to that of Mr & Mrs Dick Fuld, I take this as a benchmark of our uniquely valuable creativity. Our bonuses are justified rewards for superior creative human capital and should not be relativised to the bottom line of mere profits or any other mundane comparator. I agree with Rene Magritte's comment on relativism.Talking of which, new European Union rules require that only part of bankers bonuses are paid in cash, provisional retention of another part, and some other part that may even need to be cancelled should risk performance outcomes warrant that?
We senior bankers know that our bonuses are a deserved return to 'human capital'. That return was depressed for decades. It directly correlates to the relative superiority of our education skill levels that only in recent years rebounded strongly to regain at last the same relative remuneration and skill in our human capital of the 1920s.Human capital is an asset, as we remind everyone, "the creativity of our staff is our most important, most valuable of all our asses!" Its market value is well attested by how the financial return on human capital investment (total remuneration divided by base salary) that has demonstrably held up well as all other asset classes fell (in mark-to-market terms).
Notwithstanding evidence we presented to demonstrate persistent skill-supply shortage, and using peer-group comparators to disprove the notion that experienced bankers are worth any less today than a few years ago, regulators insist on a more risk-diverse bonus calculation or less-cash only, structure, that offers some sensible tax efficiencies for all - effectively a system for lending by and borrowing from our remuneration bonus pools over time that will deliver yet higher return, what I call pleasure not lost, merely postponed. I wish to make it clear that while we took bonuses proportionate to profits as per our US competitors, it is not sensible to make sudden changes when profits become temporary losses; this is a longer term game.Following discussion with regulators, however, some adjustments are now required. Therefore, according to new guidance, the present value of the average bonus of $1 million per rain-maker in our bank (better than others and 20 times average wage) may be under $800,000, with 40-60% postponed payment payable over 3-5 years. Half of the bonus paid will not be in cash.
This means that you can only get at most 30% of due reward in immediate cash.
For those of us with bonuses of several $millions, deferred consideration is over 60%. A maximum of 20% ($200,000 from $ 1 million bonus) will be cash-credited to you immediately. You want to know how much you will get later, soon. Your deferred bonus of $600,000, half of which can be paid in cash, half in securities. This may be discounted for risk of poor performance and prudentially postponed. But, starting from a low point in credit cycle performance, actual payment has a tremendous upside potential. The superiority of human capital skills & education value among bankers in banks is fully proved by banks profitability and the speed of our recovery from the credit crunch recession, by how we skillfully helped government to help the wider economy by saving the banks painlessly through asset swaps and deposit guarantees for which help we are more than happy to buy government bond issues. We are over-subscribing to new issues and doing our best to squeeze out pension and insurance funds at the long end.
On the matter of deficits and national debts, far be it for me to point out to those who resent government deficits that they should note the obvious correlation of balancing budgets with imminent triggering the next recession, and double-dip will not help anyone, not even if the Euro Area appears to be gagging for one?Saving and rewarding the undoubted values of banks, including remuneration of bankers, is not for everyone, involves a steep learning curve and an inflexion point only after about ten years of hard graft at the front end of financial services i.e. our bankers take years before they earn their bonuses, often also after years of paying high college and MBA school fees, which they have to repay and earn a good financial return on, let's not forget that basic fact of financial life!Regardless of your initial background in say natural sciences, mathematics or some secular philosophy like MBA study, whether you have any formal qualifications in banking, you must have at least 5-10 years valid experience well-earned (keeping your job and getting promoted) before bonus hikes kick in, and that is both only prudential and fair. The Gordon Gekko banker image is Hollywood fiction.Compare this fiction with the very real Jamie Dimon, a great survivor, great leader, a pugilist and realist bar none among top bankers like myself.YOUR 2009 BONUS:
Assuming 5% risk of withdrawal of bonus each year and discount rate of 4% over the present value of money over five years, your bonus cash element falls in NPV from $300,000 to $213,000. That part ($200,000) paid in securities e.g. convertible bonds and in shares ($300,000) the risk of loss is outplayed by upside potential of say 0.75 of book value to 1.25 of book, which could and should be worth a conservatively forecast gain of $250,000, subject to say a % discount risk factor (net $140,000 upside or 28% return on your bonus investment over say 2-3 years, plus perhaps half of that again in annual bonus increases and a rolling additional 14% annual investment gain, say).
The risk factors of say two times 5% plus a hair-cut of 7% and the risk of claw-back given double-dip recession risk hitting our net interest income will modify and postpone tax payable, giving you more capital to play with in the interim than otherwise. Your $million bonuses could and should double every 5 years. That is great news! Other calculations and forecasts are possible, but it will be roughly on the above basis that our rain-makers can obtain personal loans at our lowest internal rate at up to 85% against bonus pool funds.
I for one have no fear of a possible return for a prolonged period such as in those post-WW2 decades when bankers and stockbrokers were considered boring bureaucratic desk-johnny, servile customer service-minded, paper-pushers. We will remain the kings of the global financial jungle - have no fear about that!It is only sensible given our enterprising capital and securities markets skills that we "my word is my bond" bankers are firmly to be counted among the net wealthy, prepared to put our money where our mouth is.
Some analysts quip that in recession and recovery periods our output (wages & profits) and unemployment estimates tend to be over-optimistic. This hypothesis I promise to disprove in the case of banks and bankers, our income, our jobs.In the past great artists and musicians, like today's football stars, were rewarded as a premium quality human capital. "Back in the day" as our American cousins like to say, the great days, uniquely talented individuals would coalesce into groups and teams, and from that tight economic unit create service product of high value for wide distribution. That is the quality and nature of today's creative bankers, a high-value, highly prized industry, however commoditised, reproducible, repackageable, rebrandable, along with the recycling capital that pump-primes it. Where other industries automate and replace human capital with synthetics, we computerise but never forget the human capital and its necessary rewards at the heart of banking.
Those Cassandras who call for a return to boring traditional fraction transaction banking do not appreciate the importance of human capital, or our humanitarian understanding of what is truly important, human capital, why we defend $20-30 billions in quarterly bonuses. Just look at the skills required to be a modern banker:"Our bank canvassed human resources professionals to bring you the following list of CV qualities when seeking or holding down a job at my bank. Qualities include:
1. Dealing experience (ability to grab capital allocations to leverage your bets) in both cash & derivatives markets. Some great skills were required in recent years of markets' undoubted liquidity shortage (double-default in insurance & near zero liquidity in the secondary markets for structured products) problems. Also, we needed skills to navigate how stock markets became shredded by alternative channels, but could hedge those problems as derivatives grew exponentially even if ultimately into a spaghetti mess and reinsurance "snake-eyes". Our rain-makers are syndicators, structured financiers, M&A, mezzanine and MBO specialists, an undoubted skill-set in recent years of MBO dearth and private equity competitive problems, but any booked deals will do for us that show double digit margins. It's experience that counts, especially if you look like understanding the basic intracies of structured products.
2. Be prepared, well groomed, for the interview process for our wealth and private equity divisions where the bar is loaded and set high. We test candidates on anything from financial modelling to verbal proficiency (dealing room and institutional sales jive talk), NPV reasoning and mental math, our smoke 'n mirrors hothouse personality that never forgets the bottom line of how to slice 'n dice the deal and the market. You must demonstrate business judgement of a shark (distressed debt hunting) and the vulture (finding hidden unrealised asset value), and able to think like a day-trade CFD investor.3. Speak one or more foreign (European or Asian) languages. In some cases recruiters say speaking Chinese, French, Japanese, German or Spanish is a prerequisite in primary credit markets, less so in asset management. Our candidates are frequently asked what their third, let alone second language is; first language: MBA English.
4. Show operational and IT experience. Be a team player capable of scoring individual goals. Restructuring or distressed debt experience is popular as we grapple with senior tranche triggers and other portfolio problems. The challenge is to marry deal-making with industry or operational process so that you know your cog and mechanism for how to take biggest bites our of the food chain and our internal 'deal carousel'. It is easy to find dealers, but few who combine that with operational experience to book most nominal profit.
We have moral values to define our bank by. :Our strapline "Money: if you'll take it, we'll make it!"
5. Have the right sector expertise - property and other collateral management, and fixed income (but forget small firms, retail distribution or trade manufacturing unless we post you to Germany or China). Strong sectors where we want hands-in-the-till experience are chemicals, pharma, oil, gas, institutional funds, and healthcare.
We reject Main Street's opprobrium of individual banker's success as unfair in the UK as anywhere:Other quality advice:
1. Don't embellish; cut to the chase, to the bone. A common pitfall is candidates listing deals in their CV they didn't control or had only cursory involvement in. We note when you umm and aah if asked to discuss deal-makers versus deal-breakers, or risk-accounted ins and outs of the deal, or when we ask you for an investor's perspective. If you're too into long term fundamentals you're not worth human capital investment by us.
2. If a trained accountant or actuary or economist, downplay that; classic capital & securities skills have ago changed. We used to look for corporate and treasury finance backgrounds - not any more; today we use deal-closers, salesmen who can talk upside and downside simultaneously polished on whatever side gets us the best upfront margins.
3. Referencing Goldman Sachs won't help - smells of failure in staff turnover stakes; no one leaves GS unless they're crackpots. We need candidates who were highly rated, notn simply having worked someplace unless with a financial regulator or central bank.
4. Don't assume working with large clients qualifies you. Private equity needs people with a broad portfolio of company board-level executive experiences at both large and small entrepreneurial outfits generating double digit returns i.e. an above average bonus history.5. Don't come across as young or naïve, or over 50 (early retirees). Candidates must demonstrate street-fighting skills in algorithmic analysis and monte-carlo research and more and more MBA maths mature. You may not be leading a presentation by a management team, but you will be a basket points or goal scorer."
You must talk the talk while instructing others how to walk the walk.The credit crunch and ensuing crisis exposed flaws in banks' business models to survive a whole credit cycle, but these were merely the flaws in our great society.
So, let's not hear more about the foolish risks of the financial sector or the devastation to the economy, or fiscal deficits. Too little has been appreciated about the wider societal moral deficit that is hardest to correct. We operate on a morality of profits, not deficits. We judge ourselves by peer review, to do better than our competitors have done in the last decade and the next and or last quarter and next quarter.One of the lessons of this crisis is a need for collective action, which is only the role for government. When markets blindly shape our economy and society, doing their level best, we rely on government to pick up dropped balls, run and pass back to us to cross the line. We take care to shape events to what we want going forward; questions of blinkered targets and purblindness we leave to others, to good and sensible government.
best regards to all my staff,
Your CEO
see note attached

REGULATORS GET TOUGH BUT WILL THEY CAP BANKS' PROFITEERING?

2010-08-11T03:39:00.000-07:00

If, in our western capitalistic economies, we think of profit-hunting (a concept beloved of some fund managers) as akin to lions hunting, then non-financial industry is like the female lions who do the chasing while banks are like male lions who lie and wait but get first servings and second helpings if they want.
Bank lending is as essential to businesses growth as male lions are to the reproductive role of females, but the latter do nearly all the work while the former get to take what they want whenever by virtue of seniority, droit de signor.
This is the kind of analogy we are used to if discussing governments taxing of the 'real economy', but it is today undoubted by most people that banks, generally speaking, enjoy similar powerful privileges but, unlike government, without political democratic checks and balances, or a marketplace to be relied on to assert limits - a problem perceived when banks' profits appear too large a share of all corporate profits.
The question is whether, as banks seek to reproduce again the high net returns they enjoyed in the immediate pre-credit crunch years, the problem of banks was not taking excessive risks but imposing excessive risks on their customers by taking too much of the whole of an economy's profits? It has become as if established fact that banks led us into the credit crunch because they took excessive risks? What would that mean in our analogy - the male lions ate too much of the kill leaving too little for others, or decided they could do the hunting themselves and decided to care less about the rest of the pride, or perhaps they sat forever by the water-holes charging too high an attrition rate for access to the liquidity?
There can be little question but that lions (banks) were kings of the economic jungle pre-crunch. Now post-crunch the elephants (government regulators) have stepped in to reassert authority and dictate to the male lions new rules of behaviour, and maybe listen to the complaints of herbivores unable to risk drinking at the watering holes.One of the biggest stories of the Credit Crunch has been the two-way exchange of ideas between UK and USA elephants, the respective central banks and other financial authorities. The US Federal Reserve following the Frank-Dodd Bill has special responsibility for supervisory regulation of the biggest banks and non-bank financial institutions - those that have been branded "too big to fail" or "too big to bail" and "to big to feel".
The Fed's FDIC board approved creation of two new divisions under the regulatory overhaul: The Office of Complex Financial Institutions to oversee bank-holding companies with more than $100bn in assets and non-bank firms deemed systemically important by the new Financial Stability Oversight Council. The OCFI will be responsible for liquidating failed bank- holding companies and non-bank firms. The FDIC is also establishing a Division of Depositor and Consumer Protection to enforce rules of the new Bureau of Consumer Financial Protection. The rest of the FDIC will be responsible for policing several thousand small banks with less than $10bn in assets.
The Bank of England will have similar responsibility in the UK, but also a lot more, covering all banks and systemic risk, but not yet planned to cover all major (systemically important) financial institutions.
The basis for the Fed's supervision should be the Basel II Capital Accord, and to take its template from the FSA's Prudential Sourcebook, which inevitably in spirit it appears to, but actually not in all fundamentals.
The Fed's supervision manuals are a groaning bookcase worth written by legislators for other attorneys into a jungle of verbiage impenetrable except by the most intrepid legalistic risk experts, geeks, nerds like myself and my colleagues.
US regulation currently is oriented to Sarbanes-Oxley, and its legal system to questions of insider trading, saying one thing in public and the opposite in private, for example. There is also the question of insider lending, and for every $ of incestuous lending how many $ are to 'outsiders' with over-close connections that negate standard pricing and risk assessment, a commonplace issue in property development lending, as all in the property industry know well - the type of matters that brought down Anglo-Irish Bank and fatally threatened many others?
Governance is important including all codes of practise and moral issues, but these are only a part of the much bigger technical risk landscape. Sarbox is not wholly fit for purpose.
Where the FSA's main, and very comprehensive, guidance to risk management, calculation and reporting, for financial firms is a thousand pages, the Fed's is two thousand pages, mostly of ethical imperatives, and each page far more densely worded, and, astonishingly, almost totally without graphics, charts or equations, except a few daft ones like this one that suddenly pops up but only after 230 pages into the supervision manual:After the Credit Crunch it became axiomatic to blame regulations as well as regulators for being dilatory. But, much of this criticism originated first in the USA, and some in UK because of N.Rock, because risk regulation there was more governance oriented post-Enron with Sarbanes-Oxley (Sarbox) that is not nearly as comprehensive or systematic in risk accounting and risk analysis as well as in governance and risk culture as the Basel II Accord. For example, this checklist graphic for supervisors, which comes up after over 500 pages of Sarbox style requirements: It took 80 pages of explanatory material before summarising what US Fed supervisors must first do before anything else when risk auditing a financial services firm: "Consider whether the financial-contract activities are closely related to the basic business of banking; that is, taking deposits, making and funding loans, providing services to customers, and operating at a profit for shareholders without taking undue risks."
If this defines a bank then a lot of trading companies who insist on advance payments (deposits) and who then offer 'trade credit' also qualify. If such a starting point question is needed, which I doubt, it should be, "is this business properly and fully registered in all its parts as a regulated bank; if not why not?" e.g. should AIG and GE Capital be classified in large part if not wholly as banks? GE capital with over $500bn assets has 100m financial customers and owns banks, but is not 'a bank'. AIG is more than an insurer and behaves like a bank but is not one, yet has over $800bn financial assets and in the last 3 years booked $62bn gross in realised losses and $39bn unrealised losses (that summed to almost the same in net losses).
Further on this: AIG is regulated by the Fed, but GE Capital is not. GE capital is shrinking its assets from $650bn to $400bn after credit crunch losses of about $10bn only for which it had to rely on funding support from its parent GE and on US government guarantees to stay technically solvent. GE Capital Loss ProvisionsGE Capital wrote many $billions of mortgages including tens of billions in UK, but is now a tiny fraction of that volume, cutting back far more than regular banks. But, despite losing its AAA rating, GE Capital is supremely sound because of its massive industrial parent, as part of a grouping that is expected to benefit from $100bn in engineering contracts alone from the Obama fiscal stimulus package to boost US recovery.
Looked at in context, GE is better risk-diversified than banks with too little exposure to industry, manufacturing and trade. If GE Capital was a bank it would be be among the top 10 of the USA's biggest.The Fed is now acting tougher than before, not least over stress-tests of the banks, following the rather weakly and narrowly defined European example this year that followed after the similarly vapid tests of US banks last year. It was perhaps fair enough to let the banks etc. get away with mickey-mouse quality scenarios and stress-tests given the urgency required and inexperience of all involved. last year the urgent question was halfway through the budget year what might the banks need before the end of the budget year. The results were:The get-tougher stance is similar to the more intrusive approach adopted by the UK’s Financial Services Authority from last year following The Turner Review and earlier knuckle-wrapping over Northern Rock and by implication other cases.
There is an abiding problem for regulators, which is budget and skilled manpower retention, especially when any with risk-audit experience inside regulators are prime recruits for banks who pay more for the privilege - a doubtful one in my opinion since 'regulators' and 'bankers' are still on the same steep learning curves.
There is, especially in the wake of Credit Crunch, a large dollop of mutual mistrust and fear between regulator and regulated. One result can be that a bank offers up a best effort account of itself and its risk accounting only to be told the result is not enough or not acceptable, when of course ultimately banks' reports are never entirely perfect.
But the banker might ask why a report is unnacceptable, only to be told to read the manuals again or that the regulator does not have to explain himself? Regulators, perhaps out of depth themselves, sometimes resort desperately to asking more questions instead of providing answers or solutions to a bank's apparent difficulty. If risk reporting and analysis is top-down more than bottom-up the regulator can insist it should be more the other way, and if vice versa then vice versa to that too!
There are internal (micro-prudential) benefits to becoming sophisticated and ever more realistic in stress testing, and external (macro-prudential) benefits to the whole banking sector, as last year's and this year's stress tests have shown in lowering of credit default spreads. One of the FSA's strongest cards is or was its ARROW reviews where regulators would interrogate senior management individually to determine if they understood the basics of risk management and risk accounting - if not, then it was questionable if the interviewees should sit on any of the bank's boards or risk committees including ALCO and ALM committees. Nowadays similar rigour is applied to the numbers and the less than wholly adequate systems for calculating them. But, it remains that the biggest question is not just where banks are now but where they will be if there is another major downturn shock anytime soon?
The EU stress tests of 91 banks didn't show problems as uncovered a year ago by the US tests on 19 of the top banks. The worse-scene scenario for 2009 & 2010 (economy to shrink 3.3% in '09, unemployment at 8.9% and home-prices fall 22%). Based on this, 10 of the banks were required to raise their capital to maintain solvency.Fed regulators have since then increased scrutiny of USA’s largest banks, digging deeper (audit-trailing from lower to higher 'granularity') into 'riskier' activities and pushing firms to conduct more rigorous “stress tests” of their 'risk appetites' and checking the veracity of governance statements.
Tighter oversight is justified by the genuine fear of another financial crisis as devastating as the current one - to close regulatory gaps that permit unsustainable risk-taking exemplified by Lehman Brothers, AIG and Bear Stearns, to which may be added WaMu, Wachovia, and Merril Lynch, and factors necessitating government funding loans to JP Morgan, Morgan Stanley, Goldman Sachs, Citigroup and Bank of America.
Some experts suggest the stress tests are no more realistic than 30mph head-on car crash tests, adding that sadly the most appropriate and realistic aspect of the exercises are 'dummy variables': So, as we experts have always said, eventually regulation of banks would focus centrally on stress-test scenarios, the very aspect that banks dragged their feet on and ignored, preferring to complete everything and anything else first.
The tougher policing focuses on stress tests and this time also on details of banks’ realised and unrealised profits. What that means is that simple discount factors cannot be crudely applied to headline figures.
Federal examiners are asking banks for more details on the P/L of each line of business and per asset class, especially securities and capital markets and investment banking, rather than focusing only on group balance sheet totals as before. Lifting the carpet to check what's underneath, begs some questions, mostly about how risk-taking could be hidden among layers of risk aggregations and how these risks are more exposed when disaggregating?
It seems to me that the real risk measures are those that understand the external financial markets and macroeconomic context factors, because riskiness is rarely obvious in a balance sheet however detailed only by looking at it in the context of itself.
Apparently, 'deeper analysis' we learn has informed the authorities that before the credit crunch rising bank profits were coupled with a hidden increase in risks!
Well, gee, knock me over with a feather!
Before the turmoil, the finance sector worth perhaps at most 15% of US GDP was generating 45% of all corporate profits in a massively fast-rising segment of GDP i.e. roughly fluctuating at or near to banks' total share of 9%/GDP:and doing so with decelerating equity prices (falling p/e)and to anyone looking at stock market values could see that, with corporate profits rising higher, securities were over-optimistic about timing of the economic cycle: and something was surely hugely amiss in profit-accounting by the financial sector reliant on booking unrealised profits that were unsustainable. The data shows finance sector at up to35% of all US corporate profits pre-crunch, and these profits are after the high staff bonuses of up to half as much again! From a government's point of view unrealised profits and bonuses are taxable so there is a possible niggling disincentive to question the banks' sagging bottom line even if it looked very like a casual hang loose attitude to risk?
Data on finance sector as a whole is imprecise because the sector includes a lot of business services, investment funds, asset management, insurance, accountancy, corporate law, real estate and not just 'financial intermediation' the term for banking. Looking at the broader sector data that has grown very dramatically in the last 1 and 2 decades as a share of GDP and that would explain a lot of the sector's share of corporate profits, but which still seems excessive. Perhaps, financial authorities thought corporate profits are merely a counterpart to the yield on Treasuries and naturally banks take the pride-leader's lion's share of that kill? Regulators before the credit crunch paid little attention to the increase in the amount of mortgage-backed securities on banks’ books. It is also not the job of auditors to audit banks' risk statements in reported published accounts. Auditors sign off the solvency of a bank for the next twelve months, but that is not based on risk or economic analysis, but only on the current solvency of the balance sheet.
Now, bankers complain that regulators are putting pressure on them to be much more pessimistic in stress tests about their ability to respond to economic shocks. That is hard in the absence of precise details, models, templates and without knowing who and how or exactly when that will be externally audited.
What they are complaining about is that regulators are edemanding more detailed realism, but unable to explain what precisely they mean by that? This is new, relatively unknown territory, poorly understood, where blue-sky thinking is required to be populated by all dark clouds imaginable.
None of the stress tests and results show a capacity to reproduce the events of the recent past, of 2006-2009 for example, and that should be the first test of the realism of stress-test forecasting models.
If any bank can show me that it has macro-models that can roughly emulate the events of the the shocks of the past four years I will buy its shares and its bonds.

CREDIT CRUNCH FUNDING GAP NARROWS LIKE CLOCKWORK?

2010-08-03T10:03:00.000-07:00

This is a dark night of a wintry City of London - the banks' 'dark night of the soul' continues even in Summer months with Barclays profits (mainly from investment bank Bar Cap), almost 'normal' high profit by HSBC, and return-to-profit by LBG with margins also creeping up.
But, short and medium term uncertainties continue, especially for banks that are directly as well as indirectly in the power of government to influence. Government may decide to split investment banking from traditional banking? This has yet to be investigated and debated. Perhaps the big banks feel these are arguments they can win, and yet they appear to be risking government anger by not growing small firm lending, which after all is only 1.5% of their balance sheets! LBG, with the biggest market share in UK banking (c.25+%) appears to have it first priority to get its share price above the threshold of 62p, which it has achieved, and then past 73p when government might be tempted to sell so that it might escape state control, for reasons not unlike its change of mind half a year ago over participation in the Bank of England's APS.
For the government and the economy the biggest question repeatedly asked is why are banks not lending more to businesses to aid recovery, especially to SME firms? This is deeply vital to its economic forecasts.
The UK government's economic strategy depends on the Office for Budget Responsibility's forecast that job creation will repeat the experience post 1991 recession. But are UK banks doing their bit to make this happen? Whether less bank lending results in serious damage to the economy depends upon what bank credit is financing. If financing intra-financial sector activity the impact on aggregate demand may be minimal. Asset prices fell 25% in the credit crunch and after sell-offs, some recovery and shift to fair value accounting are today 10% below pre-crisis peak, but in the property asset class which constitutes banks' biggest collateral exposure may still be 20% off, and that is without a compensating inflation as in past property collapses of the 70s, 80s and 90s causing unexpected complications.
If banks grow credit to finance stock-building, consumer spending or purchases of plant and machinery, or covers cash-flow gaps and running losses while businesses expand or cope with a downturn, then the real economic impact will be direct.
The banking system is is essential pump-priming in the economy. Depression is associated with a collapse of bank lending and money supply (on assets side not just liabilities side of banks' balance sheets).
Even non-monetarists should be watching money supply (disaggregated) and bank lending numbers like a hawk. If bank credit stagnates and or continues to contract, especially in areas where economic growth would be directly boosted, then the government and everyone else can conclude the economy is not being served by its banks.
Banks have few friends and admirers; few happy customers. They should be doing all they can to be genuinely seen to be helping economic recovery even if it means postponing restructuring their balance sheets to get back to 'normal' 150-200bp/assets margin profits sooner than later. Are the banks looking back to the last recession recovery period that of the 1990s and seeking to replay their lending recovery of those years? I suspect they may be doing this but drawing negative conclusions. The property market in low inflation is not liquid and not providing the lending demand that would boost economic recovery as it did in the 1990s. Banks must therefore this time look more positively at business lending. Part of the government's strategy and forecast is to grow UK trade, not least manufacturing on which the UK still relies for over 40% of its exports but has low bank borrowing and low debt servicing (10% of profits); most of UK industry is under-borrowed.
The banks claim they approve 80% of loan applications, by which they really mean 80% of those judged to be higher quality borrowers, which, as BBA spokesperson says, "have good business models" (pots and kettles?) as if banks really knew, but that translates to about 40% of loan demand being satisfied and many of these are merely loan roll-overs, not net increases because loan outstandings are not growing.
Banks also all say that businesses are more interested in building savings and lowering their debt. That may have been more true over a year ago, but corporations are raising bond finance and equity while SME firms wholly depend on banks. But this is a function of small firms birth and death rates. Annually a third of a million firms close for various reasons of which under 10% go bust, and a third of a million start up. In recession and low growth periods start-ups fall more than closures rise. The sad fact is that banks are building up the share of deposits in their liabilities and to do so holding down loan approvals (stricter credit risk conditions like higher collateral, even insisting on more liquid collateral!) and thereby shrinking their total loans in real if not absolute terms. UK banks lending from UK branches is making zero additional lending in aggregate. Better (positive) lending is available from foreign banks into the UK, but that hardly qualifies as banks playing their part in recovery. HSBC's mid-year results may have lifted banks shares by up to 5%, but the components of revenue growth invite questions and there are several overhanging questions that are troubling to the banks:
- can government persuade the banks to increase small firm lending? - balance sheet shrinkage - when is it time to stop and to grow new business? - how to cut costs without losing good people and harming valuable business? - will UK Banking Commission recommend splitting off investment from 'trad' banking? - it reports by Sept.'11; can or will government sell any bank shares before then? - from profit what splits to make between Retained profit / Dividends / Bonuses? - is net interest income solid so that dividends & shares can dependably rise? - will corporate bonds and small firm defaults peak later or are we over the hump? - additional regulations to curb risk-taking: are they a real burden; do they work? - sales of banking & other units; are the issues more problematic than their price? - what is the value of branch networks to retail commercial banking? - can banks solve their core systems problems to update and replace them soon? - living wills, how to simplify large banking groups to satisfy the regulators? - are our largest banks beyond management oversight & control by boards? - if so, how and with what systems to assert effective control of 'risk appetite'? - are supervisory regulators going to 'pass' all the banks risk reporting? - where are UK, USA, EU economies & global trade heading - new patterns to finance? - can banks do comprehensive macro-modelling required by Basel II Pillar II? - property holdings of banks from foreclosures - is it now time to sell? - is confidence restored among funding sources to easily finance funding gaps? - back-to-normal? Can banking return to doing business just as before the crisis?
Answering such questions is the work of very special consultant experts, who may borrow watches to tell the time and check the wall clocks, but the landscape of time telling for banks has become exceptionally surreal, very Daliesque. Nearly all bankers they are in strange territory doing business in circumstances they have no previous experience of. I (and my colleagues at Asymptotix.eu and elsewhere) have ready answers for all of the above and more. I (we) daily get calls from strategy advisers, institutional investors, banks, and sometimes regulators, to discuss such questions at £200 per hour, sometimes, irritatingly, they get advice for 'free'! I (we) often feel like private sector solicitors practising in regulatory law or like proof-of-concept supervisory regulators.
In the past two decades, traders and junior managers increasingly drove banking businesses silo-fashion. Banks looked more like conglomerations of specialist units - mortgages - business lending - trading teams per asset class - structured products - domestic - international - retail - investment - all divining their own risk appetite (that ubiquitous term beloved of risk regulation and private client investing that no-one really knows how to define or compute) and they were silo-wise responsible for their own narrowly defined profit/loss.Like clock mechanism in which each of the cogs are acting quasi-independently at whatever speeds they can the whole rarely tells the right time (in terms of the underlying economies) and were out of control, but who cared so long as bookable profits resulted, whether realised or not. In a much more fragile environment boards have struggled to reassert control and are discovering just how difficult, even impossible, that is! They, boards and regulators and central banks, would love to be able to understand banks and see them working like clockwork, like a mechanism with a handle that they can jointly operate - - but it's not like that! Banks position and reposition themselves to service whatever business demand comes to them. They also like to believe they find that business with professional skill, creatively and diligently. But, when they really have to compose how and what they do in uncertain times self-confidence goes and the banks look like mechanisms that have lost battery power and need governments to shake or turn the winding spring. To feel like passive victims of events, no longer 'masters of the universe' is galling and anxiety-making - they now know that they cannot really justify their bonuses but cannot bear to countenance that!? Many bankers know they do not know banking like a watchmaker knows his mechanisms; they do not see the whole of the back mechanism. This is the culture change that Basel II regulations insisted upon, that bankers should comprehensively know their banks and understand how risks are interconnected and how their business performance relates to risk-taking, to 'risk appetitie'. The same questions as banks are asking of themselves, those whose pay-grade and seniority warrants looking at the big picture, which is precious few people in any bank, are also being asked by wholesale funders, institutions and other banks. The gauge is funding gap financing. Which banks can fund themselves more easily and cheaper than others? Share investors are wanting to get back into bank shares but which banks' performance to trust. These questions I get asked regularly, but it is hard work to explain to others the composition of factors in the different shaped mechanisms of different banks. Banks are far less uniform internally than they appear to be outwardly. My answers begin with the risk diversity of each bank depending upon the national economies where they do business, are these export-led i.e. business lending and capital investment biased, credit-boom i.e. property and household lending biased, a mix of these in cross-border terms or in terms of some countries compared to others. Then what are the internal culture, management and systems qualities of each bank - how well-driven from the board-room or how lucky or unlucky are they. Do their mechanisms work well in a coordinated way or not? Have they he ability to model and track their business in its various contexts? Do they know their aggregated and disaggregated risk appetite and risk diversity?
These are the essential questions that supervisory regulators ask in risk audits (to the best of their abilities in judging the data they are presented with). But, the fact is that all major banks and most others have severe problems of one sort or another, and then the question is do these problems matter short, medium or long term? The systemic context is important but that is subsumed within macroeconomic forecasting, and here lies the rub. The performance of economies are very dependant on what banks collectively do, but the banks don't want to see matters that way; they prefer the idea of having no direct responsibility for the behaviour of economies! Banks cannot (refuse to) factor themselves into the confidence and riskiness of clients and customers.
When the Credit Crunch struck UK banks had nearly £1 trillion in funding gap (between deposits and loans). That was double their regulatory 'own capital' and 15% ratio to total assets (loans & net trading investments). In general funding gaps are borrowing short to lend long, precisely the liquidity risk in the liabilities side of their balance sheets that is generally derided as classic high risk. In the years 2000/1-2007/8 funding gaps grew almost exponentially. Had recession kicked in two years earlier in 2006 problems of the Credit crunch would have been much less severe. Structured products (securitizing loanbooks) postponed recession by two years. Those banks with the largest funding gap refinancing needs in 2008 were hit worst by the short-sellers when they refused to jump at the hurdles of sharp rises in funding gap price spreads for fear of losing their bonus-laden profits. The results were they risked their banks' solvency.
If banks should operate in repeating fashion year-round like clocks, bankers do so like thoroughbred horses in a steeplechase taking bets, but running the course too -
- where the fences are like funding gap financing, turning over medium term notes and covered bonds and seeing loans recycling back onto balance sheets as deposits. In the Credit Crunch that refinancing got harder, the fences higher, and many horses fell. The UK banks' financing fences remain high today. While banks of other major European countries, such as France, Germany and Italy, face major funding issues mainly next year, none have to refinance the same amount as UK banks, which must replace debt securities of twice as much as the average in 2005-07.
But, with government's help (Bank of England asset swaps worth £500bn) and their own balance sheet shrinkage (first netting off derivatives, then liquidating other own portfolio trading assets, withdrawing cross-border interbank lending, and letting loans mature with minimal new lending (i.e. shrinking their loan books) and waiting for deposits to rise, UK banks' funding gaps have shrunk from nearly £1tn to less than half of that!
LBG and RBS restructured their balance sheets most of all - they had to - including reducing assets (loans & trading book) by more than a third over the short to medium term, 1-3, not 1-5, years. This was largely to better manage their refinancing requirements, reducing wholesale funding and the % of short-term financing within that. The Bank of England (and no doubt UKFI ltd. of HMT) advised all banks to shift their wholesale borrowing to longer term maturities (as the government itself was also doing) and of course thereby getting that borrowing more in line with asset maturities - and worry less about interest rate risk. The banks have to forecast and calculate the 'stickiness' of deposits, more closely align liabilities (mainly deposits) to assets (mainly loans) - in effect get the cogs of the banks on both sides of their balance sheets to move more precisely with each other. This restructuring forces banks to stop net new lending - but why? The answer is, like government borrowing and budget cuts, the fear is of negative judgement by credit markets, the markets who by recoiling in sudden panic propelled the credit crunch. The banks collectively have to cope with:
- cross-border interbank lending rapid shrinkage
- closing funding gaps substantially i.e. shrinking customer lending by 20-30%
- let 3% annual inflation whittle away at private sector debts
- play for time for mortgages to amortise so outstandings and LtV ratios fall
- build up capital and prepare for off-balance sheet assets coming back on
- work out delinquent loans and not make new ones for fear of higher defaults
- prepare for possibility that past pattern of trade and bank lending cannot be repeated again, not in next 5 years or so at least?
Internally within individual banks, shrinking balance sheets to realign assets and liabilities appears sensible and prudent, but not when all banks in aggregate are doing the same! Externally, to those on whom banks should be seeking to win back goodwill and confidence, it looks like selfishly putting the banks first and the economy second. If we want our banks to look more like traditional clockwork mechanics, then the rest of the economy will have to shrink too and grow more closely to the lower rate of income growth with much less credit recycling. Government won't mind that so long as there is at least positive growth in the economy above the rate of inflation and a prospect of tax revenue recovery without higher tax rates. But, its projections depend on employment growth and unemployment falling, on higher exports, lower imports, on banks and other services continuing to generate net foreign earnings to offset the trade deficit, and on the balance of payments not worsening over-much even if the trade deficit balance narrows i.e. a conjuncture of positive factors - but it is many years since we have done anything like that while bank lending has ceased to grow or shrink! In past recessions and recovery periods bank lending did not absolutely shrink! This time is perilously new.
Without the high budget deficits of 10%+ of GDP, M2+ could have been contracting at more than 10%. Similarly, without the deficit nominal private sector output could have contracted at a depression rate that in the 1930s for several years was about 15% annually. Government has limits (partly those of Maastricht) to its fiscal stance so that it cannot on its own stop both real and nominal GDP stagnating, and in a world were most countries are seeking more external than internal growth impulse, the prospect of growing at substantial rates is low without substantial growth from capital investment for which bank lending to businesses is a major supply-side driver. The implication from ongoing contraction of bank lending and repair of bank balance sheets is that high government deficits to boost private sector output will continue just to keep nominal GDP from again contracting. Government attempts to recover the economy are made fragile by banks shrinking their loanbooks. For a private, highly leveraged, debt-based economy, there can be little or no private sector growth with bank lending contracting at 5-8% of private GDP. UK banks need to refinance £390bn in the next two years, about £200bn in maturing bonds and residential-backed mortgage securities, remaining £190bn in reversing the asset repos (out of SLS & APS which the Bank of England insists will be phased out by the end of 2012) and existing preferred bank shares (£60bn) of Government bank capital funding, and the Credit Guarantee Scheme etc. Much of this is to do with how rapidly and how recently banks, biggest banks especially, grew their balance sheets just before the Credit Crunch hit.Shrinking of balance sheets, and if combined with government retrenchment is undoubtedly a macroeconomic risk that could be worsened if government and regulators try to try to wean banks off Government support too quickly, even if, as some may think, it seems important to government budget balancing and spending cuts for the banks to become fully-privately funded as soon as practical? In my calculated view there is substantial profitable gain that will accrue to taxpayers from government retaining government support for banks longer than first planned. The mechanisms whereby this can happen are not clockwork - many confidence factors play a part including the relative perception of the UK versus other countries. The Bank of England admitted in its Financial Stability Review that replacing funding gap finance as it falls due is a "substantial challenge", and put the total figure on the amount that UK banks need to refinance by the end of 2012 at £750bn to £800bn (half of which I judge therefore to be reverse asset repos of what is pledged at the Bank of England and maybe, conceivably another £150bn elsewhere, plus about £300bn maturing securities paper like Medium Term Notes), working out an average monthly fundraising of more than £25bn. This looks like a precise 12 hour 25bn per hour clock - actually it is not like that, more lumpy, with an average of 2-3 months to get large MTNs away 9fully subscribed). Some banks have rolling MTN programmes in different currencies (£,$,€) of 5, 10 and 20-50bn each. Maybe they could roll up more of their loan books into SPVs with clearly attractive rates and standby liquidity financing with Bank of England support that might also gradually re-absorb some of the assets swapped there sufficient to attract institutional and foreign asset managers - rather than an on-off private or public liquidity funding support, more like the USA's TARF, a mix of both private and public structuring - just a matter of a well-geared beautifully-crafted central bank designed mechanism?The assets swapped at the BoE belong to management holding companies ('Special Purpose Vehicles') and therefore quite how and how much will have to come back on balance sheet and at what cost is unclear? The Bank of England has the option to roll over the assets swaps for a longer period and could step in to expand the APS or create a new one or to use its balance sheet leverage to buy banks' securities, or create its own TARF, any of which I judge to be a profitable business and a good one for taxpayers to be in.
If the banks had assurances from the Bank of England about how it can step in as a backstop to ensure completion of refinancing deals, then this might also usefully take the pressure off the brake on bank lending. Our clocks are currently going backwards!If there is no such set of options and possibilities discussed with the banks, then anxieties remain that the banks' funds raising rate is dangerously high and hence they are currently back-pedalling fast to reduce it. A Bank of England prepared to extend liquidity at this time in a volume equivalent to its £200bn Quantitative Easing would reassure funding sources considerably. But, anyway, the banks have also boosted their liquidity reserves by a similar amount, but only part of these are clear funds that could only temporarily replace shortfall in funding gap financing.
Raising money for and by banks may come up against a much tougher backdrop for the banking industry, especially once (and if at al) the EU stabilisation Fund of €750bn starts monetizing its state guarantees to borrow against its bonds (though I judge this will take most of this year to structure contractually) which though conditions (risk spreads) have improved marginally are still far from the easy money of the credit boom years.

CAPITALISING BANKS TO SAVE THEMSELVES OR US?

2010-06-30T08:17:00.000-07:00

When banks hit the rocks like ships caught in horrendous storms and governments have to send out the lifeboats and tugboats and the populace and shops are fearing for loss of jobs as trade suffers, and salvage operators circle like vultures, we are told that there are three questions potential investors in banks need to ask.
How much liquid capital is the sector going to need to refloat and stay afloat?
What will regulation do to normal EXPECTED earnings and borrowing and lending costs?
How is the economy when there is a drought in financing; should we fear deflation, another recession e.g. in EU and Euro Area, fall in world trade hurting China, Germany especially, asset bubble-burst recession in PR China, emerging market countries running higher deficits, world growth stuttering, etc? Tidbits from the Group of 20 meeting, stress tests by banks, and what is being called Basel III new regulations for banks to build up larger buffer reserves to cover unexpected shocks (e.g. double-dip recession) and the US Congressional bill for financial reform (agreed without special tax levy on US banks of $19bn)and similar developments in Europe, may partially answer the first two questions. What is not answered by anyone convincingly is how the banks may be anchor-dragging on economic recovery because they continue to shrink their loan books. The truth is that many banks remain beached and the lending tide to refloat them and for them to refloat stangnating business remain out.One has to wonder at the gall of banks such as the UK clearers who can say to Government boldly and on television that they are approving over 80% of business loan requests especially to small firms, when Bank of England survey data shows the figure is only 40%. Senior loan officers in several banks tell me the true figure is much below that, in fact banks are refusing 80% of loan requests! Are our bank managements knowingly telling lies or just ignorant of what is going on underneath them, or relying (as they often do) on some number that some bankers casually quote about a period of time long past and parrotting it as if still current because it sounds good. I suspect the latter.In the USA, if this was the case Congress would erupt in anger, but nothing like that anger is so far occurring in among UK legislators, matters being left to Vince Cable leading an enquiry tour of the banks and the new Banking Commission enquiry. The HoC Treasury Select Cmte voted in (not appointed) may take a stronger line than hitherto. They could do no better than ask me for the facts. UK legislators are respectful toward banks even though the banks are not important sources of political campaign money. In the USA where firms can now donate any amount of money and it is an election year, legislators will still get very angry about the banks because this has strong public appeal, but may blunt their swords as in the banking reform bill. How much banks can rely on bribery or PR lobbying is therefore quite complicated. How much firepower can any sector have that remains underwater and in hock to government? For example, what should our politicians be thinking about the stark facts (among many I have collected) that German banks lend 16% of all non-financial customer loans to small firms, US banks lend 10%, while UK banks (domestically, including foreign-owned banks in UK) lend only 1.5% of all customer loans to small firms? Let us not forget that small firms employ half roughly of all private sector employees i.e. 40% of national totals.
Governments, G20, EU, NGOs and various policy pundits, journalists and economic forecasters are torn between how urgently they want banks to cushion themselves with generous amounts of reserve capital and wanting banks to pump-prime recovery by boosting lending to key sectors such as small firms, manufacturing and business generally.
In 'credit-boom' economies like UK and Spain and Greece there is also some pressure on banks also to resume mortgage and property development lending even if this will not help narrow trade and payments deficits. Central banks in Spain and Greece will resist this, but the UK is uncertain given the continuing housing shortage.
Governments are also committed to no more banking shipwrecks. But banks are making way in stormy seas, some more powerfully than others, but all are variously interdependent, netyworked. Shipping, for example, is transport, a transmission mechanism like banks, exposed on the ocean waves of the world economy, but dependent not on their own power so much as on the tides, currents, and world economic system. It is not part of regular business management thinking, however, to see firms as part of the global system, but only as succeeding or failing by whatever they do for themselves. This is only half of the truth. The other half is what banks, governments, business science and poltiics have most difficulty coming to terms with. Why because there are too many variables for them to compute, and they do not have the geostationery guidance systems yet to make sense of all of that. We should not be surprised therefore when "every man for himself" is the repeated kneejerk response to systemic panic.Those fearing another bout of embarassing losses among banks as they unwind their Credit Crunch spaghetti of inter-linkages, and start to count up realised losses after recoveries and collateral disposals, want banks to hold enough tier one capital to withstand another financial crisis as big as the last one. It is actually similar to requiring banks to carry enough water to refloat themselves like ships off the rocks, or like BP must have enough capital to pay all damages and clean-up costs of the Gulf of Mexico disaster. Yes, but what is the next Credit Crunch is more like ships in a desebanks to refloat off the reefs without government support. In my view this is foolish thinking for two reasons:
1. banks would have to hold three times minimum regulatory capital i.e. 24% ratio to risk-weighted assets, and
2. government bailing out of banks is very cost efficient and over the medium term profitable to taxpayers.Credit Crunch was like ships suddenly finding themselves in extreme ebb tides straned in a desert of all liquidity sources dried up so that they could not refinance their funding gaps and stock markets withd more negative liquidity (shorting and panic selling) than positive liquidity (long term investors). Government had to step in and water the desert or dig channels and drag the hulks back to sea. Authorities (of all kinds), however, are now urgently keen to see governments disengage from bank aid-packages and to sell stakes in banks as soon as possible, to return all matters to private markets, and this against a background of a Greek Chorus chanting "let banks fail, no more moral hazards" (including some banks such as Banco Santander and HSBC and others' related views). The idea is that when assets are underwater banks should have enough compressed gas in their recovery balloons to lift the sunken wrecks back to the surface for repair and recovery. My three times regulatory capital estimate was recently confirmed by the FT commenting, "For months now banks have been worried because if “support” includes all benefits from implicit taxpayer guarantees – for example the ability to generate a high return on equity from excessive leverage and a lower cost of capital – banks would require more than three times today’s level of equity capital to compensate, according to some studies." (i.e. mine.)
But if support simply means covering losses, US banks have tier one capital to cover gross losses up to $1,200bn. Yes, but then they must rapidly replace that capital or they are insolvent. Net losses, would be half this or less, but they take a few years to confirm i.e. $1.2tn gross capital replacement that become $600bn net. In Europe the figures are similar but larger i.e. $2tn and $1tn.
Many may argue this thinking is too lax. But if new Basel capital adequacy standards eventually follow the G20’s lead, a big worry for potential investors, banks will require half as much again in liquidity reserves. How do they do this? They have to sell off some operating units, non-core assets, asset management and insurance, and reduce their own portfolio capital for trading. In my view this is taking defensive thinking too far and too abstractly. The general concern is to stop banks building up asset bubbles again. This is a symptom and in some sense what always has to happen anyway. It is more vital to consider the matter less abstractly and more in terms of how banks are risk diversified. Banking has gone too far in containerisation to only see the portfolio boxes and loans in the abstract and not what is inside the portfolios, inside the many same shape containers.In my view it is far more important that banks rebalance their loan portfolios so that they are much better risk diversified across all sectors of the economies where they operate. In export led economies like Germany and China banks lend two third to business, directly and indirectly (via loans to other financial firms), while in credit-boom economies banks are lending more than two thirds to mortgages and property. These extreme biases lie at the heart of extreme imbalances in the world that were the ultimate original cause of the Credit Crunch.
Market analysts are incapable of looking at the macroeconomic picture. It is above their pay rate. They are tasked to be obsessed with how big a dent to banks' net interest income profits in the short to medium term that financial reform may make? It is impossible to know for sure; the answer is certainly less than feared, but analysts have to come up with some numbers. Hardly a day goes by when some analysts from a bank or fund management does not call me to ask the same question “what will the impact of “Basel III” new regulatory requirements on banks’ profits?
One big last-minute change to the Congress's derivative legislation, for example, allows banks to keep trading interest rate and currency swaps in-house (81% of swaps by gross notional value according to BIS). Another change relaxed the expected restriction, slightly, on banks’ lending and investment in private equity and hedge funds: US banks may expose 3% ratio to tier one capital to AI and Hedge funds.
A bigger question is whether big banks may yet be split between traditional retail and investment wholesale banking? Canada plays a key role here as an example where banks avoided the worst of the Credit Crunch despite having also ended their Glass-Steagal type division between retail and investment banking at the same time as US and UK, which to many observers is like the difference between merchant ships and navy vessels. Implementation periods for implementing new capital reserve build-ups have also been stretched out and important definitions – such as the language around proprietary trading – still leave room for manoeuvre, just as there also remain foggy fudging of fair value, stress tests and other issues in Basel II and IFRS.
In all, analysts reckon normalised earnings per share could be anywhere between about 5 and 15% lower for universal banks in the USA, and 10-15% lower for the brokers such as Goldman Sachs and JP Morgan, with mid-single digit declines for regional and trust banks. This will be similar if applied in Europe. All that changes however if the Euro Area falls apart, if there is an EU recession and if Far East markets, especially China, and emerging markets go into a tailspin.
Forget the charges such as the surprise recoiling from applying a $19bn fee to offset the cost of the new US bill, or Bank Stabilisation Funds in Europe and other bank taxes – investors will look through one-offs for valuation purposes. The most important reforms are the move to trade and clear derivatives on-exchange, the possible death of certain swap desks, and the ultimate re-definition of proprietary trading in terms of limits as well as accounting under IFRS, and the debasement in Europe of ratings agencies. These and related matters could yet contain some shock surprises. But the potential for damage to shareholders is limited in the case of long term investors. The problem is that short term profit hunters, brokers, “day traders” and stock-shorters continue to dominate as can be seen in market volatility. Even if these regulations pull down net profits by 20%, compensation would only have to fall by a tenth to match the decline. This assumes the recent relationship between revenues and profits stays about the same and 40% of operating revenues continue to be paid to employees, including bonuses. And it excludes the inevitable impacts in the finance sector of new tradable instruments.
Other factors that analysts are blind-sided by include the need of all banks to modernize (replace not upgrade) their general ledger systems and to incorporate a new generation of risk accounting systems. Naming no names, the current state of banks’ back office systems, GLs and risk engines is appalling. Many banks lack systems for risk accounting of loan collateral, some have only a dozen or less credit risk counterparty types, or less than 20 major GL headings, or subjective intuitive ratio inserted here there and everywhere. No banks are free of bug fixes that generate more system bugs, or, for example, account numbers that may be the same for different customers in different branches, and all big banks have complex networking of systems between tottering opaque legacy systems, outdated versions, impossible to scale up, historical data breaks between systems, held together with duck tape and chewing gum and new ones that lack modular design or have impossible interfaces and on and on. The cost of replacing system in any big bank runs into $billions and by the time they are implemented, assuming efficient, experienced professional teams are available, they will be out of date.If stress tests applied to banks’ accounting systems, both cash accounting and risk accounting, as Basel II proscribes, they would almost all fail. It is a great irony that regulation requires certifying and externally validating everything, yet computer systems that in the end are what express and safeguard everyone’s finance, are not required to be certified. Auditors ought to be doing this, but of course cannot and would not do so thoroughly. Therefore, there should be regulatory supervisor agencies set up specifically to audit banks’ financial computing systems.
According to a Credit Suisse analysis, a team I admire above many others, the estimated impacts of the new so-called Basel III proposals are very material for European banks. The revisions will reduce tier 1 capital to 2.6% and require €600bn- €1,000bn of new capital for European banks to comply with minimum capital proposals. That assessment seems harsh, but is caveated by taking existing data and not assessing the impacts over time, over say 3-5 years. The liquidity provisions will require €3,500bn-€5,500bn of new long term funding. This I also find to be several times too large, but must bow to the fact that my view is intuitive wheras CS has done the math. Finally, the impact on European bank earnings is estimated at €250bn (equivalent to 37% of 2012 earnings), with a drop in return on equity of 4% to 5%.
Interesting then that in the UK and elsewhere there are many groups hovering in the wings anxious to cherry-pick banking assets and to buy existing banks, parts of them, or set up new ones. Maybe they are the only long term investors making an impact on the banking sector; not the short-term bonus-motivated current generation of bankers.

EMERGENCY INTERIM UK BUDGET 22 JUNE 2010

2010-06-22T11:27:00.000-07:00

The first thing I liked is the return to a traditional plain dark red cover for the budget report, hopefully meaning no more New Labour PR spin, but that would be a revolution in politics.
In his speech Chancellor Osborne rose several notches in everyone's estimation, as did Harriet Harman too, labour's acting leader, in one of the best opposition responses to a government budget for years, which balanced excoriating attack whilst welcoming some of the Coalition's measures.
The Budget Report begins, "The British economy has become unbalanced. It has been too reliant on growth from a limited number of sectors and regions. Overcoming these challenges will require a new model of economic growth built on saving, investment and enterprise instead of debt. This Budget is the first step in transforming the economy and paving the way for sustainable, private sector led growth, balanced across regions and industries." This is wonderful for being the first statement in a long time on economic policy in our party politics that looks round the corner past the question of government finances and talks about more than just supply-side notions, or am I being over-hopeful? The June Budget report does state that the UK private sector has become the most indebted country in the world at five times GDP (or ten times higher than government) and a graphic is supplied to show this.But, this is hyperbole because the information ignores the other side of the account of what the rest of the world owes back to UK banks and other factors such as the quality of collateral offered to banks by domestic borrowers etc., all of which would show a small net surplus. The point should be that lending and borrowing are not necessarily signs of anything unless you look at both sides of the balance sheets.
The June Budget Report instead of doing that says "Between 2002 and 2007 there was a near tripling of UK bank balance sheets and the UK financial system had become one of the most highly leveraged in the world, more so than the US. As a result, the UK was particularly vulnerable to financial instability and was hit hard by the financial crisis. The loss of confidence and withdrawal of credit that followed precipitated the deepest and longest recession since the Second World War: output fell by more than 6 per cent." This is nonsense on several counts. "The UK" was not highly "leveraged" in terms of the references above, and the fall in output was exceeded by other countries such as Germany, which was not at all "highly leveraged" in the sense implied above. More such guff follows including quoting the ratings agency Fitch & Co. who make errant assumptions about 'public sector' when they mean 'central government' and are no better than newspapers at in depth analysis - another set of jokers in my view, playing with fire. I can show that if the Bank of England was counted within the public sector then the extreme opposite is true that the UK was massively reducing its net debt position in both 2008 and 2009 to the lowest in the OECD!
The Budget report discusses UK competitiveness, but this is interpreted in tax competitive terms. Hence there is a clear plan to lower corporation tax significantly and introduce other measnures to retain and attract investment.
The fact of the matter, to be absolutely clear about this, and so on, in my view the UK economy's problems lie elsewhere, mainly in extreme imbalance in UK bank lending of 70% to mortgages and property, only 1.5% to small firms (who employ half of all private sector jobs) and only 23% to business that is not related to property and only 5% of all lending is to UK industry making tradable goods on whom we rely for a fifth of our economy and most of our exports! That the UK is the 7th biggest manufacturer in the world and not far further down the league table is no thanks to UK banks! These are the issues that government has to address in "rebalancing" the economy to compete in the world. German banks lend ten times more to domestic industry and small firms than UK banks. UK banks lend more to foreign industry in foreign countries than to businesses in the UK.
Like its predecessor the Coalition is keen to improve funding access for small and medium sized firms, but I doubt it understand the scale required to compete, for example, with Germany or China, in banking lending available to SMEs. The measures it discusses might increase funding for SMEs by about £1bn or 2.5% when 100 times this is required to grow over the medium term.
We have to look hard at the fact that the UK was a leading credit-boom economy alongside USA, not an export-led growth economy like Germany or China, which is not good idea either. The OBR forecasts predict a surprisingly significant improvement in the UK trade balance, partly due to the weaker pound but at the same time continuing deterioration in the balance of payments? Also, the forecast expects employment to continue growing and unemployment falling, which counters Labour's fear of double-dip recession and half a million job losses with 25% cuts over time in central government departments. The forecasts expect the contributions to growth of business investment and improving trade balance to exceed household spending's contribution to growth. The June Budget report shows this graph of economic growth to show the historically steepest fall of any post-WW2 recession, as if most shocking. The UK performance was in good company. It mattered little if one was an export led surplus or credit boom deficit country, all fell together in 2008.I do wish that mandarins and politicians would have the temerity not to exploit partial facts and do more to discuss the global picture.
In case anyone thinks there is a pragmatism at work in the Budget Statement in place of merely the 'make government smaller' kneejerk Conservatism, there is a page 1 in the budget statement: "Reducing the deficit is a necessary precondition for sustained economic growth", which is purist rhetoric that makes no actual macro-economic sense except to signal the balance of the coalition's conservative stance. It is good politics, however, when most people have a grossly exaggerated idea of the size of government in the economy. Figures of 40-60% are bandied about as cast-iron fact when the true figure is only 20% and best not get too much smaller than that! UK government sector has always for example during the twentieth century been smaller as a % share of the economy than in the USA, but most people would imagine the opposite to have been true!
The Office for Budget Responsibility (OBR), in its pre-Budget forecast stated that "without further action to tackle the deficit":
•• public sector net borrowing would remain at 4% ratio to GDP in 5 years time,having
been above 5% for 6 consecutive years, unprecedented in the post-war period;
(This is so; the Maastricht criteria of a maxima of 3% ratio to GDP and 60% national debt were based on long run UK experience - don't tell the other signatories in the EU. But 4% would be a good result and actually is an exaggeration because OBR took no account of one third of Government Debt held by government itself or the income and sales revenue to be gained when disengaging from interventions that saved the banks!)
•• the structural deficit would be 2.8%/GDP in 2014-15, while the structural current
deficit would be 1.6% and national debt would still be rising in 2014-15 to 74.4%/GDP, with annual debt interest reaching £67bn in that year. (But those are only the gross figures, and could easily be greatly reduced by deploying the government's financial assets that balance the other side of the account- more later).
The fiscal consolidation that is additional on that planned by Labour is shown in the following table: The Government states that its mandate is to achieve "cyclically adjusted current balance by the end of the rolling five-year forecast period" (2015-16). That is a very welcome statement, much more sensible than the idea of totally eliminating the structural deficit.
The plan is for £40bn deficit reduction (4/5 by spending cuts, 1/5 by higher tax rates), which sounds ok, representing 7% of the budget and only 3%/GDP. But, this is on top of budget balancing plans inherited from the outgoing government's March Budget. The June Budget plus plans the Government inherited represent a total consolidation of £113bn by by 2014-15 and £128bn by 2015-16, of which £99bn per year
comes from spending reductions and £29bn per year from net tax increases. Over 5 years this amounts to about £460bn and to about 15% lower government spending that will make the government, according to Conservative commentators, shrink by one quarter in financial terms by the end of a full government term. The liklihood of this being accomplished is not high given the strong possibility of a Euro Area and EU recession soon when the government will have to cyclical adjust its spending upwards again. Actually public spending does not fall:The spending increases approach 5% and debt interest falls modestly. These values are within rounding errors of inflation, interest rates and other factors. Therefore, arguably, there is something of a joke here in ratio to the almost hysterical banter about debnt and deficit in the election politicking. Marshall McLuhan quipped that behind every joke lies a grievance. Looking at the figures they do not appear too different from the inherited projections. In a stable democracy stability in handover of government is important. The projected differences for the year 2010-11 in my view are within error margins and not as yet cause for alarm. The Coalition Government cannot be accused of playing fast and loose with the inherited projections and the differences do little more than reflect a slightly faster economic recovery than forecast. Here are Labour's projections.The big moves that are possible in public sector finances from unwinding government support for the banks will not happen for another year.
What is on the Treasury butcher's block?
1. earlier than planned spending cuts, but actually not much
2. cut structural deficit to zero within 5 years but subject to cyclical factors
3. spending cuts building up to £120+ billions = c. 15% of government budget.
Labour had spending efficiency savings in mind of about £80bn over 5 years plus £100bn of asset sales not counting shares in the banks etc. But,someone in HMT or OBR must know that to cut the deficit by £100 requires a £128 spending cut, while a £100 spending increase generates £28 in directly related taxes plus £12 in same year indirectly and another £20-£30 over the next 3 years depending on the line items and £20 leaves the economy to pay for imports. The Budget forecasts expect about £450bn in spending cuts and higher tax revenue, but a net £115bn higher spending, which is a 20% restructuring of government finances over 5 years.
In my view any government can and should legitimately seek to achieve that degree of policy flexibility if politics is to have any meaning.
What I dislike has been the electioneering rhetoric, much of it false or empty:
- UK heading for highest national debt ratio in EU or G20 or merely highest debt
- Public finances in a mess; largest borrowing requirement in UK history; debt interest costing as much as Defence or Police (£41bn) and some say about to exceed Education
- Tax burden for future generations (unspecified - decades or a century?)
- UK 48% or more than 50% or in some regions 60% and 70% of the economy, of GDP etc.!
- Government unproductively too big etc. £90bn hidden black hole etc.
My arguments:
The hysteria about public finances is normal in election campaigns; same plank that got Labour elected in '97 when it unrealistically accused the Major Government of over-borrowing and no one batted back to ask what Labour would have borrowed had it been in power to reflate out of the recession in the early 1990s.
The hysteria is also important to holding the coalition parties in government together on a predominantly Conservative financial agends albeit one that assumes if only the government finances are in balance then everything else in the economy will be ok and enterprise freed to grow?
But, the truth is that public finances are not in a mess, not compared to private sector debts at three times government's (not counting banks' foreign assets & liabilities at 8 times governemnt gross debt and that matters not a jot as much as the confidence required for UK banks to competitively borrow five times as much as government this year to refresh their funding gaps.
The Public Sector's net position in financial assets is very solid e.g. 1/3 of national debt is owned by government and could be cancelled by fiat or sold off without increasing the national debt. 1/3 of debt interest is paid by government to itself. And after debt interest is taxed net interest cost is only half the gross budget figure. Last year, QE buying in gov. bonds exceeded new borrowing by £30bn = actual net negative government borrowing!
The structural deficit cannot be reduced to zero because it includes £100bn national savings, currency in circulation, and because banks, insurers and pension funds need an annual supply of new gilts for investment and capital reserve purposes (recent auction were four time over-subscribed). banks especially need a handsome supply or they will be buying foreign government bonds instead in large quantities.
National debt heading for £900bn is offset by off-budget items such as £240bn of the debt owned in gov. accounts, £50bn bank shares, £30bn financial assets in public sector enterprises, £30bn reserves, c. £500bn bank assets swapped for £260bn gov. paper = £140bn surplus (off balance sheet), and a stock of other assets conservatively calculated that roughly match or exceed the total of the national debt.
The budget deficit is narrowing with recovery faster than expected, leaving the 'structural deficit' calculated to persist in 'normal' years, of about £70bn - though this seems high. But given this is for necessary capital investment (and actually Osborne in his speech all but said that Brown's Golden Rule lives on). But in rebalancing the economy, Osborne is cutting public sector capital investment when capital investment in the UK is one of the lowest in the G20 and it needs serious rethinking. Serious attention should be given to measures to ensure UK banks lend far more to business and far less for property and mortgages. The governmen plans to discuss with banks the regional distribution of their lending and to SMEs. This should extend to a lot more, in the ontext of to what exten the UK must be less credit-boom led and more export-led, especially concerning long term lending to business sectors.
The money markets have the UK, Euro and Euro countries they hope cornered like a highway robber having stopped the stagecoach and is levelling pistols and demanding gold watches. The markets are presuming everyone is more scared than wise to them and unable to call their bluff. I would call their bluff.
In UK (and US too) the profit from off balance sheet bank bail-outs (replacing private sources of profitable funding gap finance) alone can recover half of budget deficits over the 5 year medium term. The tax rake-back on the other half over recovery to higher growth plus small doses of inflation will see budgets 'normalised'. There will be no perceptible burden on 'future generations' and the borrowing and off balance sheet financing is in any case more tax-cost effective than higher tax rates.
The OBR forecasts expect residential property values to grow much more slowly than in past years and for commercial property values to recover significantly faster. This suggests that the OBR expects there will be a significant shift in bank lending including property development and mortgage lending from households to business. The basis for believing this would be interesting to enquire into.The Coalition government believes that private enterprise will grow more with the budget redaction. Labour's view is that the economic cake risks being made smaller not larger by shrinking the state and that half a million jobs will be at risk. Spending is now projected to fall from 48% ratio to GDP to 40% by 2015-16 and receipts are projected to rise from 37% to 39% ratio to GDP. Cyclically adjusted
public sector borrowing will be reduced by 8.4% to 0.3% ratio to GDP in 2015-16. This is based on the following GDP forecast.

In conclusion my point is that balancing or normalising the budgets and debt positions are only a matter of time once the hysteria about public finances has calmed down. A quarter of all the budget consolidation (£110bn) over 5 years is expected from lower government capital investment and asset sales. It is my expectation that considerably more can be done and that should also be done to sustain a much higher level of capital investment. There may be an element however of battening down the hatches in anticipation of a Euro Area recession or prolonged low growth?
For the Euro Area fiscal problems are rather different. In part this is because all Euro Area national central banks gave away theo money market activities to the ECB and have much less flexibility than the UK, such as when calling on the ECB for responses on a scale commiserate with the UK and USA. The UK can roll over £100bn of treasury bills off budget, while that is not feasible for Euro Area members except indirectly via complicated negotiation with ECB, which is in any case not set up to assist with state governments' financing.
Therefore, Euro Area states' banking sector funding support interventions had to be 'on budget' and this is essentially the Greek and Irish problem, but others too, including Germany where the banks are extremely vulnerable to falling business profits causing loan losses and vulnerable to disappearing net interest income becauser the banks lent 60% of all loans to industry.
The EU and Euro Area have much bigger problems to solve in determining how to reform the Euro system as they head into serious trade winds that should propel them soon into a year long recession!

UK NATIONAL DEBT, GOVERNMENT BUDGET, SPENDING CUTS

2010-06-10T09:46:00.000-07:00

In our general election it became axiomatic that the state of the economy and public sector finances were one and the same. It was surely curious that parties, media and it seemed the general voters did not have stomach for debating the financial crisis, recession and world economy. This would have suited the Labour Party, but the political rhetoric could not stretch to these matters to make them party political, although the Conservatives did their very best to blame it all on Labour, and the Liberal Democrats were happy to plant their flags somewhere inbetween but not shy away from bemoaning the state of public finances, which was essentially the Conservative agenda.
It is poetic justice that labour is ousted from power by the same accusations it levelled at the Conservatives in 1989, live by the sword, die... etc. Many people are understandably cynical and see whatever government does as at best oil on troubled waters and likely failure to stem the pollution a la BP. Now that the dust has settled and we have a coalition in government, which is I think a positive outcome insofar as it was long overdue for the Liberal democrats to be blooded with power in central government. I doubt I will see a Labour Government in power again during my working life and I will not be surprised never to see one party with an overall majority in power again in my lifetime. That is nothing compared to the generations some wags speculate it will take to undo the financial consequences of recent years as if it will impoverish all innocents unbearably.The general public is full to brimming with anxieties showered on them by election politics. Central to this is their grappling with what national debt and budget deficits actually are. Decades of refinement to determine what is in or out of the numbers, what is consolidated off balance sheet, what is in the Maastricht Criteria or not, and so on have not made it easy even for experienced economists to be "absolutely clear" as politicians like to say when presaging their fuzzy remarks.
What the politicians say is not cast-iron clear and what they actually know for certain to believe we cannot be sure.
Politics is myth-making as well as reality-checking. Some of it is long term ideology, some short term so-called "hard choices" that appear counter-intuitive to what parties are supposed to stand for.
To take a few examples of what everyone, or the great majority, have been led to believe as essential facts:
- government is half of the economy and employs over half of those in jobs, a view gained from wrongly describing all of the government budget as a % of national income
- government is under 25% of the economy and employs 20% of people with jobs including many who are not full-time but merely part-time jobs
- the fast-growing national debt is an egregious burden on future generations
- that is hard to prove rhetoric; easier to prove the opposite, to show that borrowing is more productive and less of a burden than taxes, and far less than private sector debt, and easiest to argue, technically, the burden on 'future generations' will be imperceptible to them, if a view that most would deem politically too benign to be creditable
- government borrowing is unsustainable, added to which the government has vowed to eliminate the 'structural deficit' that is the bulk of borrowing that is not caused by the effect of recession causing tax revenues to fall below trend
- truth it that eliminating all government borrowing is unsustainable because banks, insurers, pension and life funds and other long term investors need a steady supply as a matter of law as well as prudence, and government needs to make long term investment that should not be entirely a burden to current years' taxpayers
- government is too big / national debt is £14,000 per man, woman and child and growing to £22,000 / if we shrink government and get debt and borrowing down or eliminated then everyone is better off etc.- no, a third of the national debt is owed by government to itself and could actually be cancelled by government fiat, and government has nearly as much again as the national debt in financial assets, but anyway private sector debt at £66,000 per man, woman and child should be considered a more compelling matter, not counting £120,000 owed to foreigners per UK man, woman and child by UK banks. These are silly ratios because in each case banks foreign balance sheets, the domestic private sector and the government all have balancing assets, liquid and property that more than balance the books. Why therefore, except for political reasons, are we so centrally obsessed by government finance; there is more to the state of the economy than that.
- everything government spends and taxes is our money and we (taxpayers) own the debt and deficit
- no, nearly 30% (28%)of tax revenue is taxation exerted on government spending; it is actually not possible to draw lines between private/public and taxpayers/ government to define our economy as if government is made less then private and the whole economy will be worth more; government is not outside our economy or on another planet!
- if we technically could have netted the buying in by government of government debt and counted the value of public enterprise balances and shareholdings bought in the banks out of fees for asset swaps there would have been zero net borrowing by government in the last two years - years when gross government borrowing was trumpeted as the highest ever in history etc.!
- government spending has to be cut urgently and front line services may not be immune, and we will all feel the effects of government spending cuts!
- no, we won't all feel it, and much of it happens anyway, and there are big items that can be cut or encashed without any obvious pain to the general public; life does not always have to progress through 'hard choices'!
What are these items? There are typically £15bn a year efficiency savings not counting all kinds of savings here to spend more there that is regularly part of all departments, agencies, services and enterprises, £20bn asset sales, £15bn public enterprise profits, and not forgetting £45bn in bank shares and many £billions in profits from asset swaps and charges to the banks, offset by benign factors such as steady growth in national savings premium bonds, cash in circulation, foreign currency reserves, and much else.
Compared alone to banks that are selling assets and cost-cutting and needing to re-borrow £hundreds of billions, plus other private sector recycling of borrowings, the government's accounts and financial balances are in reality much less worrisome.
The financial markets don't know any more about all this than others, but like politicians it is there job to stir the pot and test opportunities to trade on uncertainty as they have been doing very successfully with Greece and other 'sovereign debt' politics shaking the Euro. But, this was predictable because it always happens after recessions when governments have to shoulder the burdens of economic recovery.
Does it matter if government cuts spending sooner than later. yes, maybe, but only because the differences are very small and fragile between national income growth rates subject to the intricacies of how these are estimated, and defined for accounting purposes, and need to be just enough to at least bolster confidence compared to slightly lower rates of growth where all can appear doom and gloom. Recovery is both real and psychological, about confidence for the near term future as much as about actual cash-flow and debt management.
Government is steering a political path between the psychology of recovery and its economic underpinnings. They have to talk the talk but may not need really to walk the walk, not all the way. We can bemoan the duplicity of politics and politicians but thank god for them too otherwise who is there to control the panic?

STATE OF THE UK ECONOMY'S GENERAL ELECTION

2010-05-04T01:51:00.000-07:00

After a month of electoral canvassing and 'presidential' debates the media has concluded that the result is not the only matter that is the least predictable. Apart from 30-40% of voters remaining apparently undecided until the last moment according to the pollsters, there is a general view that the parties have failed to be "absolutely clear" about their budgets, especially their draconian budget cuts. The parties and the media have manufactured the idea that economic policy is only the government's borrow, spend and cut plans.
There is no doubt that a blackmail is being exerted in the money and bond markets and by the ratings agencies helped by the sovereign debt and cost of funding crisis hitting Greece, Spain, Portugal and Ireland, and others. This, and the Conservative Party's successful campaign claiming that government finances are in a mess, has propelled all parties into accepting that steep spending cuts are essential, whether they really are or not. That they might not be, and the unpleasantness involved is also a factor in parties being somewhat vague about spending cuts. This is a reasonable position. It is not normal for budget cuts to be spelled out in precise detail ahead of time.
All Chancellor candidates and real experts know that efficiency savings continue all the time. Mostly they are generated by moral and ethical imperatives within the public services to apply the money saved to other essential more urgent priorities. They also know that long term plans can be cut and that there is a continuing programme of asset sales. Annual efficiency savings and asset sales are worth about £35bn. The Conservatives want to take most of that out of the government budget while Labour want to re-apply most of it to support welfare priorities and continue to directly support economic recovery. Conservatives believe in more indirect supply-side support by entrusting the private sector to know better what is best, by how much and when. The Liberal Democrats policies lie somewhere in the mix between these two arguably ideologically polar opposites. That is also the parties traditional positions. The Conservatives want to take the current recovery's sustainability for granted while Labour does not.
Recession and public spending cuts seem abstractions to most voters, those who have kept their jobs and actually grown their savings (net personal savings rising 8% annually) while not having had to sell a property at a loss. Property values appear to be rebounding upwards very fast. Therefore, the whole hair shirt debate about cuts seems as real as a 3D shark. It is undeniable that the Labour Government is jaded and tired and doughy faced. They have been on the field of play for 13 years. Conservatives and Liberal Democrats appear full of bounce, energised and fresh-faced. The civil servants are filled with the gleefulness they always relish at the prospect of yes ministering to relative novices.
'Time for change' is consequently the catchphrase of the election. Coming from the lips of Labour politicians it seems perforce least convincing. The electorate is being asked at this anxious time to vote for the devils they know or the devils they don't. It should be no surprise therefore that they are feeling shifty, misled, suspicious of 'snake oil' and therefore unusually uncertain who to vote for, and not least for the fact that so many MPs are retiring following the expenses scandal?
I respect the parties' ideological differences and wish they would make more of them. The many new MPs who will enter the House of Commons regardless of the outcome of the election are however probably the least ideologically opinionated generation since the middle of the 19th century! When ideology is weak then technical attention to the true complexity of economics facts, to the real SNAFU world of unintended consequences, has to be that much greater. Will they see through the fog of electoral war to see the true state of the battlefield?
Currently the fog of political battle is a pall over the fuzzy majority called the 'great majority, the 'middle classes', the 'hard-working families,(blue-collar and white-collar) and not only their income and net wealth issues, but also the very uncertain quantitative facts and qualitative and legal realities of migrants.
We have a fudging in the middle ground because it is perceived that only there are the few thousand swing votes required to make the difference.
The last hours of the campaign have for example hotted up in Scotland because, ironically from the point of view of the Scottish National Party, it is there that the pollsters have most recently decided the outcome of the UK general election will be decided. What none of the parties are saying is that for every £10 of lower borrowing spending has to be cut by £13. None are predicting how much the budget deficit will narrow as the economy's growth is restored to 2% GDP growth and above.
The general election debate has discussed the crisis of the economy as if it is a crisis only of government finances, budget deficit and debt. The economy is centre-stage we are told by all pundits and politicians, but in fact only that quarter of it that is government and only the part of the general government budget that any government has the power to change, less than one fifth or about £120bn. This is enough however to either add 1-2% to general economic growth against trend or to subtract that impetus.
The idea that the budget deficit and debt in the short term is all that economic policy of government should be about is of course absurd. It is as if the short term collective memory has been wiped. No party refers to the tripling of private sector debt over the past decade when, until the recession hit, government deficits and debt remained steady and at times fell in ratio to GDP. Banks alone will this year borrow three times as much as government will borrow.
Private sector debt will cost current and future generations more than public sector borrowing and debt, even if there are tax rises, but it is the latter that has attracted all political scare-mongering. This is the price we must inevitably pay for ya-boo politics, and may be an important factor in why the third party, the Liberal Democrats have been elevated into a share of the popular vote that is likely to dictate that we have a coalition government forming after May 6th.
What the politicians are not discussing with the general public is that there is much more to public finances than money in money out or the Maastricht criteria. There is also much more in the government vaults, and more than the gross debt or empty hole imagined. Government is holding more than sufficient financial assets to make the debates during the general election totally redundent. The debate about the £800-1,000bn size of the government debt and deficits of $160bn falling to £100bn reduced to whether to raise National Insurance or cut £6bn this year, but is not discussed alongside the £45bn of bank shares that could be sold, or the £185bn government bonds bought in (to add to another £200bn government debt owned by the government and merely owed to itself) any of which could be in due course sold, or the nearly £500bn in banks assets owned at the Bank of England earning about £40bn annually or the £200bn of other public sector assets available potentially for sale, or the balances of national enterprises, and so on and on. Public finance apparently may only be discussed in small bit sizes that the public can understand.
The amount that the budget deficit will recover automatically with higher economic growth is not a quotable figure. Politicians fight shy of hostages to fortune. They 'fight' politically as much by what they fail to say as by what they do say, what they feel they can say without being satirised by their opponents. Satire is a major player in British politics. The general public are feeling not only angry but satirical towards the banks while merely satirical towards the government and other political parties. The automatic closing of the deficit leaves what is called the structural deficit. All parties have said they intend to close the structural deficit by making spending cuts even though this deficit was not required to be closed in years before the Credit Crunch and Recession. The truth is that it dare not be closed for fear of denuding banks, pension and insurance funds of the government bonds they need every year to add to their capital reserves and investment funds. The politicians will not tell the public that there is a minimum amount of government borrowing that is simply irreducible because it is essential to our savings and to the health of our banks.
Much is made, variously by all parties about the size of government in our economy. It is often heard in the national regions that 60% of jobs depend on government when any simple scrutiny of publicly available data shows that the true figure for Scotland, Wales and N.Ireland is 30% and not much different for regions of England and Wales.
Poorly schooled pundits, politician and others believe government s as big as its budget (over £600bn) is a 43% share of GDP (over £1400bn). The size of the government sector in the economy is only half that figure because one third of government spending is not part of GDP and anyway it is also taxed. Government pays more in tax on its spending than the average for the rest of the economy - about 28% of government revenue is taxation exerted directly on its own spending. It is reasonable politics to worry that government is too big, but not if the perception is totally out of proportion with reality.
There is a half-submerged issue about membership of the European Union and the extent to which we are governed by Brussels and not by London. The debate fails to see the greater proportion of our policies and laws that we derive every year from examples created in the USA, not because we have to but because our governments and parties choose to. Our economy's recovery similarly is dictated more by growth in the USA than in the EU. But, this along with other practical realities is never, or very rarely, mentioned in our political debates.The parties competing for government are of course focused on how they can be better trusted than the others with hands on the tiller of the ship of the UK economy, especially that part of the engine that is the public sector finances and how these may dictate to private sector finances. What should be clear is that the parties actually do not believe they have as much navigational choice and engine horsepower as the public are told to believe. The Conservatives want to make the power of the public sector greater to change direction but smaller in ability to power, to finance, any change. Labour are not seeking more power for Government, but do not want that engine power to be made weak.
The Conservatives see general acceptance of spending cuts as an opportunity to reduce the size of 'big government' and to some hard-to-measure extent replace it with 'the big society' where there will be more initiative available that central government does not dictate.
They have constructed an argument that says this will boost economic growth by growing 'the real economy' and not harm growth or risk a double-dip recession as Labour claims. The precise policies for helping business are not very different between the major party manifestos other than Labour has more of them (the advantage of being in government and having published a full budget) and more where there is actual money committed. All parties have a problem in drawing a line between the national interest and voter segments self-interest. On balance, it seems that the parties believe voters are more compelled to vote according to short term self-interest than what is in the longer term national interest. Perhaps this is why Labour has not successfully sold the quite true story that it made the right calls to save the banks and save the economy and to lead in international coordinated action. Like Churchill in '45 Gordon Brown is failing to convince the electorate that because he managed to gain victory in war he should be entrusted to manage the peace. The psephologists say the election outcome will be dictated by women who are the majority of the 'swing vote'. Gordon Brown was the only PM candidate to mention women (implying policies for women) in the three television debates, perhaps also because he does not believe he can appeal to them televisually?
The voters believe that budget cuts and whatever they will have to pay because of those results from them having bailed out the banks. The parties are not willing to say that taxpayers money was not involved, to explain that the banks were saved off-budget and 'off balance sheet' or to predict how much taxpayers will reap a profit that will do more than anything else alongside recovery in economic growth to balance the budget. This is a dimension too far it seems for politicians to risk telling the voters just how innovatively and cleverly the system of public finance can operate.
The parties all seem to under-estimate that 15% of voters work for the public sector other than promising no cuts, or very limited ones, in health and education, and of course in Defence and Police. All say that only back-office not front-line cuts in public services are planned. Economists, civil servants and disbelieve their assurances. That front-line workers disbelieve that their jobs are safe has much to do with the fact that one third of them are part-time employees.
What none of the parties are prepared to say is that the cuts they propose are trivial and in some measure self-defeating i.e. that revenue can fall when spending falls. The likely outcome of whoever gains the command of HM Treasury is that the composition of government spending my change slightly, but it is unlikely to fall in absolute terms. The trumpeted cuts will not cut as much as intended. There will be false economies. The abstract belief that a smaller government share of the cake means a bigger private share is very entrenched. The idea that the cake is smaller when the government slice is reduced or the cream taken off the top is not understood.
The big question about whether we return to a property-led credit-boom approach to economic growth or do something to re-orientate the economy more to productive business and export-led growth via manufacturing - which has in the last decade received only a small share of bank lending while being responsible for most of UK exports, while banks have lent 70% of loans to mortgages and property developers. In export-led economies like Germany and China the opposite has been the case. UK banks lend more to foreign manufacturers than to UK manufacturers! All parties say it is essential to do more for small businesses, the lifeblood of the economy, only source of new jobs, business of the future, hard working, under-valued etc. But actually, if the banks don't take orders from government on doing more to support small firms long term, then not much can change. Banks (and finance sector generally) have been caught up in three ways in the election debate. Politicians appear to agree that the UK economy became over-dependant on finance, big banks may need to be broken up, and the Labour government was misled by Big Finance.
The finance sector is very large in the UK economy. It is the next biggest sector after Government when all indirect as well as direct business employment is counted. It is an important competitive advantage of the UK that does do much to make up for UK trade deficits. If we had more than the big 5 banks responsible for 70% of domestic bank lending we might improve the competitiveness of the UK domestic banking market.
The traditional economists assumption was that banks were neutral with respect to the performance of the macro-economy. The Credit Crunch was a shock to that idea. We can now see that banks did not diversify their lending across the economy but concentrated too much on mortgages and property. German banks for example lend three times as much to small firms who employ half of private sector jobs as UK banks, in ratio of 12% of GDP compared to 4% of GDP. None of the parties have policies to help business and to boost capital investment that approach the scale of the problem. None are prepared to tell voters that speedy restoration of property values and mortgage lending is not desirable. As recovery strengthens there is little indication that a return to a credit-boom economy will not be automatic.
The parties are not committing to relieve the housing shortage by a return to building public housing. Council house building was abandoned thirty years ago - a large factor in the UK property price boom. Housing associations and policies to encourage house-building and affordable housing and sell-offs have not made up for the gap caused by the ending of public sector housing investment.
Labour says it has renovated 2 million public sector homes but will in the next few years cut back capital investment by government as a major part of its spending cuts! Capital investment in the UK is currently extremely low by international comparison, a tenth of what it is in extreme export-led growth economies of Germany and China.
All parties want to boost capital investment by industry. Only Labour has put some numbers behind this, but very modest ones.
Only Labour's Gordon Brown in the three debates, mentioned 'women', but none of the parties have explicitly stated a fact well-known to economists that women, children, disabled and pensioners are 80% of Welfare State dependants. The biggest direct responsibility of government in terms of quality of life and income are pensioners, especially the third of pensioners living in poverty whose state pensions are only worth half of what they were 60 years ago! If any of the parties had been sufficiently desperate to win the election outright they could have promised over a decade say to double the state pension. The trouble is that to justify this when public spending is poised for major pruning requires explaining the roundabout way in which the economy really works. Pension costs after tax are low because pensioners and all poor people spend whatever they get.
Looking at the difference between the gross cost of public spending and the net cost to taxpayers after tax was a practise at The Treasury that ended in 1979 and has never been restored since. Not even the Institute for Fiscal Studies any longer looks at revenue and spending in those terms? The result is that the politics of house-keeping in the public finances is heavy with myth-making, light on practicalities.
The public sector is not less productive or less efficient than the private sector or more debt-ridden. The public sector is not much bigger than the minimum size it needs to be to be effective. It is not outside of the real economy any more than the banks are. There are many myths at work. Politics is war only by other means, civil war perhaps. The propaganda in peacetime is only be exceeded by propaganda in wartime. Everyone should vote for whichever party they believe knows the difference between propaganda and what is more essentially true, however paradoxical, and is more likely to betray the propaganda before betraying what is in the real national interest that will serve all and not merely a minority or merely the majority. That is my wishy-washy recommendation.

UK BUDGET 2010

2010-03-24T07:18:00.000-07:00

There has never been, in my memory, such a creatively imaginative budget as that delivered today by Chancellor Darling, very different in character from budgets of Gordon Brown or Ken Clarke. Some UK broadsheet newspaper comment began with words such as boring and vacuous before finding items deserving of positive praise and some muted excitement. I am surprised.
Many commentators said the budget is of marginal impact, steady as she goes. And yet David Cameron's attack centred on this budget doubling the government debt again, having already doubled it once since taking office. Not sure how he calculated that? It is a sign of just how jaded and cynical the country has become, not just the government. The Gilts markets had primed themselves for a sell-off, helped by Portugal's sovereign downgrade. The stock market rose 1/2%, which means nothing.
Most media comment overlooked the raft of measures designed to help small businesses. There was general discounting of economic recovery as the main factor that will narrow the fiscal deficit and raised doubts about the realism of nearly £60bn of medium term spending cuts, especially the £11bn efficiency savings.(I have followed 30 previous budgets in detail looking for exciting changes, rarely finding anything sexy but plenty 'sexed up'.)During the Chancellors's speech there was growing enthusiasm that rumbled more than cheered on the government benches. One political result is that it may have marked Alistair Darling at last as a giant of the Labour party that he has not been perceived as until now. Ed Balls could not have achieved that much even had he been Chancellor in place of Darling. Darling was quite daring in saying that if the budget deficit had not grown and government not intervened the revenue losses would have been much greater and the deficit consequently even wider! This was a telling point that went unchallenged in the debate? Government budget is roughly 45% ratio to the economy, but its share of GDP is really close to only 20%. It also needs to run a deficit just to generate Gilts to feeds the needs of banks, insurers and other finance sector needs, which currently are very high as they seek to improve the quality of their capital and liquidity reserves - but Darling did not say that; he should have!
What is somewhat galling about the debate and media comment on the budget is the idea hat he only elephant in the room is government debt and borrowing. But that is only one quarter of the debt overhang in the UK economy. To cope with that we need to see some of it shifted from private sector shoulders onto the government's back - that is not dogma, just realism.GDP ESTIMATES
There was much debate in the House of Commons and in the media about the reliability of the Government's GDP estimate of over 3% for 2010 and 2011. The unrecognised fact is that first, UK growth is very closely dependant on US economic growth, and second, that consensus forecasts are always wrong.The forecasting errors have been relatively trivial until 2008-2009 when large error crept in should not be surprising. In exceptional years of recession we can never trust governments to predict the depth of recession publicly for fear of thereby deepening the recession by negatively influencing expectations. Otherwise, the Treasury's forecasts have been as accurate as anyone should expect. Roughly it will take the economy 7 years from 2008 to achieve the level of output it would have expected to reach in 4 years. Pre-2008 is an output trend based on a property and asset based credit-boom growth. The Opposition parties skirt around 'credit-boom' - it is not in the political lexicon. They merely express something in that direction when they refer to an 'overblown finance sector'.
EXTERNAL TRADE & COMPETITIVENESS
At he same time here is acknowledgement that 'finance' is a major competitive advantage sector of the UK economy'S competitiveness. But, however well that sector performs and recovers, the UK economy must seek to change its growth strategy and focus more on industry, on what will narrow the trade gap even if the result is only to hold the deficit steady. There is a risk of the deficit widening dramatically with a sharp deterioration in current account for reasons that will become clear when discussing the budget debate below, especially the issue of banking lending. In most years, budgets are only interesting in the macro-economic details they provide in the Budget's Red Book, little of which is normally discussed in the main Speech, though not this time. The Red Book is the UK Government's only fulsome statement of economic policy. We do not have the equivalent of the USA's President's Council of Economic Advisor's report to Congress.
The key issue is noted in page 177 of the Red Book:"There is a risk that the future supply of credit is constrained by concerns over the availability of bank funding and the cost of refinancing existing funding [of funding gaps = about 1/3 of banks' balance sheets] following the collapse of the shadow banking system and the general repricing of risk. The authorities will continue to monitor developments in funding markets as banks continue to restructure their balance sheets and reduce their reliance on short-term wholesale funding."
The fact is that funding costs have not yet come down to a level that makes expanding business lending profitable for the banks! The banks do not say so and instead claim that lower lending is a result of the speed and extent of private sector deleveraging, while their own deleveraging is merely described as 'tighter credit conditions'. PRIVATE SECTOR DEBT
To take the pressure off so much political focus on government deficit and debt, Darling and the red Book could have said a lot more about private sector borrowing and debt. The minimum was said? The Red Book says that, "The level of household debt rose substantially in the last decade, as households mainly used debt to finance house purchase and other assets. Household balance sheets have weakened in the recession due to falling asset prices, which has served to lower the ratio of net assets to income. These factors, together with the tightening of credit conditions and past increases in asset price volatility, may have contributed to the significant adjustment already under way, as demonstrated by the sharp rise in the saving ratio in 2009."
Deposit savings have risen but not as fast as interbank lending, especially cross-border has shrunk such that the £800bn funding gap of the UK banks has not narrowed other than the liquidity measures (e.g. SLS and APS) of the Bank of England and HM Treasury. The general rise in private saving is a mirror of the increase in government borrowing, which remained flat in ratio to GDP for a decade while private sector borrowing doubled and tripled, but mainly to lend to property, mortgages and finance sector i.e. based on asset prices and unearned income.
Traditionally, in the Red Book there was a graphic showing how private savings and government net borrowing match each other in ratio to GDP. Since Labour came to power in 1997 that chart has been left out, which may have a little to do with subsequent confusion about the positive relationship between government debt and the saving in the economy, which is contrary to most people's intuitive assumption. this is an accounting identity of the balance between private and public; the more one side borrows, the more the other side saves. The banking crisis forced the private sector to save, partly by denying credit and partly by inducing a recession. Increased government borrowing and its counterpart increased private saving both can look like a cause of recession, of reduced tax revenues and increased pressure on government to loosen fiscal policy to cushion the economy.
Therefore Chancellor Darling's reference to higher private savings does not tell us much until the private sector continues saving and banks deny credit requiring government to borrow even more - hoping to reverse this is why government is now neutralising its fiscal stance. But, it is dangerous if government tries to drastically cut borrowing suddenly as long as the private sector is fixed on saving and banks on shrinking their loanbooks, when cutting public borrowing will only depress demand. Only when firms, households and banks regain capacity to borrow and invest that government can reduce its deficit.
THE BUDGET SPEECH
Budget speeches in non-recession years mainly only report marginally adjust tax rates and transfers in the main speech. Partly because of the credit crunch recession, the imminent general election, and as the first Budget where Alistair Darling could make it fully his own, he went quite far in setting manifesto policy - it may, of course, be Darling's third and last budget and much of what it promises may be changed by a new incoming government. If the government party changes, there are some signs that the precedent set by labour in 1997 of adhering to the preceding government's budget-setting for 2 years, on the tax changes at least - if not, I hope Labour is re-elected for another term.HOUSE OF COMMONS
The Opposition Leader David Cameron responded with more sarcastic and satirical, enthusiasm, desporting an energy and passion, than I recall witnessing before in response to a budget statement! Many Labour MPs departed the chamber rather than listen to him. Where do they go? - perhaps to speak to journalists, others to write valedictories on their web-sites or to read the Red Book, and some just nowhere special such as their desks, knowing that whatever the results of the next election they are out of politics?
HoC members are not well versed in budget and treasury matters, even less so about economics. If the number of members left to debate is an indicator of macro-economic literacy among our Commons parliamentarians, then there is much to be hoped for in the turnover of MPs awaited at the soon to be announced General Election.
Following Cameron's reply, before Nick Clegg could rise to speak for the UK's third party, most of the Labour benches cleared out, which was a vote perhaps against the prospect of an alliance should there be a hung parliament, or simply insulting?
After Clegg spoke only 7 Labour members including The Chancellor and two of his deputies remained in the chamber compared to about 40 members on the opposition benches, which then too slowly thinned as The Chairman of the HoC Treasury Committee spoke - his last speech before retiring from The Commons.
The ensuing debate was tedious and of trivial import, while the Budget speech was wholly absorbing and the Opposition's riposte electrifying. The next day's debate, once key front-benchers departed was again reduced to only 30 members, 15 on either side of the house - a very poor showing that can only undermine those who exalt the importance of back-bencher debate. Bt 5pm on Thursday the number of members of parliament debating the budget had fallen to no more than 10!
The main figures are:GROWTH FORECASTS
The budget speech declared that growth forecasts remain fairly intact with only a small downward revision for 2010's GDP growth, which will still exceed 2-3 times last year's of about 1%. Budget deficits will halve in 4 years helped by expenditure savings of £11bn without harming frontline services, assets sales of £16bn, £11bn in feees and bonus taxes from banks, and another over £60bn in medium term expenditure savings, plus some tax rises (without as the Opposition pointed out, mentioning £4bn in 'stealth taxes' i.e. rises announced in past budgets that only come into effect this year) and reducing tax evasion of which 60% will impact the top 5% and 1% highest income earners.
Corporation tax (a quarter of which came from financial services), which was the main fall in government revenue, will remain at the lowest rate among G7 countries and national debt among the lowest in the EU and no more than the G7 average. He said that government gross borrowing between now and 2014 will be £100bn less than previously forecast. This and other related information provided should take a lot of the air out of the political tyre pressure for spending cuts. PROFIT FROM SAVING THE BANKS
It is puzzling why no firmer estimates, even within a wide band, can be forecast for the £tens of billions of future revenue from not only selling equity in RBS and LBG, currently worth £40bn, but also income from asset swaps and fees - just as no mention of the £200 billion of bought-in gilts and other gilts held internally to government, and tax on that, which greatly reduce the budget's net debt interest cost by half. George Osborne for the Opposition picked up on what several MPs said in the Commons that debt interest exceeds expenditure on education, which is madness - er, um, it doesn't? Gross debt interest is £10bn less, but the same as Defense, but net debt interest is much smaller, about half.
NON-TAX INCOME OFF BUDGET OFF BALANCE SHEET
Chancellor Darling referred to £8bn recovered in fees from banks and £2.5bn on taxing bank bonuses. The £8bn came from RBS and LBG in respect of the Asset Protection Scheme (APS), and other items? (The APS took £282bn off RBS's balance sheet in addition to about £275bn taken off banks' balance sheets via the SLS). Among assets for sale (The Tote and Dartford Tunnel) no mention was made of the expected sale of Northern Rock with £10bn mortgages and £19bn deposits. From the sale of B&B and NR, and the nationalised bad bank of NR and B&B impaired assets the government expects to recover £50bn. The roughly £400bn of bank assets there must be an annual income of at least £15bn. The total of these incom and sales items medium by 2012 generate £100bn government revenues.
The Opposition parties accuse the government of dishonesty over the deficit and expenditure cuts. But, they are not addressing how it is that the government has made £hundreds of billions of interventions with the banks without any of that being on budget. The government cannot openly predict the returns from sale of equity in the banks and the precise repo swap net income on banks' assets, which may simply be used to pay down national debt. It is under-appreciated that all the help to bail-out banks has been off-budget, off-balance sheet with a negative actual current expenditure. The Red Book only makes this vaguely clear in pages 211-216. The government has a large ownership of banks worth more than £1 trillion of a balance sheet where assets and collateral exceed liabilities by about £700 billions -hardly a situation of difficulty. The government is reluctant to be transparent about this because options remain open as to how much profit to reap before letting private investors and private wholesale funding providers back in. EMPLOYMENT & UNEMPLOYMENT
Darling introduced a raft of measures to support small business, R&D, education and training, and took pride in more than 1 million fewer jobs lost compared earlier recessions (at 1.6m claimant count) that was met with loud guffaws on Opposition benches who believe the true unemployment figure is 1 million higher? But nearly 200,000 are being kept off the claimant count by £1bn spent on sponsored employment experience for education leavers. Insofar as darling's claim is true, it is a remarkable feat mostly ignored by media comment. The UK's recessions (except for 2001, the only time boom-bust was smoothed over) almost always exactly follow that of the USA very closely. In the USA unemployment is more severe than earlier recessions, while the UK is claiming this time the opposite to be the case? USA unemployment is shown below: UK employment, whether the figures have been flattered, nevertheless continue to show a high participation rate and employment of over 70%, and it has to be a fact that the claimant count is lower than expected, if lower for 'stealth' reasons than it should be?. SMALL BUSINESS
2.7m small firms employ half of UK private sector jobs (in USA the number is 27m small firms). UK small firms employ as many jobs all 32,000 large companies. Among help for small business, rates will be zero for 300,000 small businesses that The Chancellor said employ 1.6 million and rates discounts for other small firms should benefit these firms by about £1,000 each. RBS and LBG are being told to lend £94bn in new business loans in 2010-11 half (actually £105bn of which £41bn) must go to small firms and SMEs. When only 6.5% of all customer lending by all UK banks goes to small businesses that employ 13.5 millions this item in the budget report may appear trivial. He also announced creation of a Small Business Credit Adjudicator with statutory powers to enforce judgements. The Adjudicator will work closely with an expanded Financial Intermediary Service to ensure that small businesses are treated fairly when applying for loans. There are in the UK more than 2.5 million small businesses of which 1 million borrow from banks on a business loan basis. If even 10% of these have complaints the FIS will have its work cut out!INFRASTRUCTURE
There was £250m to mend potholes and improve motorways amid remarks about infrastructure for trade, but nothing, as two MPs noted, about public sector or low income housing. The BBC calculated that UK's potholes in roads needs £9 billions to mend and that the government's 3100m for this will not fill many of these holes, which has now become a metaphor for mending holes in the budget!
Darling's alternative to doing anything on social housing is only to sharply raise the threshold for housing stamp duty threshold for first time buyers (a proposal that the Opposition claim to have proposed first) while putting it up to 5% for £1+ million homes from 2011 (which the Opposition does not claim credit for).
Cameron in his comments claimed several times that UK business is stuck, nothing moving, and that half of UK adults of working age are economically inactive! This is rhetoric since UK's participation remains high at nearly 70%.
One very valid point Cameron made is that the budget speech neglected tax rises already in the pipeline (£4bn 'stealth taxes). Cameron mentioned the postponed (but now due) higher business rates that will impact some key businesses. Cameron did not mention that universities are due to lose $1 billion. But what government takes away in one hand often gives back directly with the other; universities can compete for a quarter billion special funding, and there was a lot of support for small businesses, though not all of it easy to quantify or time. BANK LENDING TO SMALL BUSINESS
To aid small businesses, Darling said £billions of government procurement would be routed to small firms, including invoices paid within 5 days (1 week) and making the major banks RBS and LBG, who cover half of domestic lending, make £90bn in new loans to small and medium sized firms especially plus several peripheral initiatives to secure this including a small business loans ombudsman service.
Clegg rightly pointed out that new gross lending is not the same as net lending increase. In the last year when £12bn and £15bn in net new lending to small firms was insisted upon by RBS and LBG, their general customer lending fell by about 8% or roughly over £60bn, despite new lending of £79bn as confirmed by a Treasury Minister who also claimed that the promised £94bn for new lending in 2010-11 would be a substantial economic benefit.
Darling also said these banks are half of the UK bank lending market, actually 40% is closer to the true figure. There is some confusion. Total UK banks' small firm and SME lending is only £220bn of which £100bn is mortgages. LBG and RBS have only 25% of this lending. If the two banks do authorise £94bn in new loans as Darling said, though the Red Book says £105bn, half to UK SME and small firms will this have a positive net effect? The Red book says £41bn of new loans or small businesses.
The two banks currently have £79bn outstanding to small firms and SMEs of which £35m are longer term corporate mortgages. That suggests that in the year £112bn was cancelled and £44bn new loans granted. If these loans are renewable annually as is normal and only £41bn new loans made to small businesses then these two banks lending to small businesses could shrink by £3bn! The banks say they are not refusing loan requests more than by the usual 15%.
I wish that all of the £105bn would allocated to small businesses and then there could be a rise of £21bn, which nevertheless remains trivial in terms of these banks' balance sheets. The two government controlled/influenced banks should make another £100m of new loans to bigger business. Either way, Clegg's point is made that obliging firms to authorise new loans gross does not guarantee a net positive effect? The Chancellor and his deputies have emphasised that these are "new" loans. They may not appreciate that almost all customer loans are renewed annually except mortgages.
Chancellor Darling also announced a new UK Finance for Growth investment corporation and a New growth Capital Fund with £500m. The business support proposals in the budget may be those proposed by Lord Mandelson, the Business Secretary, who in January announced plans to guarantee as much as £20bn of bank loans to small and medium-sized companies to ensure credit keeps flowing. There was no further mention of this. It is to apply to companies with sales of up to £500m will be able to qualify for the support, which covers a wide range far above that of the standard definition of small firms. He said, "UK companies are the lifeblood of the economy, and it is crucial that government acts to provide real help". It strikes me that there has been a looseness with detailed definitions. Maybe these will become clear in the legislation?OPPOSITION PERFORMANCE
Cameron was exuberantly rhetorical about the government's economic growth forecasts including repeating again that growth recovery will come from cutting deficit spending sooner not later.
In direct response to Darling saying that the financial crisis and recession began in the USA, Cameron later claimed the UK was first into recession and last out, implying it all started in the UK, as he tried to repeat in various rhetorical ways? He said that the government's borrowing is greater in one year than in all previous Labour deficits summed together and claimed that what Labour has done to the economy is the damage that Labour always delivers. This is untrue in either cash amounts or in current values, but must be derived from some synthetic analysis. He also castigated the government for relying on growth figures (over 3% GDP growth in 2011) above that of consensus forecasts. But, as any economist knows, and he should know, independent forecasts offer a wide range and the consensus value is invariably wrong (2.1% for 2011). This is part of the Conservative Policy case for a quasi-independent Office for Budgetary Responsibility to monitor Treasury modeling. I suspect this is a copy of the US Congressional Budget Office that I find infused with think-tank dogma producing severely error-ridden forecasts.
Cameron offered IMF and European Commission as evidence for the government's deficit reduction being to slow. He also made great play of a couple of survey findings that the UK has fallen from 4th to 84th and 86th in tax and regulation burden in world rankings. This is obtuse on both counts - political points-scoring coat-trailed by George Osborne on 8th Feb. - see http://www.egovmonitor.com/node/33416 The accusation was again levelled by Cameron that the UK government is responsible for the recession and that its spendthrift ways of seeking to get the economy out of recession exhibits the same quality of economic management as that of financial services - a theme that caused much merriment on his side of the House. The implication here is that the finance sector in the UK became 'overblown', a term used in speeches by Shadow Chancellor Osborne, and by Nick Clegg in his response to the budget speech on behalf of Liberal Democrats. The Finance Sector is 5-8% of GDP depending on definitions, but has been 25% of corporate profits, and actually supports about 20% of all jobs in the economy indirectly as well as directly, as many as government. We may not advantage the rest of the economy by shrinking the finance sector? It is undoubtedly an important part of our total economy's size.DARLING STATEMENTS
Darling said the government would sell its equity stakes in the banks and that 900 branches would be sold off and more competition encouraged. All this does bode for further break-up of the biggest UK banks? He wants to establish a green investment bank to fund alternative energy developments, various tax breaks for use of UK registered patents, higher tax thresholds for small firms and pensioners. Darling said that state pensions have doubled since 1997 to a variously conditional guaranteed £132pw and that these would increase somewhat above inflation, which is almost good news if in reality very muted and tentative (far short of the reality that state pensions are 40% below their 1950s value) for impoverished pensioners, but not something anyone in the debate picked up on.REDWOOD'S BIGGER PICTURE
John Redwood MP claimed the government grossly underestimated the size of the economy it is dealing with (an hour and a half after the chamber nearly emptied), saying that the budget's stimulus is only £1.4bn in a £1.4tn economy! How he arrives at this is a total mystery - he is stepping way out on a limb to imply that deficit spending at 12% ratio to GDP has no significant effect? This shocked me, but indeed on a cyclical basis it is confirmed by the Budget Red Book! The graphic is accompanied by obeisance to the Growth and Stability Pact (Maastricht Criteria), "The UK is subject to the Stability and Growth Pact (SGP) as part of its membership of the European Union (EU). Treaty obligations require the UK to endeavour to avoid excessive deficits, defined as 3% of GDP on the Treaty deficit measure. The UK is not subject to sanctions or corrective measures if it does not comply. Twenty-one EU member states are currently subject to the Excessive Deficit Procedure of the SGP. EU leaders have agreed that the flexibility provided for in the SGP should be used, and that fiscal consolidation should be undertaken in line with economic recovery. The EU’s Economic and Financial Affairs Council has recommended that the UK bring its Treaty deficit below the 3% reference value by 2014-15... the Government has taken a judgement on the appropriate pace of fiscal consolidation, consistent with its fiscal policy objectives. The annual pace of consolidation for the UK set out in Budget 2010 is the fastest in the G7 on IMF forecasts for the period up to 2014."
The early reduction in fiscal stimulis is possibly a sop to the EU or to the financial markets, but if Bill Cash and other Euro-sceptics on his side of the house were not fiscal conservatives this would make their blood boil. For mixed reasons it rightly angers John Redwood.TRADE & CURRENT ACCOUNTS
There was no discussion of the UK trade and current account, which is a serious matter from a sovereign risk perspective. There has been a third narrowing in the trade deficit to about 3% ratio to GDP and a much smaller current account due to net gain in financial services. The external accounts of the UK have been ignored by the government for more than a decade in line with the lack of discussion about the UK's credit-boom economy and in line with similar blinkered fashion prevailing in the USA. But, given the discussion about this is respect to Greece, Portugal, Spain and now the UK, it seems a gross negligence not to discuss the matter and show what improvement is being achieved.
The high trade deficit that was has shrunk in part due to sterling's depreciation and the profit to UK banks when liquidating net foreign assets. But, the cause of the trade deficit being due to UK manufacturing and export industries being relatively denuded of finance, of bank loans and trade finance, as well as the credit-boom stance of the economy that favoured property above all else, has not been addressed by the budget or the debate about the budget and the government's economic policy, or indeed by policy emerging in either of the major Opposition parties. Industry (production including manufacturing) is 16% of GDP and delivers 80% of UK exports. It gets 5% of customer lending (excluding loans to finance sector) by banks! Construction is 8% of UK GDP and gets about 20% of customer lending! The Budget forecast expect a large rise in capital investment including by business that in turn includes PFI projects (i.e. construction).
CAPITAL INVESTMENT
In the 2009 Budget capital investment was said to have grown sharply and expected to continue at high levels. Instead it fell by a third in manufacturing and generally by over a quarter. It had been about 3% of GDP. In extreme comparisons with trade surplus countries, in Germany industry is 30% of GDP and capital investment is 17% of GDP, and China capital investment is an extremely high 40%. It is obvious that capital investment correlates with similar percentages in bank lending relative to GDP. If business capital investment is to grow at 10% per annum it will scarcely add to UK competitiveness. Capital investment in industry and manufacturing needs to be at least 10% of GDP.REDWOOD ON BANKS BALANCE SHEETS
John Redwood reported that RBS slimmed its balanced sheet by over £700bn, and LBG somewhat similar on a more modest scale of £100bn of which £50bn in customer loans, which while not all the balance sheet slimming is in UK loans it does denude credit liquidity for business borrowers. He could have said that banks cutting back their lending negates the government economic reflation efforts. He did say however that evidence suggests that the banks are refusing to lend i.e. it is not only customers' deleveraging. He did not say that RBS's balance sheet shrinkage is £282m moved off balance sheet into the government's APS and nearly all the rest is netting off derivatives with no effect on customer loans.
The facts are that customer loans by RBS did fall including in the UK, but by less than £15bn. But all banks have shrunk UK customer loans to businesses last year by about £70bn or 5% ratio to GDP! And, only 5% ($100bn) of business lending goes to UK export businesses compared to 16% in Germany ($620bn).Redwood said the banks have been broken and are being nursed back to health in a way that shrinks lending not expands it. So far, he is quite right about that.
BANKING REGULATIONN
Redwood also claims that there is too much regulatory tightening at the bottom of the cycle when the capital requirements should be relaxed! But, actually it is not capital tightening but funding gap tightening and the high cost of refinancing funding gaps that has squeezed business lending - because it cannot be grown profitably. He says the boom was caused by weak banking regulation and the bust caused by over-regulation bringing on bank-bust and recession, a "violent cycle", "punk monetarism", "cheap money for government own uses", "starving the private sector of money", brought about by changing the structure of banking regulation and mismanaging the banking cycle.
My own UK banks' business lending data for end 2009 is shown below. THE BIG ISSUE
The problem for both Bank of England and FSA is that they do not have macro-economic models with which to assess the impact of changes in banks' balance sheets and the economy! The Bank of England is seeking to rectify this, but it will take maybe another 2 years' work!
In general the private sector has not been denied bank credit - private sector was showered with money, but not those parts most important to the UK's external account about which nothing was said in the budget, a point noted by at least two MPs. The Red Book provided a table that shows a rapid return to trade deficits only slightly less than before 2008. The government's help for industry and small business, and the twenty times that Chancellor Darling used the word "support" in his speech, does not extend to recognising that we cannot simply return to a credit-boom economy and must now focus more on putting some effort behind exports. The Red Book expectations are negligent of he UK's trade deficit and the wholly inadequate financing compared to what is necessary to secure the UK's competitiveness. It becomes even more important when net transfers and net foreign incomes, including possibly FDIs, are expected to dry up?The private sector was not denied credit borrowing; it grew threefold in a decade. The economy was heavily dipped in credit-boom growth. But, Redwood only adverted to that in terms of government letting banks balloon their balance sheets - but this was 70% in mortgages, most of the rest of loans being to finance sector - plus a lot of balance sheet assets in derivatives. Productive small firms and exporters were denuded of bank credit, small businesses as always, only 40% of which even have bank borrowings, though not SME property firms.
There can be little doubt that banks' lending to businesses, however small in their balance sheets (scandalously small) has been pro-cyclical and placed the full onus thereby onto Government to alone pull the economy out of its hole.The Bank of England and the government are not overtly empowered to change that - only now, and only in the case of 2 big banks. In the past, however, it is true that The bank of England could have strongly advised banks generally to reduce mortgage and property exposure and otherwise restructure their balance sheets. It did not exercise this under its continuing responsibility for systemic banking risk and did not hink it proper to do so in the name of systemic risk to the whole economy! We can see how for a long period the contribution to UK growth of production industry has been so small notwithstanding that the economy relies on it for its major contribution to the economy's trade and current account. EXTERNAL BALANCES
The issue of external balances in the world did not get raised until after 4pm by Michael Jacks MP (Con) in his last speech in The Commons. He is an ex-Treasury Minister and said that in a global world there has to be agreement on reducing the extreme imbalances. He also welcomed the government's measures for small firms, employment, stamp duty for first time buyers. He then asked the interesting question: where the £80bn in halving the deficit will come from out of the economy. He sensibly said that efficiency savings are always the order of the day. He wants a fundamental review of public spending. He wants to see the level (in the economy) of government spending fall.
DARLING'S SUPPORT FOR INDUSTRY
This challenges Chancellor Darling's repeated argument for how UK industry has to be partnered by government to be helped, which he exemplified in a range of measures from reducing capital gains on small firms and raising personal allowances to active investment, credit. R&D, training, positive financial support measures for particular sectors, and raising capital investment allowance to £100,000 ad the capital gains tax threshold to £2 million.
WHERE CASH COMES FROM?
Bill Cash, Conservative MP, in his last speech in The Commons, emphasised that all government revenue comes from the private sector as part of his argument for shifting the boundary between private and public sectors. He said that this is an indisputable fact that even the government would not argue with. Cash is a very likeable and passionate about British sovereignty.
But, he is quite wrong. A lot of government revenue, roughly 28% (£200bn next year) is from taxing the public sector plus earnings from assets and liabilities that do not impact private sector tax or taxpayers' money. And, non-tax income in government revenue this year will be just over £50bn on-budget. Government will sell assets.
And then too, off-budget off balance sheet revenues will be much greater, and again nothing to do with tax. The idea that all government finances are taxpayers' money is not a fact, just dogma. Government has wealth and financial resources and they do not belong to taxpayers but to government itself, to The Crown. Private sector is not the only producer of national income. Government in the UK generates one fifth not counting those utilities and enterprises and non-profit bodies that are government owned, of which there are 86,000 all registered for VAT and subject to other taxes.
John Redwood made a valid point that he applied to government but should be aimed too at all parliamentarians that they must all do more to understand the scale of the economy, to gain a realistic perspective and sense of proportion. One of the first issues to begin with is understanding private sector debt before agonising about public sector debt, and then do more to understand how that is backed by assets and serviced by income, and then how productively the debt is applied.

UK BUDGET (GENERAL ELECTION) DEBATE?

2010-03-10T05:37:00.001-08:00

2008-2009 and 2009-2010 UK budgets at a Glance - courtesy of Daily Mail. Budget Day has been announced for 24th March, only weeks before a general election, scarcely time enough to pass The Finance Bill, thus government finance will be at the heart of the white heat of electoral debate - about whether spending cuts are required now or later and whether frontline services will need to be cut or not. Labour says cut later when the economy can afford it. Conservatives say cut sooner but not frontline services, and not the NHS, and won't confirm if tax rate rises are in their plan - though the chosen head of the Conservative proposed Office for Budget Responsibility (OBR - inspired by the US Congressional Budget Office), Sir Alan Budd and other HMT ex-mandarins interviewed by the BBC say frontline services will inevitably have to be cut, and some tax rates will rise - to rebalance the budget i.e. reduce the borrowing requirement.
Labour has a planned schedule for reducing government borrowing and already has in train £15bn in efficiency gain cuts and more than same again in expected annual asset sales i.e. somewhere in public sector there are always some cuts happening and 'other' income sources operating. Should election politics seek to make a big issue out of government budget deficits and public spending cuts?If government spending and borrowing are not responsible for the global credit crunch crisis and recession, and not solely to be blamed for the budget deficit rising should they bear substantial cuts, or should we rely on the economy's recovery to restore balance to the government's budget?
Government services are part of the total economy, part of the real economy; not outside it. Will it help the total economy's recovery if the public sector part, currently a substantial economic buffer in the crisis, that it should now be cut back too? Public spending is akin to an automatic stabiliser. Rising unemployment caused a 12% rise (£23bn) in social security and other related spending. With a 15% rise (£5bn) in defense spending, these two necessary items are half of the total government spending increase this year. Fall in employment and slightly larger rise in registered unemployment explain much of the loss of employment tax income and the higher social security spending. Total government public spending rose 9% this year, but that explains only 40% of the rise in government borrowing; the rest, £75bn is caused by inevitably falling tax revenues: £56bn less tax from business and employment and £20bn less from VAT. Tax from business fell 32% (£17bn) and from employment fell 10% (326bn). This is no more than expected in a recession when the economy lost over 9% of output (unadjusted for inflation). Public spending has been very stable in the economy; an important source of stability. It should not be a business enterprise budget that can be expanded or cut in line with the general economy. Its role is to be a counterweight to economic cycles.see also: http://www.wheredoesmymoneygo.org/prototype/
Year to date government borrowing may be roughly 11% ratio to GDP and slightly higher is expected in 2010-11, but that is the amount required to provide for recovery, and proportionate to how governments of either party responded to past recessions relative to depth of recession.Adjusting budget setting for the direction of the economy is to some extent like a sat nav operation. It is the economy that dictates the deficit far more than government choosing it. Chancellor Alistair Darling in his December 2008 Pre-Budget Report forecast the UK economy would shrink 3.5% in 2009, before expanding by 1.25% in 2010 and by 3.5% in 2011. Commentators and analysts at the time described the figures as overly optimistic. In April 2009, Darling said the UK was facing the deepest recession since WW2. He was again rounded on for his forecasting. But, the 2009 forecast has since proved to be quite accurate. When positive growth returned in the fourth quarter of 2009, output was 3.3% down on a year earlier, up 1% in cash terms and GDP for the year is 3.58% down at current prices. But 5-7% real growth was lost over the recession and 8-10% in cash-flow terms. The UK had experienced a long period of 15 years of positive growth and high private sector borrowing and asset bubbles therefore it was not surprising that recession was particularly deep. If the economy grows positively in 2010-2011, there could be a £100bn recovery in government revenues without tax rate rises. One quarter to one third of that recovery will be from tax exerted on the government's own additional borrowing and spending plus £30bn from business taxes and asset sales. The remainder could come from the indirect effects of the £200bn quantitative easing.
What risks this amount of budget balancing is continuing negative net lending by the banks to business as well as mortgages and consumer loans. 90% of all foreign trade requires trade finance and a similarly large % (uncalculated) in domestic trade. banks are not currently helping economic recovery - leavingthe matter entirely to the government sector. Only when bank lending rises can we envisage cutting back in the government budget deficit. Banks claim in there defence that they are not dictating lending levels - that these are subject to borrower demand. This is not entirely true - not least if it was true bankers should not get bonuses for gowing their loan books. Banks have tightened credit conditions. UK banks have also not filled the gap in lending to UK borrowers by foreign banks. Since the above graphic, bank lending to businesses has become negative - no umbrellas in the rain, at least not generally. Deposits have grown but banks are still striving to close their funding gaps before resuming lending growth. Hence, UK businesses are deprived of liquidity and this is reflected in sluggish trade and business investment.

The pattern of world trade is changing and UK needs to reduce its external trade deficit, for which it is hoped the lower trade-weighted exchange rate helps. But, the effects of that have not yet fed through.

As with much else in the UK economy, the same story may be told of the problems of securing recovery in the USA economy.A high budget deficit is necessary to cope with lower tax revenues, kick-starting the economy, and doing so in the face of falling lending to US businesses, plus need to narrow current account, reduce the trade deficit. Without trade deficit reductions, then the economy's growth path returns to another credit-boom model and that is only sustainable by banks yet again financing the deficit through selling large tranches of securitised loanbooks!If more is not done to secure business and exports through higher bank lending to business and less proportionately to property and mortgages, then the high private sector debt levels that fuelled credit-boom growth will be returned to and prove to be longerlasting as a general burden than government debt. And, in the case of the USA, the sensible reduction in government borrowing is contradicted by the Congressional Budget office for the years after 2011, for reasons implicit in the design of CBO model projections that I judge to be political-ideological. I wonder if the UK Conservatives idea of an Office for Budget Responsibility will be similarly minded. George Osborne told the BBC that the OBR will depoliticise budget setting decisions i.e. as Chancellor he will rely on OBR predictions over his own - and presumably over that of HM Treasury? OBR echoes of course Labour's George Brown and his Ministry of Economics in the 1960s that eventually The Treasury snuffed out. Would a Conservative Chancellor think to ask the Bank of England for macroeconomic reasons to strongly advise the banks to restructure their lending portfolios? It was the bias towards mortgages that denuded lending to non-finance non-property businesses, especially manufacturing.

POLITICS OF SOVEREIGN RISK

2010-03-03T05:32:00.000-08:00

All governments have had to take unusual, even relatively extreme, measures to cope with world-wide credit crunch, US-led (Anglo-Saxon) recession, and the ensuring domestic (and in international markets) inflammatory politics. Market traders chasing short term profits (profiting from both price rises and falls) love sovereign risks (where a country's total value is questioned) because if that is so then everything else is up for reconsideration and for portfolio churning. After broker-dealers, prime-brokers, money-brokers, FX dealers and equity-traders' profits have dried or been hit by some losses, nothing better restores the bonus-finances than a sovereign debt crisis, or better still a whole series of them! This is why what politicians say is not just about the story; it becomes the story. I doubt that politicians are sufficiently aware, especially just after a recession, how much what they say and do is at the centre of how financial markets behave! - the subject of this essay. Markets move on news-only some of the time. Politicians' statements on national debt and borrowing, and so on, are big news in the financial markets - why, because they can be exploited to get prices to gyrate more. Research has shown that at least 25% (60 days out of 250) it is only news (not numbers, results reporting, economic analysis, or chartism) that move market prices. In stock markets, daily price changes of 1.5% or less are normal vibration, what I call 'camera shake', but that means an individual stock can have a normal inter-daily price variation of 3%. It is easy therefore to associate company announcements, industry sector news, politician's and regulators', and other news, with a change in price, and when you trade at the heart of the markets to guess immediately the popular direction of a price change. It is only persistence of incremental price changes over several days that are meaningful. The long period falls of bank shares in 2008, and today the Greek 'debt crisis' are examples of that, helped very much by the feedback looping effects of follow-up instant news and then also next day's news and weekend press stories. This does not mean that there are fundamental-technical factors at work; it may only be the effect of political argument and prolonged disputes among analysts. Markets like arguments with at least two sides (bull and bear) pulling equally well because they need two-way markets to trade in. Hence there is a tendency for many to seek to prolong disputes about facts or to make them fuzzier, more uncertain. Big questions such as the direction of a currency rate or a whole market index are ideal, because no one can really be certain of what all drives price changes. Traders can individually, by sowing rumours, and collectively, by inspiring volatility, make end-investors nervous - rattle their cages. I recall a train ride some years ago from London to Cambridge with a LIFFE own trader - he may read this. It was a Friday. New York had opened and the US Treasury secretary made a speech in which he twice said the $ dollar was too high. The S&P500 fell a 100 points or more and my friend was up £300,000 by Bishop's Stortford, having I calculated made more than the first class ticket price of the journey every second. His office phoned three times to report and to ask whether to take the profit. He dithered thinking this is Friday; he has the weekend to analyse matters further. Then, when New York returned to trading desks after lunch (liquid lunches still de rigour then), the markets decided to rhetorically ask, "what does the US Treasury really know about the $ anyway?" and promptly bounced back. Within fifteen minutes, when alighting at Audley End, my friend was down $50,000!
This should be the markets response to OECD sovereign risk anxieties - what do they know? - and if Europe's Maastricht Criteria didn't exist or were set higher or turned off for a period fo 2-5 years, say, who would care about the ratios of today?
Yesterday, George Osborne, UK Con-servative opposition shadow chancellor, said that if the country re-elects Labour the UK will lose its sovereign debt AAA rating, which the ratings agencies would down-grade, and suggesting there would be a run on the pound and so on - nightmare scenario stuff! This kind of rhetoric or political grand-standing is irresponsible mis-direction, not what someone in power or close to gaining power should be indulging in - professional politics perhaps, but unprofessional for a budding Chancellor. Of course, the UK ratios look high, largely a reflection not of the domestic economy but of its size as a global financial centre. When the cross-border borrowing (matched by assets) is removed the UK ratio remains high, but this is also for reasons of the size of the finance sector and also the UK's above-average property values that are the collateral-security for much of UK private debt, up to 70% of what appears in UK banks' balance sheets. As the charts below show the US and UK economies' total debt levels are where they are today because of private sector borrowing - mainly by finance sector. These debts impact everyone more than the governments' shares, which however high these appear to be relative to GDP (annual national income), they are only a small and relatively stable part of the total - and by far the least risky of all of a country's debt - which is mainly owed internally not externally, except in poor emerging market countries.
The UK and the USA economies are intimately linked. Their debt profiles reflect similar responses to the credit crunch, with their central banks having greatly expanded their balance sheets to replace private sector funding of banks' medium term borrowings, as well as guaranteeing banking assets, mortgages especially. But, the size of their on-budget national debts (dark blue in charts below) is typicaly of all OECD countries. Politicians have a choice - to sound like they know only what the general public hears and then mirror back the public's anxiety, or they can sound as if they have privileged insider knowledge, the advantage of expert advice, and either way an Olympian view? Governments strive to sound like experts and opposition parties like Joe and Jenny Mainstreet. UK Conservative candidate to become the next UK finance minister (Chancellor of the Exchequer, Second Lord of the Treasury), the Right Honourable George Osborne MP, with his across-the-despatch-box, street-fighting, politician's rosette firmly pinned on, chooses to ignore the other side of the balance sheet, the professional economist's details, in order to rail about gross debt, not the net or comparative position relative to other credit-boom countries similarly striving to climb out of recession. Electoral politics, yet again, even now after forests of newsprint and €$£billions of airtime about the credit crunch, is not about debating tricky details; instead it chooses to shout and stump about, angrily, pronouncing on symptoms, as if there is nothing new or deeper to learn. As a possible future Chancellor, he should, may I suggest, re-orientate his posturing to look more like the Chancellor he intends to become - try to look like someone who can and does, pragmatically as well as judiciously, read balance sheets and economic statistics until he understands them? Instead, so far, he seems easy meat for simple theorems, as sadly Margaret Thatcher was too, such as the idea that rising national debt always pushes up interest rates, or that government action cannot ever truly reflate economies, or that borrowing today must mean higher tax and/or severe spending cuts tomorrow, that nothing government does is ever a free lunch. In his latest polemic, by drawing attention to the ratings agencies he vests in them too much 'hostage to fortune' power to hold countries to ransom - and at a time, as he ought to know, when governments and their new regulatory NGOs are investigating the ratings agencies to the extent of threatening their continued existence? It is also dangerous to vest power in the hands of credit ratings agencies whose models and behaviour through the credit crisis are under severest scrutiny by EC, US and other regulators, and have been disavowed by major banks.
Apart from that, the problems of borrowed debt, insofar as these are not adequately netted off by appropriate assets, the bulk of nations' debt is a private sector created, not directly a public sector created problem, and very clearly so in the US and UK, but elsewhere too. Osborne and the Conservatives, Republicans in the USA, and Christian Democrats in Germany, who are making a political mountain out of government indebtedness are surely conspiring in diverting public concern from private debt and the role of the banks, when the debt-mountain is mainly that created by the finance sector.Sovereign risk, whether about the UK, Spain, Ireland, Greece, or even the Euro Area or the USA is a matter of calculated confidence in a country's ability to service interest and redemptions and to sell its government bonds and bills at a price very close to face value. The very idea of any OECD country losing triple-AAA is shocking because it is extremely unlikely - even in the politically highly animated case of Greece. Its crisis is about compliance with Maastricht and Euro Area prudential ratio ceilings, not about whether it can absolutely service its debts, but about the discount and penalty margin the piranha-infested markets are exerting on it. It is also about the country's trade deficit financing, not whether it can finance that, but the now higher margin cost of doing so.
In the case of the UK, the markets see that there is are political accusations flying at the government propelled by the upcoming general election. The anxieties manufactured are a boon to traders profiting in volatile markets who can also themselves add to that volatility. The Conservatives want to invoke memories of the sterling crisis of 1976 and Labour can recall Black Wednesday 1992, which statements about sovereign risk by George Soros make us worry that once the hedge funds have finished staking out the Euro, the £ is the next target! Currency exchange rates are relative to other currencies, but I cannot see a technical or fundamental reasons currently for why sterling should be targeted by the markets, by hedge funds, and not after it has already fallen last year. Hedge Funds ought to be politically more cautious at a time when there remains a strong impetus towards making them more transparent and subject to closer regulatory oversight. An estimated $12.1bn of short positions are outstanding against the Euro, according to the Commodity Futures Trading Commission. At the beginning of February, there was just over $7bn of short positions against it. Some hedge funds, thinking the better of it,have closed out their positions against Greek debt. other hedge funds raised their bets against the debt of Greece and other troubled Euro Area economies and then had to raise their bets too against the euro. But, they must also assess how far they can go and not fear a regulatory backlash. The biggest hedge funds are very concerned about fierce criticism by US and European politicians especially that their sovereign risk bets add to the crisis of confidence in sovereign markets. Lord Turner, chairman of the FSA, the UK micro-prudential regulator, is one of several heavyweights to call for investigations of speculative positions in financial instruments that gain from a fall in prices of sovereign and corporate debt. In his case he can not only call for a review but implement one and then devise limits and penalties.
Is there a solid UK financial accounting anvil for all the verbal hammering of sovereign debt - No! It is partly long-established market lore that following recession shocks these should be followed by sovereign debt crises. Recessions are real enough, but sovereign debt crises very rarely are among OECD countries. And, given that the recent/current recession shock was triggered by banking insolvencies and the great increase in size of central bank balance sheets this necessitated, the popular expectation is therefore for the mother of all sovereign debt crises. But, central bank balance sheets are precisely that, balanced. In the case of UK government debt balance it too is very robust, with £600bn in government liquid assets plus banking bail-out investment gains to come, plus that its debt and fiscal deficit are not much out of kilter with its peers - somewhere within the mixed range, and employment/unemployment and property values have retained unexpected resilience, how much of the debt (at least one third) is internal to government, and much else including first phase of recovery in GDP and tax revenues, the gross position of government finances should not be technically worrying at all, in my and others' considered view; the net position and the macro-economics of the government's stance should be celebrated as prudent and efficient.
But, of course, that does not satisfy party political need. Labour unfairly accused the Conservative Government in 1997 of financial mismanagement when fiscal deficits had been the main recovery weapon from the recession in '91 and a brief anxiety attack in '95 when the US economy stumbled due to a very harsh winter that propelled the UK Chancellor Ken Clarke to break his fiscal stance forecast, which he sensibly regularly did anyway. The Conservatives are not slow this year to return the same jibes they failed to defend in '97, something they could not do convincingly in the last three general elections when there was no recession and Chancellor Gordon brown had maintained a fiscally prudent (conservative) stance.
This time Chancellor Alistair Darling is talking politely back to explain his necessary recovery measures - to which the opposition parties are, of course, deaf.

One of the reasons apart from the foolish war or foolish post-war management why Tony Blair had to resign was a public feeling cheated by, and now intolerant of, political spin meistering. Ironically, when economic crisis hit, the same public appeared to miss the glossy spinning of hard facts. It was frightened and wanted feel-good assurances. PM Gordon Brown, after a decade of poker-facedness (necessary, and expected of, Chancellors), provided assurances, but earnestly without smiling, groaning with solidity, not sparking with exuberance of rising to a great challenge - he read the situation as requiring trust in sound policy, and in public again buttoned up his natural humour - yes, it exists! His smile can seem churlishly sweet rather than seious and sunny. Blair's smile for years seems stitched to his face like The Joker. He eventually mastered seriousness in public, but, ever embulliant, cast that off at the slightest opportunity until the consequences of the war got to him too. Brown had far less opportunity to practise a Sunny Jim look, (possibly remembering that it didn't work for Callaghan when PM). Chancellor Alistair Darling, Brown's very close friend (if not quite the collegiate buddy that Ed Balls became and who wants his job), has a most highly evolved sense of humour, but felt he must, above all, tell the precise truth, believing that when the public tired of spin they wanted truth, straight facts, something expected of Chancellors, and that led to his statement (that reportedly angered Brown according to Andrew Rawnsley's book) saying that this is (was) the longest deepest recession for 80 years etc. They both said we will get the economy out of the mire and restore prosperity. I don't buy Rawnsley's take on this because it is possible to quote Gordon Brown having described the profundity of the credit crunch and recession many times, if perhaps less nationally and more globally! Either which way, the public is still not getting happy-smiling positive news. Instead, the politics of spin, as now led fearlessly by the Conservatives is to be prophets of doom and gloom unless 'you vote for us!', blackmailing (not bribing) the electorate how to vote. is this not spin of the wrong kind demanded. Her Majesty's Opposition, led by David Cameron's idea of what is a patriotic choice, seeks to insinuate itself into power (a most apt phrase) by any negative means including telling the public it has a patriotic duty to vote the Labour government out of power - a dangerous form of stump, or sump, politics - populism in a multi-party democracy. The beleaguered US and UK governments try to reassure their electorates with 'steady as she goes' and 'trust us to finish our job' messages. When electorates are jaded and cynical and hurting, they need facts as much as assurances. They also need to see the major parties agreeing on some key aspects of economic recovery if they are to gain confidence in that. How can anyone trust politicians in general when they so mercilessly, emotionally, even satirically, condemn each other in such serious matters as where the economy is heading short term? Instead, an uncompromising disputatious political anxiety-making currently prevails in the bite-sized media (and in sloganising that advertisers promote). This is damaging to political recovery as it is also damaging to voter participation. UK and the USA political public punch-ups would have been unpatriotic in the global war of WW2; is it not so in the present global economic crisis - or is that a totally unrealistic expectation, to expect that at least in matters of economic policy when economies are in crisis globally? It is an election year in both UK and USA, and, of course, taking economics out of other issues like health and education would leave only moral ethics and not all politicians are comfortable with that?And this political anxiety takes its toll on consumer confidence (lower consumer spending) - acting as an additional drag on economic recovery. The faltering economies of UK and USA, and fear of double-dip in the Euro Area, embolden the FX, bonds and money markets in pursuit of short term profits, for whom, especially short-sellers, 2010 promises to be a bumper year. It was the '92 attack on sterling, when Norman Lamont was Chancellor, and which was preceded and succeeded by attacks on some European currencies that propelled the EU into creating the Euro in place of the EMS currency snake, to provide a defensive scale to Europe's currency in the world. When the UK Bank of England was forced into extreme measures to defend the pound in '92 all the pressure was off by simply withdrawing from the EMS, and within a year or sooner the UK's foreign currency reserves had been restored. When the 1976 sterling crisis triggered by IMF negative outlook reports the UK Chancellor Denis Healey had to negotiate borrowing rights with the IMF none of which were in the end required, but there had to be spending cuts.
Healey, Lamont and Darling share an unusual hirsute distinction of highly distinctive 'caterpillar eyebrows'. Such irrelevant coincidences are no less fatuous than other coincidences that markets like to fuss over to rumble the tummies of everyone's risk appetites. I would not be surprised by some brokers' notes headline of "the eyebrows have it!" and "caterpillar risks!"Our three caterpillar eyebrow chancellors experienced desperate exchange-rate crises, and also share a chest-beating need to announce sharp spending cuts - though I do not see how government spending was or is to blame directly for these crises. In past post-recession periods, such spending cuts as often a not did not amount to much, and may not do so now. Budgets were re-balanced by recovery more than by spending cuts. President Clinton balanced his budget by economic growth supplemented by a regular $10bn cut in defence spending and by delegating major programmes to the 50 states. Reagan and both Bushes talked and walked spending cuts but never looked like balancing their budgets. Today, if California was a country, it would be the biggest sovereign debt crisis, but spending cuts wouldn't solve it.
Today, in the UK, despite higher year on year deficit spending, some cuts are already in train - about £15bn worth before the recent political furore about whether to cut more now or later? The current savings being pursued are in efficiency savings, offset by bringing some spending programmes forward. Sizeable spending cuts are not desirable in the teeth of recession or the early stages of recovery, but that is not to say restructuring of government spending, not least to be more tax efficient, is not a great idea - where some areas are cut and others boosted. This was part of governments' Keynesian thinking before the 1980s. Since then, such thinking was replaced by a decades-long presumption that however much government spending is described as 'tight' to, at the same time, assume government spending in general can always make room for substantial cuts even in a crisis; £90bn is currently an oft-quoted figure in the UK. What is missing is a more subtle and more realistic idea of redirecting spending to benefit recovery, doing so at least risk of requiring tax hikes. This line of thinking is opposed to another politically fashionable presumption that there are no 'soft choices', only 'hard choices'. Choices are not in practice so two-sided, more bi-pedal. A classic example of a hard choice that was also hard and soft either way) was Edward VIII's decision, prompted by political pressures, to choose his private duty over his public duty. Politicians over-indulge a belief in public duty to favour 'hard choices' as if economic survival and progress has only ever been secured by always preferring hard over soft bedsprings. There is also a delusion that private business success is always based on taking hard decisions. In truth, such decisions are often the product of one-sided analysis of the balance of facts. An example of such one-sidedness in macro-economics is to no longer look at differences between gross and net of tax cost of different public spending. That practical view was outlawed (by convention) at The UK's HM Treasury after 1979, for reasons entirely political - not logical in economic house-keeping terms. Similar blinkers became similarly popular among US legislators, and extremely so at the Congressional Budget Office. Making anything sound sensible is a matter of how tightly drawn (simplified) the wider context is. A major context today is that our banks, for their own (internal) house-keeping reasons, are cutting back on customer loans (by about 8% in the UK in 2009) that may continue for much of this year (I predicted a total cutback of c. 15% in USA and UK). Banks see this as a necessity forced on them by their balance sheets as cross-border interbank lending shrinks (in Europe) and by the economics of funding gap finance that are only now beginning to return to a near-normal economic cost - if not yet an attractively viable market cost - and that is despite the boon to corporate debt of the Bank of England and US Treasury QE measures of buying in $200bn and £200bn of government bills and bonds (by using off balance sheet assets). In the UK QE equates to a quarter of UK National Debt, and as much as the Government is expected to issue in new bonds in 2010. Hence the fiscal deficit stance by the UK Government of 8-12% ratio to GDP (similar to that in the USA) is wholly appropriate - and no less than any super-hero economists recommend when asked. Of course, banks, who now have for regulatory reasons to hold much more of new government bonds themselves, are keen to lever what discounts they can in the primary issue market by exploiting sovereign debt anxiety-making, and, as traditional Conservatives, there is an additional motive: the kneejerk tendency to rattle Labour's cage in an election year. But, this is also further evidence of banks not waking up fully wide-eyed to the new political-economic realities, failing to acknowledge fully the hatred and mistrust of them by business and household customers, and by the general voting public. Banks cannot be certain of how much better or worse off they will be depending on which party wins or whether the UK election outcome is a hung parliament - or in the USA a handicapped White House? They should fear the possibility that one thing everyone can agree upon is resentment and suspicion of banks - the mob will have its pound of flesh. Banks should duck low, hide their arrogance, behave obsequiously humble, and conscientiously do their best to shoulder the burden with government of ensuring speedier economic recovery. If they did that they'd be super-heroes too - an unlikely story?

DEFICIT AND DEBT DEBATE - POLITICAL MANIA

2010-02-22T01:05:00.000-08:00

In the lead-in to the general election in a few months the sore-head-in-hands debate about government borrowing and the national debt is especially politically venal. One effect is to rule out discussion on whether public spending cuts are necessary at all? The debate is focused by 67 economists and their supporters validating Darling's wait to see if recovery is secure then 'cut later' and the 20 economists and their supporters backing Osborne's let's not wait 'cut now'. The 67+ say that cutting now is foolish and arguments for doing so are without any rigorous proof. The 20+ say it is a matter of market confidence and thereby elevate appearance over substance.
There is also underlying this a fightback by monetarists and general equilibrium theorists apalled at the whole world apparently re-embracing Keynesian thinking.
At least the Keynesians have empirical macro-economics models and the National Income accounting system to rely upon. They 67 are not just theoreticians, but aware of the only models that predicted credit crunch and recession, which were Keynesian - emphasising the accounting link between net acquisition of financial assets and trade balances, which pre-crisis had globally become very extreme that is not central to FSA, Bank of England and other similarly expert views.
The 20+ opponents take their ideas from relatively isolated factors echoing and being echoed by the limitations of media comment and debate. Some of their supposed fears are for loss of confidence in UK that might hit the currency and even of a buyers strike for UK government debt. But is this reality or merely political flag-waving - is there really a possibility of banks refusing to buy gilts in the £200 billions of auctions in 2010? Buyers regularly threaten partial strikes to lever a discount in the primary market. But there has never been such a strike to my knowledge and indeed there cannot be one now because financial services firms are hungry for government debt including by being forced to buy and hold onto twice as much as normal to shore up their capital solvency. In the UK especially there is the usual high demand for long-dated debt by insurers and pension funds. Gilt maturities are well balanced between short, medium and long dated. Demand, respresented also by annual turnover in the secondary gilts market trading is at least £3 trillion (official DMO figure). With new issuance last year and this the turnover should nearly double. It should be double this already, but even with less than half, probably less than one quarter, truly available at any time for trading, turnover seems low, indicating pressure on banks and others to hold their gilts and the effect of uncertainty on pace of future base rate rises.
The only purpose of strike rumours is to generate small primary market discounts, a moot matter when £198bn has been 'bought in' this year under QE. Government has about £300bn in gilts that it could 'restructure' and sell directly into the secondary market without changing National Debt. Some, perhaps politically-minded commentators, e.g. Daily Telegraph, say they fear a "re-run of 1976 IMF debacle" and a "full-blown (government) funding crisis", or perhaps some would welcome precisely that if only it can be manufactured before the general election 1976 was a crisis for Labour but not a full blown one - that was Black Wednesday 16 years later for the Conservatives when the cure was, following my advice given on Tuesday, as I like to think, to withdraw from the EMS currency snake. '76 was a crisis of confidence' without doubt, and it was political, but the UK never did not have to draw on the IMF standby credits provided i.e. there was an over-reaction to current economic data that was subsequently revised upwards as is most often the case with UK National Income data.
Some commentators want to characterise National Debt at more than double the official total (including public sector pension future liabilities + off b/s liabilities). This is a silly argument, and could be more devastingly applied to private sector indebtness - and arguably should not be so applied to estimating pension fund shortfalls as if pension funds should not take sensible account of future premium and investment income. If public sector debt should be so calculated gross (without net balance) then why not include all the liabilities of the nationalised banks as well for another £3 trillions plus £1 trillion plus of BoE/HMT off balance sheet repo swaps with assets of the banks?
Gross debt is important to know, but so are the the full balance sheet of assets, liabilities and collateral, worth in the government's about £1.5 trillion at market prices, plus another £2.5 trillions at the nationalised banks excluding funding gap borrowings.
Nearly half of the National Debt is today internal to government, merely representing debts between various arms of government including the more than one quarter held by Bank of England which offsets its t-bill etc. off budget/off b/s borrowings from HMT? Commentators have been very unclear about how to interrpet
UK government borrowing of £200bn in 2010-11 while at the same time having bought £198bn in under QE in 2009-10? The same question arise in the politicised debate about US Federal debt.
Even if UK National Debt triples in ratio to GDP compared to pre-crisis levels, this will be because income and corporation tax receipts not only fell but are taking a few years longer than normal to recover. This will only happen if the private sector is not pulling its weight in dragging recovery forward sooner. The 20+ economists cannot say why government deficit spending constrains the private sector from gaining recovery sooner?
Public spending cuts won't help, and if new debt issuance is any less than planned, there will also be an unmet demand I calculate, from the banks and others. Then UK financial sector firms will have to buy a lot of foreign government bonds with predictably higher external account deterioration including in the trade balance, which continues needing to be financed.
New global and EU financial risk regulations are enforcing banks to triple their holdings in capital reserves of government bonds; they have to get these from somewhere? In fact, we can say, there is a level below which government borrowing and outstanding debt dare not fall - quite apart from questions of delivering positive or negative growth impulses to the economy, and also of restructuring debt when base rates significantly change or shift from one trend path to another, and also funding redemptions when it is considered this should be budget-neutral.
There is too much politics based on counting on only the fingers of one hand. The media is full of hyperbole about the "vast unprecedented scale" of new government debt issuance. Average net borrowing was £30bn for a decade after gross issuances of about £50bn annually. In the past decade, UK National Debt stable when not slightly falling remained stable in ratio to GDP, but only until the credit crisis and recession struck. Redeptions should rise and of course were overtaken tenfold by QE. - See: http://www.dmo.gov.uk/documentview.aspx?docname=remit/drmr0910.pdf&page=Remit/full_details table 2.B
Today, National Debt is about £850bn (over 60% ratio to GDP, rising to 78% medium tern. But, let us not ignore that in the same period UK personal debt doubled in a decade to £1,400 billions (to more than 100% ratio to GDP) and total (gross) private sector debt doubled to nearly 500% ratio to GDP i.e. private sector gross debt is 6-7times greater than that of the public sector, and 10 times more ater deducting government internal debt, half of which is non-marketable.
Of course, there are asset (including future expected income streams) and collateral offsets, but government has these too and of such better credit quality than the private sector. It must be obvious that Government has in gross debt terms been far more prudent that the private sector and in net debt terms also. It has officially over £600bn in financial assets before the crisis, which with nationalisation and asset swaps has now increased depending on how one chooses to measure it (whether or not to include off-balance sheet items) to 4-6 times this.We should not buy into Prof.Rogoff (one of the 20+) et.al.'s absurd interpretation of the correlation between high national Debt and low economic growth as if the former dictates the latter and not the other way about?
Why should over-leveraged private debt not worry us as a cost to UK economy now and in the future? Is the historically-high private debt not also a burden on UK citizens and tax payers?
Gross UK National Debt equals only the total of 6 biggest UK banks' funding gaps (850bn), gaps that the banks found they couldn't refinance cost-effectively, or at all, hence their technical insolvency problems!
The UK banks lost £1 trillion in capital writedowns and defaults that government made good for them using off-balance sheet swaps, of which in time the banks will recover 30-50% of nominal losses and same again from sell-offs, then same again in medium term in net interest income plus more than same again in asset value recoveries as another 90% recession-effect loss temporaily hits heir capital reserves. One consequence however of Government stepping in where private sector failed is that it will generate £2-300bn in medium term gains for taxpayers sufficient to cover a third to half of medium term budget deficits (a complicated accounting). This gain is threatened by the Conservative (and others) idea of selling out of the banks cheap sooner rather than later!
Finally, there is another attempted rewriting of history gaining traction among some of the fiscally most conservative media, to say that "financial market didn't cause the crisis" (S.Telegraph (21 Feb), that it was "fraud" (by which is meant some theory of 'printing money and risking inflation), political incompetence, "guaranteeing bank bailouts" that "warped risk incentives and stopped financial markets from working"! This view aligns with one of the effects of the debt crisis debate, which is to divert the subjective impression of the credit crunch nd recession from focusing on the banks to blaming government - it is a perverse aspect of the 'better government is smaller government' ideology to blame anything scandalous on government sins of either omission or commission.
That is either sublimely and very subtly true or simply the most absurd wishful thinking? Governments may be to blame in how far credit boom growth was tolerated, for ignoring worsening external trade & payments balances, and even giving up social housing provision, and in how certain other matters were handled. A favourite bete noir is to blame too much or too little regulation, or incompetent regulation. But, regulation is an international matter.
If such errors should be centre-stage, in this government was surely also encouraged by financial markets who over-leveraged in 'interbank' and related credit derivatives, and not least the fast growth in banks' funding gaps. But, it is debateable what powers the Bank of England (responsible for systemic macro-prudential risks) and the FSA (responsible for individual firms' micro-prudential risks) to ensure they are listened to by banks and others before the credit crunch. To this should calumny should be added the irresponsible diversion by banks of lending to finance, mortgages and consumer credit while not growing (even decreasing in real terms) lending to 'productive' sectors especially exporters. Banks (and others) chased highest short term profits and ignored macro-economic risk diversification and liquidity risks. The credit crunch was not unprecedented, except in its scale and global systemic effects.
Banks are ignoramuses in macro-economics not because they lack the resource to do better, but because they are in the habit of choosing to be so. They prefer having a very poor or no understanding of the role they play in the wider economy, which in much of economic history was deemed below their pay or profits grade. That for some years has been a major sin of mossion. If the private sector is ever to substitute for government as the only engine of growth in a recession, to lessen how much government has to apply Keynesian deficit-spending reflation in a recession, this has to be led by banks. But, so far, they have shown themselves far from ready to do so! Banks and markets are deleveraging and continuing to do so - is that how anyone sensibly thinks they should be allowed to continue? The government must feel very frustrated by the terms of the media debate much like Alice at the Mad hatter's Tea Party. More borrow & spend to make recovery more likely - "That's nonsense" as a policy according to some,such as Liam halligan writing in The Sunday Telepgraph, a policy that should have died in 1979 he says when Callaghan siad it was no longer an option. It is after that when the 'end to boom and bust' became a buzz-saw of markets and a conservative mantra that Labour aped in the 1997 election as basis for giving the Conservative Government a good kicking over how public finances were in a mess, which was as far from being true or fair as the claims offer in political reserse today - poetical justice perhaps. I doubt Callaghan when Prime Minister really understood what Peter Jay tried to teach him, Keith Joseph and Margaret Thatcher about Chicago monetarism. Keynesianism was clearly not dead or ineffective, despite all the rhetoric to the contrary. It was applied by Ken Clarke in the 1990s and by Brown in 2001 when he kept UK for first time in over a century from directly following the USA into recession! Anyone wishing to dispute this have to explain how else within a politically acceptable timeframe the economy can otherwise recover other than by government alone getting its boots on and mucking the economy out of it ordure-covered recession?
Note: Andrew Rawnsley's book serialised in The Observer, for all the storm in a teacup generated about whether Gordon Brown is a bully or not, rightly or unfairly so, Alistair darling emerges as a hero of the hour, and Gordon too, in addressing the crisis most valiantly and I believe (firmly know) most successfully.

60 ECONOMISTS SUPPORT DARLING

2010-02-19T05:16:00.000-08:00

Darling storm-tossed but unflappable.
More than 60 leading economists have backed Alistair Darling’s wish to delay spending cuts until 2011 (subject of course to the general election outcome), creating a dividing line within the profession on the crucial issue of how to reduce the UK’s public debt. Two letters in today’s FT warn of the risks of damaging Britain’s fragile recovery by “reckless” early cuts. They are a direct riposte to 20 economists who wrote to The Sunday Times at the weekend supporting the Conservative party’s argument that fiscal tightening should start sooner or soonest. Of course, it seems unfair to cut public spending when it is not to blame for credit crunch or recession, and anyway where to cut with least economic damage? In my opinion the answer is certainly not in labour-intensive services. There is a lot of cant about the budget deficit and the national debt. The media is casual in its unthinking description of public finances in 'a mess', 'in disarray', 'unsustainable', and other horror-fuelled characterisations. The opposite is true. Actually, no-one is claiming that high deficits and national debt are sustainable long term; he question is how sustainable it is in the short to medium term. But even in the short term it makes no sense to look only at one side of any balance sheet. And, sadly, I have to say that all 80+ economists are remiss in this also. It is pointless to look at the budget deficit and national debt gross, not net. Over the past year while the debt grew towards £1 trillion and the deficit to £140 billions (or 8.8-12.8% ratio to GDP depending on what is currently the most credible view of total GDP?) there has also been a growth of that proportion of debt internal to government, not least buying in up to £200bn of gilts using off-balance sheet funding, and the gaining of substantial assets in bank shareholdings without resource to the general government budget. Looked at in this light the net position is neutral to positive, hence the case for spending cuts is vacuous as well as dangerous, and indeed it may be argued that both deficit and debt should be i gross terms higher to deliver adequate deficit-spending growth impulse to the economy! We are getting a lesson in the politicians' and general public's inability to look at matters in double-entry balance sheet terms, a myopia that opportunistic politicians and their economist allies are not slow to egregiously (irresponsibly) exploit! In the medium term I calculate that the profits to be realised from the governments' bail-out of the banks will actually pay for 40% of projected UK budget deficits, though there is some question how much of that may be foregone by exiting bank support schemes early to attract institutional investors back into buying banks' shares?
There is also a critique to be offered about many economists and commntators on the subject that they have an exaggerated idea of the size of government in the economy, look too much at consumption expenditure explanation for GDP/GNP ignoring income side of the account: and worst of all assume a fixed cake in which the more flows through public sector (government) the less is available for private sector to freely enjoy and keep, which is only a short term truth, mainly at micro-level, but a medium term falsehood at macro-level i.e. insofar as government can finance recovery more painlessly and cost-effectively than relying on private sector impetus, which is understandably lacking in courage and weak by being atomistically self-serving, a realistic as opposed to a false economy we must rely far more on government in recession years than the private sector to proceed in the right direction.
All that aside, what are the economists saying?
Letter 1
From Prof Lord Layard and others.
Sir, Last Sunday 20 fellow economists wrote to The Sunday Times advocating a more rapid reduction of Britain’s budget deficit than is currently planned in the Pre-Budget Report. “There is a compelling case”, they said “for the first measures beginning to take effect in the 2010-11 fiscal year.”
We disagree.
First, while unemployment is still high, it would be dangerous to reduce the government’s contribution to aggregate demand beyond the cuts already planned for 2010-11 (which amount to 1 per cent of gross domestic product). Further immediate cuts – even supposing they are practicable – would not produce an offsetting increase in private sector aggregate demand, and could easily reduce it. History is littered with examples of premature withdrawal of the government stimulus, from the US in 1937 to Japan in 1997. With people’s livelihoods at stake, a responsible government should avoid reckless actions.
Second, Britain’s level of government debt is not out of control. The net debt relative to GDP is lower than the Group of Seven average, and on present government plans it will peak at 78 per cent of annual GDP in 2014-15, and then fall. Even at its peak, the debt ratio will be lower than in the majority of peacetime years since 1815. Moreover British debt has a longer maturity than most other countries, and current interest rates on government debt at 4 per cent are also low by recent standards.
Third, since the crisis began, private households and businesses have had to increase their saving in order to reduce their debts. It is this saving that finances the government deficit. If the government did not take up the slack, there would be a deeper recession. But fortunately, wise counsel has prevailed so far, and public spending has been maintained as an offset to reduced spending by the private sector.
Of course there needs to be a clear plan for reducing the government deficit. But the existing one for next year appears sensible. What is needed then is much more detail for the following years, and a radical plan for the medium term. That is what the debate should be about.
A sharp shock now would not remove the need for a sustained medium-term programme of deficit reduction. But it would be positively dangerous. If next year the government spent less and saved more than it currently plans, this would not “make a sustainable recovery more likely”. The weight of evidence points in the opposite direction. Letter 1 is signed by: Lord Layard,Emeritus Professor of Economics, LSE; founder of the LSE Centre for Economic Performance; Chris Allsopp, Reader in Economic Policy, University of Oxford and former member of the MPC; Alan Blinder, Gordon S. Rentschler Memorial Professor of Economics and Public Affairs, Princeton University, and former Vice Chairman of the Board of Governors of the Federal Reserve; Sir David Hendry,Professor of Economics, University of Oxford; Sir Andrew Large,Former Deputy Governor of the Bank of England and former member of the MPC; Rachel Lomax,Former Deputy Governor of the Bank of England and former member of the MPC; Robert Solow,Nobel Laureate and Emeritus Institute Professor of Economics, MIT; David Vines; Professor of Economics, University of Oxford, and Fellow of Balliol College; Sushil Wadhwani,CEO, Wadhwani Asset Management and former member of the MPC.
To clarify a couple of points: the writers are not saying that households will invest in government debt directly from their savings. In fact, the purchases will be almost wholly by UK banks less that bought by foreignors to finance the UK's trade deficit. The banks are under so much pressure to buy Gilts for their capital reserves the puchase will come from funds hitherto applied to banks' proprietary trading. The deficit is worth about one seventh of UK banks' capital and will reduce the banks' speculative exposures and funding gaps indirectly and help the quality of their solvency. The effect is not to productively absorb higher surplus household savings - these are reducing banks' funding gap borrowings. The main point missed is that the deficit opened up because of lower tax revenues in the recession in order to maintain public spending on services and other matters, but is also tivial in macro-economic terms compared to how pivate sector borrowings and financial and property firms' debt got into disarray to several times GDP compared to the Government's debt/GDP ratio of an expected peak o only 78%. The panic concern about government finances is a blind; it is private sector finances that need fixing.
Letter 2 From Lord Skidelsky and others.
Sir, In their letter to The Sunday Times of February 14, Professor Tim Besley and 19 co-signatories called for an accelerated programme of fiscal consolidation. We believe they are wrong.
They argue that the UK entered the recession with a large structural deficit and that “as a result the UK’s deficit is now the largest in our peacetime history”. What they fail to point out is that the current deficit reflects the deepest and longest global recession since the war, with extraordinary public sector fiscal and financial support needed to prevent the UK economy falling off a cliff. They omit to say that the contraction in UK output since September 2008 has been more than 6 per cent, that unemployment has risen by almost 2 percentage points and that the economy is not yet on a secure recovery path.
There is no disagreement that fiscal consolidation will be necessary to put UK public finances back on a sustainable basis. But the timing of the measures should depend on the strength of the recovery. The Treasury has committed itself to more than halving the budget deficit by 2013-14, with most of the consolidation taking place when recovery is firmly established. In urging a faster pace of deficit reduction to reassure the financial markets, the signatories of the Sunday Times letter implicitly accept as binding the views of the same financial markets whose mistakes precipitated the crisis in the first place!
They seek to frighten us with the present level of the deficit but mention neither the automatic reduction that will be achieved as and when growth is resumed nor the effects of growth on investor confidence. How do the letter’s signatories imagine foreign creditors will react if implementing fierce spending cuts tips the economy back into recession? To ask – as they do – for independent appraisal of fiscal policy forecasts is sensible. But for the good of the British people – and for fiscal sustainability – the first priority must be to restore robust economic growth. The wealth of the nation lies in what its citizens can produce. Letter 2 is signed by: Lord Skidelsky,Emeritus Professor of Political Economy, University of Warwick, UK; Marcus Miller,Professor of Economics, University of Warwick, UK; David Blanchflower,Bruce V. Rauner Professor of Economics, Dartmouth College, US and University of Stirling, UK; Kern Alexander,Professor of Law and Economics, University of Zurich, Switzerland; Martyn Andrews,Professor of Econometrics, University of Manchester, UK; David Bell,Professor of Economics, University of Stirling, UK; William Brown,Montague Burton Professor of Industrial Relations, University of Cambridge, UK; Mustafa Caglayan,Professor of Economics, University of Sheffield, UK; Victoria Chick,Emeritus Professor of Economics, University College London, UK; Christopher Cramer,Professor of Economics, SOAS, London, UK; Paul De Grauwe,Professor of Economics, K. U. Leuven, Belgium; Brad DeLong,Professor of Economics, U.C. Berkeley, US; Marina Della Giusta,Senior Lecturer in Economics, University of Reading, UK; Andy Dickerson,Professor in Economics, University of Sheffield, UK; John Driffill,Professor of Economics, Birkbeck College London, UK; Ciaran Driver, Professor of Economics, Imperial College London, UK; Sheila Dow,Emeritus Professor of Economics, University of Stirling, UK; Chris Edwards,Senior Fellow, Economics, University of East Anglia, UK; Peter Elias,Professor of Economics, University of Warwick, UK; Bob Elliot,Professor of Economics, University of Aberdeen, UK; Jean-Paul Fitoussi,Professor of Economics, Sciences-po, Paris, France; Giuseppe Fontana,Professor of Monetary Economics, University of Leeds, UK; Richard Freeman,Herbert Ascherman Chair in Economics, Harvard University, US;Francis Green,Professor of Economics, University of Kent, UK; G.C. Harcourt,Emeritus Reader, University of Cambridge, and Professor Emeritus, University of Adelaide, Australia; Peter Hammond, Marie Curie Professor, Department of Economics, University of Warwick, UK; Mark Hayes, Fellow in Economics, University of Cambridge, UK; David Held, Graham Wallas Professor of Political Science, LSE, UK; Jerome de Henau,Lecturer in Economics, Open University, UK; Susan Himmelweit,Professor of Economics, Open University, UK; Geoffrey Hodgson,Research Professor of Business Studies, University of Hertfordshire, UK; Jane Humphries,Professor of Economic History, University of Oxford, UK; Grazia Ietto-Gillies,Emeritus Professor of Economics, London South Bank University, UK; George Irvin,Professor of Economics, SOAS London, UK; Geraint Johnes,Professor of Economics and Dean of Graduate Studies, Lancaster University, UK; Mary Kaldor,Professor of Global Governance, LSE, UK; Alan Kirman,Professor Emeritus Universite Paul Cezanne, Ecole des Hautes Etudes en Sciences Sociales, Institut Universitaire de France; Dennis Leech,Professor of Economics, Warwick University, UK; Robert MacCulloch,Professor of Economics, Imperial College London, UK; Stephen Machin,Professor of Economics, University College London, UK; George Magnus, Senior Economic Adviser to UBS Investment Bank; Alan Manning,Professor of Economics, LSE, UK; Ron Martin, Professor of Economic Geography, University of Cambridge, UK; Simon Mohun, Professor of Political Economy, QML, UK; Phil Murphy, Professor of Economics, University of Swansea, UK; Robin Naylor, Professor of Economics, University of Warwick, UK; Alberto Paloni, Senior Lecturer in Economics, University of Glasgow, UK; Rick van der Ploeg,Professor of Economics, University of Oxford, UK; Lord Peston, Emeritus Professor of Economics, QML, London, UK; Robert Rowthorn,Emeritus Professor of Economics, University of Cambridge, UK; Malcolm Sawyer, Professor of Economics, University of Leeds, UK; Richard Smith,Professor of Econometric Theory and Economic Statistics, University of Cambridge, UK; Frances Stewart, Professor of Development Economics, University of Oxford, UK; Joseph Stiglitz,University Professor, Columbia University, US; Andrew Trigg,Senior Lecturer in Economics, Open University, UK; John Van Reenen,Professor of Economics, LSE, UK; Roberto Veneziani,Senior Lecturer in Economics, QML, UK; John Weeks,Professor Emeritus Professor of Economics, SOAS, London, UK.Many hundreds of other economists would sign this letter if asked. It is signed by many friends especially those from my Cambridge years. But I notice that few are macro-economic modelers; nearly all are theoreticians albeit of an empirical bent i.e. sceptical of abstract long run theory. They usefully point out that just as the deficit is automatically generated by the long deep recession it will also be automatically reduced by recovery. What may be less appreciated or not thought to be a vital point, when higher savings in the economy are required and when banks and institutional investors (in all countries)are forced for stability and solvency reasons to invest more heavily in government bonds there needs to be a healthy domestic supply, not least after £200bn of QE, otherwise they have to buy substantial foreign treasury bonds with worse consequences for the external trade balance. There is in fact a level of government borrowing always required below which it should not fall. This, most economists generally have ignored.
What the economists are responding to is party politics in the lead-up to a general election. Opposition parties are, like the Irish, averse to letting the truth stand in the way of a good story. New Labour gave The Conservative government a similarly totally unrealistic kicking in the 1997 election by claiming public finances were in a mess. At that time, mysteriously, Chancellor Ken Clarke, perhaps resigned to losing, did not riposte with the obvious question to New Labour "what would you have done differently to get the economy out of recession (in '91 & '92)?" This time, while we are still in a recession, not the case in '97, Chancellor Darling is defending his wicket and has the above economists supporting him.60 economists are less than the "350 economists from across the world" who recently wrote to G20 leaders calling on them to introduce a financial transactions tax on speculative dealings in foreign currencies, shares and other securities. It is less than the 365 economists who (in vain) wrote in 1981 to The Times calling on the 'Thatcher' government to alter its economic policy to end the current recession.
What did the 20 economists who support the Conservative Party's policy state? They said:
IT IS now clear that the UK economy entered the recession with a large structural budget deficit. As a result the UK’s budget deficit is now the largest in our peacetime history and among the largest in the developed world.
In these circumstances a credible medium-term fiscal consolidation plan would make a sustainable recovery more likely.
In the absence of a credible plan, there is a risk that a loss of confidence in the UK’s economic policy framework will contribute to higher long-term interest rates and/or currency instability, which could undermine the recovery.
In order to minimise this risk and support a sustainable recovery, the next government should set out a detailed plan to reduce the structural budget deficit more quickly than set out in the 2009 pre-budget report.
The exact timing of measures should be sensitive to developments in the economy, particularly the fragility of the recovery. However, in order to be credible, the government’s goal should be to eliminate the structural current budget deficit over the course of a parliament, and there is a compelling case, all else being equal, for the first measures beginning to take effect in the 2010-11 fiscal year.
The bulk of this fiscal consolidation should be borne by reductions in government spending, but that process should be mindful of its impact on society’s more vulnerable groups. Tax increases should be broad-based and minimise damaging increases in marginal tax rates on employment and investment.
In order to restore trust in the fiscal framework, the government should also introduce more independence into the generation of fiscal forecasts and the scrutiny of the government’s performance against its stated fiscal goals. letter is signed by: Tim Besley, Sir Howard Davies, Charles Goodhart, Albert Marcet, Christopher Pissarides and Danny Quah, all of London School of Economics; Meghnad Desai and Andrew Turnbull, House of Lords; Orazio Attanasio and Costas Meghir, University College London; Sir John Vickers, Oxford University; John Muellbauer, Nuffield College, Oxford; David Newbery and Hashem Pesaran, Cambridge University;
Ken Rogoff, Harvard University; Thomas Sargent, New York University; Anne Sibert, Birkbeck College, University of London; Michael Wickens, University of York and Cardiff Business School; Roger Bootle, Capital Economics; Bridget Rosewell, GLA and Volterra Consulting. The 20 economists' letter might imply there is no deficit and debt reduction plan. It, however, uses the word 'credible' without offering a reason why the government's medium term plan is not credible? My analysis suggests the government is being very modest and over-cautious in not targeting how much profitable gain there will be from its bank bailout measures and how quickly tax revenues will increase without higher tax rates. 'Credibility' can here mean appearance more than substance. The 20 say they worry about 'loss of confidence in the UK’s economic policy framework will contribute to higher long-term interest rates and/or currency instability' . The higher interest rate argument is really pathetic because all should know that 'crowding out' theory never found empirical proof - it's just a theory, and a very poor one. Higher interest rates to defend the currency is more credible, but this is such a contextually complex matter that my opinion is that the 20 lack a realistic perspective and sense of proportion. What has been happening across the FX exhagnge market continues not to be driven by relative economic performance and interest rates at all, but by all banks reducing their cross-border assets and liabilities, and in this respect the UK with £4 trillions of such positions after about £400 billions of deleveraging that sank the pound (usefully perhaps) what the 20 are talking about is inconsequential.
What we have here are 20 highly reputable economists who are insufficiently versed in what is going on in the financial markets and banks and the scale of thei balance sheet changes and how these impact the economy - they are living in an economics from pre-financial globalisation. This should not be true of Goodhart, long term colleague at the LSE of Mervyn King, but, no offence intended, his academic focus on the theoretical trees of financial markets interpreted in reductionist maths models I always felt blinded his research group from seeing the whole wood.
The 20 economists do advise sensitivety to economic circumstances, but I fear they do not have the applied macroeconomic modeller's understanding of timing. As noted by the 60 economists, the timetable for starting spending cuts is too soon to be sure of the robustness of recovery, just as, I may add too, we do not yet know how much of the government's budget revenue shortfall in 2009 will be recovered later as corporations' and others' tax provisions are realised, just as we do not know if banks will recover 30% or 50% of credit losses or have to eventually realise more than 10% of credit crunch writedowns.
In pointing up the high budget deficit it should be understood that much uncertainty remains that as in all previous experience will narrow that gaps we see nominally today - there is a difference between cash-flow borrowing and eventual outturn for the year seen in hindsight of 1-2 years hence. Output, inflation and even trade statistics are all severely revisable for up to 2 years.
Of the signatories, I am shocked at seeing among them Pesaran, Desai, Muellbauer, and Newbery, maybe not Newbery given his field is the most opaque mathematical economics, not empirical or applied, and not policy modeling. Roger Bootle is constantly a disappointment to me in his avowel (professional positioning) of almost neo-liberal economics since he can at least claim to have a macroeconomic model to operate, however flawed in medium term forecasting. Costas Meghir is also at the Institute for Fiscal Studies that I believe has in recent years taken an over-prudent view of borrowing over the cycle. Its stated view is "Whoever forms the next Government should put in place a fiscal tightening more ambitious over the next Parliament than that set out in the PBR, but without putting the recovery at undue risk with significant extra tax increases or public spending cuts in the coming year" - and in this respect at least does not favour cuts this year. But, in any case, it lacks an adequate model to sustain macro-economic views. Wickens is a general equilibrium theorist in closed economy models. Rogoff was at one time classified (by Stieglitz) as a market fundamentalist, and while this may be harsh it is the case that his analyses of crises begin and end with public sector indebtedness and monetary-driven inflation. It is disappointing that a first class logician remins bounded by partially-sighted theory. I wish he would retrain his focus to look at private sector debt and illiquid one-way markets.I could make similar superior judgements of others but would be unfair and conceited.
My main objection to the 20 remains however that they have a blinkered mindset when focusing on problems to treat context as "all else being equal" i.e. context-free. This is perhaps permissable for theory but not for applied prescriptions. Rogoff, for example, has the integrity of self-doubt, his only accusation against Stiegltiz is the presumption of certainty of showing no self-doubt or self-criticism. Henec, I'm surprised that he sides with the 20 in being certain that earlier spending cuts and higher tax rates are needed. Others agree with Martin Wolf of the FT, and I would have expected Howard Davies to agree too, that it is better to overshoot in ensuring recovery than try to economise on deficit spending to do merely the optimally minimal and risk failure, which is I think the best comment to end on.

SOVEREIGN DEBT IS A COVER-UP DISTRACTION

2010-02-17T04:00:00.000-08:00

Niall Ferguson, the historian who has pegged out a media stake with his History of Money book to knowing about economics and money, has been over-reaching himself to concur with neo-liberal manufactured fears about government tax and spend - claiming last week that the US will face a Greek crisis - as if he knows what the Greek crisis is, which I doubt. see: http://g20andbrettonwoodsii.blogspot.com/ and http://monetaryandfiscal.blogspot.com/ and also http://monetaryandfiscal.blogspot.com/2010/01/greece-helln-ism-banks.html
Martin Wolf, writing in the FT, promptly dismissed this as hysteria.
Ferguson stated that, according to the White House projections, gross federal debt will exceed 100% per cent of (ratio to) GDP by 2012 (currently at about 60% ratio), adding that the US is forecast never to run a balanced budget again (actually if true this would be a great thing), and saying (totally implausibly) that monetary policy (i.e. near zero central bank borrowing rate), not (fiscal) deficits, saved the US economy; but that higher interest rates are on the way and, not least, that high fiscal debt is damaging (usually implying it alone forces up cost of borrowing, which is merely ideological theory without empirical proof, and which makes no sense anyway).
When the credit crunch was lacerating the banks and recession subsequently struck in 2007-2009 none questioned the solvency of OECD countries even when jaws dropped at the scale of the bail-out responses. Now that the smoke is clearing and the public wants its pound of flesh from the banks who were losing the blame-game game there appears to be a concerted effort to shift public anger and anxiety from banks' solvency onto government solvency. Brad DeLong of the University of California, Berkeley, responded that parts of Ferguson's argument are wrong or misleading, not least because White House projections are for federal debt (that part held by the public i.e. private and foreign holders) to be 71% ratio to GDP in 2012 and not to exceed 77% by 2020. All empirical economists, as opposed to theoretical ideologues know that monetary policy (setting of interest rates and money market tightening or loosening) would not have delivered even limited recovery. Higher central bank interest rates may indeed be on the way, but there is nothing in current yield curves in the markets to suggest it, nor in any medium term relevant factor projections. Moreover there is, as Wolf states reporting DeLong's view, no reason to balance budgets in a country whose nominal GDP grows at up to 5% a year in normal times.
Wolf says Prof Ferguson (a Scot-Brit who has a professorial chair in the US) is trying to frighten US policymakers out of sustaining or, better still, increasing fiscal stimulus, even if the true issue is longer-term sustainability. I think he is merely currying favour with Republicans and UK Conservatives.
Ferguson accuses opponents of believing in a “Keynesian free lunch”. Wolf cleverly spots the implication of this that Ferguson believes (religious sense of this word)in a conservative free lunch. Wolf's counter is that the benefits of the higher output today far exceed the costs of debt service tomorrow. In fact, one can add that depending on the composition of government spending and ho it draws its income from across the whole economy including a quarter derived from taxing its own spending as well as debt interest, the costs of debt servicing are small in net terms. Moreover, banks and other financial corporations need for solvency reasons to buy and hold the majority of any new future government debt issuance.
Ferguson is not a three-dimensional economist (as I term it) and therefore can casually indulge in the neo-liberal theocractic view that fiscal tightening today would have little effect on growth in economic activity. Only when monetary policy has room for manoeuvre and the private sector’s borrowing is unconstrained, can this benign view be half-right. But, as Olivier Blanchard, chief economist of the IMF, and colleagues note (in a recent report): “To the extent that monetary policy, including credit and quantitative easing, had largely reached its limits, policymakers had little choice but to rely on fiscal policy.”
The high-income growth (trade deficit) countries that have experienced the biggest jumps in budget deficits and national debts have, inevitably, been Ireland, Spain, the UK and US, as Stephen Cecchetti and colleagues at BIS pointed out in “The Future of Public Debt” (presented last week at a conference for the 75th birthday of the Reserve Bank of India). These countries had the biggest sustained credit booms and consequential asset bubbles because banks denuded lending to productive industries and exporters to favour mortgage and consumer credit lending. It is there, as a result, that private-sector spending has been most constrained by the pressure on banks to deleverage when their capital got wiped out twice in the credit crunch and recession, which governments have compensated them for by about half on a more than full commercial rent basis.
Jumps in fiscal deficits are the mirror image of retrenchment by battered private sectors i.e. as government deficits rise so too do private savings by the same % ratios to GDP. In the US, the financial balance of the private sector (the gap between income and expenditure) shifted from minus 2.1 per cent of GDP in the fourth quarter of 2007 to plus 6.7 per cent in the third quarter of 2009, a swing of 8.8 per cent of GDP (see chart). In the UK private savings rate has risen to over 8%!This massive swing occurred despite the Federal Reserve’s and HM Treasury's efforts to sustain lending and spending by the banks. Similar shifts occurred in other crisis-hit countries. There are many of those currently. If these governments had decided to balance their budgets, as conservatives myopically demand (mainly it seems for upcoming political election reasons), two possible outcomes can be envisaged in Wolf's words: the plausible one is that we would now be in a Great Depression; the fanciful one is that, despite huge increases in taxation or vast cuts in spending, the private sector would have borrowed and spent as if no crisis at all had happened. In other words, a massive fiscal tightening would actually expand the economy. This is to believe in magic.
The huge increases in fiscal deficits were appropriate to the circumstances. I would add that appropriateness is in both scale and quality - essentially to maintain and shift public spending targets despite a 5-6% fall in sales, corporate and income tax revenues. The only way to have avoided doing that would have been to prevent prior expansions of private credit and debt and therefore to severely cap the property booms. Such deficits cannot continue indefinitely, and in fact they do not do so. Wolf reports that as Carmen Reinhart and Kenneth Rogoff point out in a recent paper, once ratios of public debt to GDP exceed 90% ratio to GDP, median growth rates fall by 1% a year. That would be costly.
This view however is based on a context-free or abstracted view that fails to take account of the composition and quality of how the deficit spending is applied. In the case of Japan in the 1990s it was applied mainly to paying down banks' loan losses while government infrastructure spending continued to be cut back and so the domestic demand in the economy continued to slump. This is not Keynesian or how the US and UK are proceeding. This graphic is the wall Street Journal view of Europe's sovereign riskiness. A McKinsey Global Institute has also noted in a recent report: “Historic deleveraging episodes have been painful, on average lasting 6-7 years and reducing the ratio of debt to GDP by 25%”. The only ways to accelerate this they say would be via mass bankruptcy or inflation or by some ways to bolster and grow domestic demand if deleveraging continues - which is hard to square with any examples? In Japan's case, bank deleveraging continued as savings rates rose and the export-led growth policy merely resulted in the country buying more and more foreign financial assets. If fiscal deficit policy is ruled out, the only option would be foreign demand i.e. export-led growth. But, this has never been shown to do anything sufficiently to restore domestic demand by itself - it is a poor growth concept, and we can see it in China - a country bidding (on the back of false GDP figures) to be acclaimed as the world's second biggest economy when per capital employment incomes continue to average about $500 a month. China cannot continue to grow by trying to outcompete India or Vietnam for low wages. What is likely to offset contracting demand in the USA anyway where the trade deficit alone is about one third of the entire Chinese GDP (its real unfalsified GDP) - and what will externally pull other hard-hit economies? Nobody, alas, is the answer, althought the Brookings Institute recently had a stab at guessing it could be huge trade deficits by emerging market economies paid for by OECD aid.
The BIS paper also noted that long-run fiscal prospects, largely driven by fast growing pensioner populations, are dire. This, however, is absurd. Pensioners are the fastest growing tax-paying segment and rich pensioners pay more than enough to cover very poor pensioners (who are a third of all pensioners) - but in any case the USA is one of the fastest growing populations and therefore the pensioner overhang is much exaggerated in both population as well as fiscal burden terms. Projecting forward (on the basis of pensioners as somehow external to the economy) the BIS argues that ratios of public debt to GDP could reach 250% of GDP in Italy by 2050, 300% in Germany, 400% in France, 450% in the US, 500% in the UK and 600% in Japan. These projections are easily refuted in my considered view by empirical models i.e. the numbers by BIS (and others such as the CBO) is plain scare-mongering.
Wolf, on this makes a huge error in my view by saying the best approach would be sharp reductions in long-term growth of entitlement spending. When state pensions are already worth less in real terms than in the 1950s this is a recipe for a kind of Holocaust of the elderly, a fiscally-driven euthanasia. It is as irrational as the economic arguments that favoured German Lebensraum of the 1930s and 40s. Holocaust Memorial - let's not have another one from this financial economic crisis. Wolf adds, that furthermore, as economies recover, short-term fiscal action will be needed. Actions will have to include spending cuts and increases in tax, to restore revenue lost forever in the crisis. I entirely disagree. Public spending programmes are not at fault and should not have to be cut. They are engines of economic growth, and by maintaining them the so-called 'real economy' will recover faster and that is how public finances will regain their balance.
I agree with Wolf there is a dilemma if private deleveraging (by banks and by borrowers) and fiscal deficits continue in the US and elsewhere for years, which is an unlikely combination even if it did occur in Japan of the 1990s. Then triple A-rated countries, including even the US, might lose fiscal room to manoeuve. But, in this case the US external account would have come into balance an the test would be on the rest of the world to turn away from trade-led growth to doing more to stimulate domestic demand. This has not yet happened to Japan or Germany or OPEC or China, but while they are in denial about the pressure on them this is a dam that may have to break soon. It might well not happen to the US anyway, since Main Street would be in so much anger that democratic politics would be severely threatened. After all, Japan, Germany, China, OPEC etc. could only continue with export-led growth so long as the USA maintained it credit boom stance. But, according to Wolf, the USA could in time do so. I see this only happening if there was an absolutely hard and dedicated return to policy of export-led growth enunciated in 1992 by the President's Council of Economic Advisors in the USA that was thankfully not implemented. It would be the equivalent of the USA adopting some equivalent to economic isolationism. If the USA followed the 1990s path of Japan would it look like this? But the US is not Greece or Japan, even if Greece more than aped the USA in credit-boom growth and Japan kowtowed to the banks instead of the helping the other end of its economy's food chain. A massive fiscal tightening today would be a grave global error propelling the world back into deep long period recession or depression. The private sector must heal. That, not fiscal retrenchment, is the priority.
Martin is correct in his critique of ferguson. To be clearer; of course there is a Keynesian 'free lunch' - we've been lunching on it for most of the past century. In the case of the USA, those at the dining table include the rest of the world. This debate is part of a dangerous shift to focus unreasonable on public sector finances - whose difficulties are surely caused by private sector exuberance, but whose resolution is surely cheaper and less painful than applying euthanasia to banks. There seems to be an agenda or simply a kneejerk neo-liberalism to imagine that the world's credit crunch and recession impacts on future lunching problems are a product of governments' fiscal stances and national debts when the problem has surely been the meteoric rise of private debt and ballooning assets when governments bent over backwards to provide the private sector with overly benign conditions i.e. credit-boom economies ignoring their burgeoning external account deficits.
The UK and USA governments responded both heroically and severely by using off-balance sheet tools i.e. treasury bills in asset swap repos thereby protecting taxpayers. And, then delivering a similar salve via fiscal deficits to punt economies out of recession. The profits to governments (& central banks) from bank bail-outs should pay for almost half of fiscal deficits medium term and the remainder will be recoverable in renewed growth medium term. Prof. Ferguson is a historian whose book on history of money was nice but not insightfully new - he is not an economist or an economic historian specialist, and I find it surprising that he posits an ability to forecast some implications of future national debt, again none of which is new, merely populist fear-mongering. There is much feverish cant and paranoia about national debt including about solvency of even OECD states. If states didn't have any debt we'd have to force them too - the world, especially banks could not function without it. Then too, a fifth to over a third of OECD national debts are internal within government and net debt is relatively small, and when including income and assets as collateral, national debts disappear as solvency issues - and are certainly serviceable. It is the private sector debts we need to be far more concerned about in "tax on the future" terms.
This does not stop irrational projections that two-dimensionally project current short term trends into the long term. Those who engage in this, including Ferguson, simply do not understand economic factors and values as part of a double-entry accounting system and models which do not permit selected factors like national debt to take off alone unencumbered by countervailing effects and brakes into the stratosphere as if spent on some other planet. If the US budget deficit was to balloon as some projections such as, for example, those by the Congressional Budget Office do in respect of Obama's medical insurance policy or future cost of pensions the implication would have to be include a huge increase in US trade deficit - already near its historical peak - but we know this is simply not capable of being financed long term as it was in the last decade. Responsibility for the global problems also lie with trade surplus countries' failure to broaden and deepen their own domestic economies' demand.
The USA is a quarter of the world economy. It's Federal debt and budget deficit are best measurable in world terms - something the rest of the world also very much needs and depends upon. The EU should do more - get into harness with the USA to pull the world economy forward. The world economy is as vulnerable as it is robust, maybe. But, rich countries angry obsession with their frustrated ambitions risks neglecting the wider world picture. This is a world of mostly many trade deficit-led domestic credit boom growth countries and a few export-led domestic credit-constrained countries (e.g. Japan, Germany, OPEC). In the past century there were more of the former than the latter until in the past decade we saw a polar shift to a few major deficit economies (USA, UK, Spain, Ireland, Greece etc.) and everyone else in surplus or near balance, of which not a few included emerging markets who gained an unprecedented boom (first for half a century) a sustained period led by the BRICS, especially China. There now will be another polar shift. If the adjustment is chaotic and mismanaged the costs won;t be represented by red ink on balance sheets but by real blood on flags and battlefield body counts.

TIME TO SELL EAST BUY WEST?

2010-01-30T02:37:00.000-08:00

Asian stock markets finished January in a falling streak worst since last March. This is partly due to US rebound and rising dollar, but also fundamental disbelief in China's hard to believe economy that claims to be overtaking the size of Japan to become World #2 - is it an economy bubbling fit to burst? There is reason to believe China's economy is only half the size it claims, no bigger than say California or Italy?
The waning investor appetite since equities hit 15-month peaks 10 days ago is most obvious in Asia-Pacific stock markets. Jitters about the impact of monetary tightening in China that expose then burst its own fragilities never mind the fragile global economy is debated from New York to Tokyo and reflected in investment bank notes.
A report from Reuters shows mutual funds in China share those concerns.‘Risk Aversion Trade’ (RAT) that feasts off sovereign debt woes, e.g. Greece or Ireland; the approaching unwinding of stimuli (government exiting the banks) in the US, UK and EU; plus concern that financial assets remain badly priced, again overpriced, and growing if reluctant respect for good-old-fashioned economic analysis, encourage bubble-talk such as is Chinese property running of a cliff and maybe a year or two down the track is EU still heading for its real recession? China's fund managers appear to be cutting real estate stock weightings by a third.
The dollar’s days as the symbol of risk aversion are over. Yesterday it rallied to a 6-month high. The Anglo-Saxon economies are determined to deliver positive news e.g. UK out of recession and US fourth-quarter GDP rising faster-than-predicted 5.7 per cent, which in its wake will pull UK out of its morass. Volatility continues however as trader jockey to keep their jobs and focus on shorter-run profit plays.
Let's look at China's GDP - is it believable?
The economic success of China dominates its image in the world. Stats reports are perceived to be critically important, major (even dominant) factors in maintaining growth. But, official statistics about China’s economy do not make sense for many reasons. It is realistic to place more confidence in India’s official statistics. It is compelling to conclude that China’s statistics are political window-dressing – propaganda- driven to maintain an image that is deemed vital to its continued growth, but resulting in the economy being measured to be approximately twice its actual size.
When average wages are about $200 per month per person in labour force (800+ million labour force and probably really only 90% in work) while national income is $300 per month per capita (for whole 1300 million population)! The misalignment is not explained by trade surplus, net foreign investment inflow (inflow worth $50 per worker per month, $20 net) – but by over 40% of GDP explained as annual new infrastructure investment (fixed capital investment i.e. construction & machinery investment in a ratio of 1 to 4, without depreciation calculations) that is $150 per worker per month. Household spending is $180 per worker, or 35% ratio to GDP compared to 70% in developed economies. The likelihood is that assets growth values of fixed capital investment between project start and finish are being somehow included in GDP!
In 1985 to 2000 fixed capital investment was 30-36% ratio to GDP, half a high again as ever was in Japan (peaking in a construction and property bubble that burst in 1990) or Germany except in immediate post-war years. When the property bubble bursts in China its economy will deflate greatly and the banks all become technically busted as happened in the 90s! Chinese GDP components, which might look reasonable at first blush. But, subtracting investment, net exports, and government spending from GDP, we arrive at sum of consumption spending plus inventory investment, represented by a steeply falling curve than dived in ‘05, even if officially not shown until '07, and can't remotely be explained by inventories. The implausible behaviour is clearer when plotted as growth rates. In '05 for example citizens spent 17% less on daily necessities and luxuries than the previous year, but not what other official statistics say - that retail spending for the year was 14% higher than the previous year, alone double the remainder calculated for all personal consumer spending.
It is impossible to calculate China’s true GDP without independent access to growth statistics across the entire country. All regions report higher growth when that is most unlikely. In OECD countries growth is never evenly spread and they have policies to transfer income from rich to poor regions that China lacks. In OECD countries it takes 2 years of hindsight to make GDP figures accurate. In 2002, I recall the senior economist for HSBC writing: "We suspect that certain local officials may have seriously overstated fixed-asset investment in their areas to boost their political credibility. Analysts can still reach useful conclusions by focusing on trends rather than exact amounts in the official figures. Sometimes, however, the problem can exceed itself.”
Energy consumption and other physical indicators do not support the reported growth of national income and some countries dispute the trade data. Note: GNP is essentially wages + net profits + trade balance, also explained separately as consumption spending + savings + new investment. If the two sides do not add up as they should – is the balance achieved by inflating capital investment as a residual estimate? It is impossible to maintain Chinese wages at low levels to compete with India and other much poorer Asian economies and at the same time expect to become the world’s second largest national economy, to seek a status as globally wealthy when the people remain domestically poor?
Bank loans have grown by 15% and then last year 30% with a fiscal stimulus to force growth but when inflation has been reported for years as very low or negative, including currently negative, despite years of 20-35% money supply growth. In much of 2009, 2% consumer price deflation and 6% producer prices deflation – to push excess output into exports to a now unwilling importing world i.e. via massively subsidized exports. Bank lending (business debts and redit supported property asset values) must now be unserviceable by borrowers – unsustainable and heading for collapse, hence the recent decision to radically rein in lending by a third, which will not put the cat back in the bag, but trigger borrower defaults sooner than later! The State Statistical Bureau takes only 15 days to survey the economic progress of 1.3 billion people. Revisions are a farce: No growth figure was ever been revised down, and upward revisions are incomplete to the point of uselessness. At best, earlier activity is measured; at worst, results are manufactured to suit the propaganda. The aim is to be able to announce that the economy has overtaken the size of Japan’s economy (when in reality it is probably not yet bigger than France, Italy or California) or about 4-5 times the size of the USA trade deficit.
In mid-2009 the main engine for growth, again, was fixed investment, rising by one-third or twice the speed of retail sales, and equivalent to a staggering 65% ratio to GDP, an unprecedented figure for an economy that is supposed to have a significant market element and a figure that cannot be reconciled with a transition to the market. Either investment recedes or the market does.
For China’s economy to be producing $4.9 trillion and growing at 9%, China must be an economy worth 25 Hong Kongs and building equivalent of two new complete Hong Kongs every year. HK’s population is 0.5% of China’s but HK has 12 times higher average incomes – just under the level of Japan and USA. Japan’s exports are $5,500 per capita, HK’s $25,000 and China’s $1,000 (or 62% of all employment wages, which is a measure of how exposed the economy is to trade – worth 25% ratio to GDP!)
India’s data is more convincing. Exports are high at 14% ratio to GDP (proportionately twice that of USA, which has high imports at 10% ratio to GDP).
Beijing's response to the crisis is to intensify pre-crisis policies instead of recognizing that it must restructure the economy – change its business model – to deepen and broaden the economy internally and relay far less on trade and export-dependent capital investment and allow wages to rise, enforce 40 hour week and encourage domestic consumer spending, even to the extent of several years, perhaps 1-2 decades falling trade surplus turning into trade deficits, which its currency reserves can well afford. The damage caused by a global demand bubble inflated by overly loose American money has been talked up by the media as something to be healed by help of Chinese production and asset bubbles inflated by overly loose Chinese money. Brookings Institute in USA went further to look forward positively to the OECD world being dragged into higher growth by poor countries (Third World as was) falling into large trade deficits to be paid for by increases in ‘western’ aid.
But China appears to have decided to put off restructuring into some indefinite future when the external situation is better, whatever that means? Of course, at that ‘better’ time, the economy will appear yet again to be firing on all cylinders (except workers’ wages) and reform will--again--be dismissed/postponed. This is the same mentality that led the banks into the credit crunch.
Keeping one's eyes pinned to current GDP growth shows an improving Chinese economy. A realistic view shows a credit boom economy (but not for the mass of the citizenry) that is unsustainable, trying to drag itself and the rest of the world back along the trail that led to the current economic crisis and heading for a steep fall into a hole of its own digging.

BBC SPINS KING

2010-01-20T08:20:00.000-08:00

(photo shows a BoE Beadle wearing the knew lightweight uniforms to replace the older heavy serge quality uniform - they, by the way, hate the new cheap style and want to return to the old uniforms, heavy and warm - BoE fashion advisor take note).
Bank of England Governor Mervyn King gave a speech at Essex University (his first since last October - a silence many assumed was because he was snowed in by complex calculations). The speech was 'meadia spun' by the BBC to suggest its focus was a severe criticism of government policy, and of No.10 more than No.11 Downing Street - an example of trying to eke a political story out of an economic one, a speech that was subtle, complex and a tour d'horizon of certain matters treated skillfully, subtly, perhaps too subtly for the broadcaster?
A clinically sober reading of the speech sees facts about the economic system's way of working described without implied political criticisms. Yet, BBC Radio 4 and BBC news web-site dramatically spun Mervyn King's speech(20 Jan) to read between the lines what was not there i.e. criticism of Government.
Full Speech: http://www.bankofengland.co.uk/publications/speeches/2010/speech419.pdf
The journalistic spin is summed up by "Mr King's remarks may have been aimed as much at number 10 Downing Street, as number 11" and in a pre-election climate there are those who would love to read the bank of England as favouring a change of government?
See last para. http://news.bbc.co.uk/1/hi/uk/8469373.stm
The journalist's implied view is that King was saying a higher savings rate is hindered by the government's deficit. But, to a trained economist, that makes no sense. Savings always rises and falls in exact proportion to GDP as government deficit rises and falls; they are national income accounting counterparts!
The quote "a key element in raising the national saving rate is the elimination over time of the structural deficit in the public finances". This states what is a factor, not what direction it is working in. UK savings rise as an exact counterpart of government deficit has been rising for many months in the same period as the budget deficit, and since Sept.08 to Nov. 09 (last published data), all UK sterling savings rose 10% and bank deposits by 50%. See http://www.bankofengland.co.uk/statistics/ms/2009/dec/bankstats_full.pdf Table B1.2
The quote, "But uncertainty about how and when fiscal policy will respond has a direct bearing on monetary policy. And markets can be unforgiving" is also cited loosely without direct comment or explanation, leaving it like a hanging chard as if implying political criticism. But as everyone should know uncertainty in monetary and to a lesser extent fiscal policy in their details are normal and necessary.
All that King wanted by saying this was to emphasise importance of statements adverting 'fiscal sustainability' - why, because he said markets gyrate around preliminary data yet to be much revised in hindsight, for which we can read spin to exploit unreliable data, and to say that new data in the next few months will be very much like that, but not to worry. He ends by saying what all empirical economists know that data remains unreliable for 2 years, which must have been his main point in the speech.
The first news about the speech on Radio4 was that King had said something like recovery would be hard and take maybe a decade - that seems later to have been dropped because it was not in the speech.
When King referred many times to 'saving' mainly about 'high-saving' countries he meant trade surplus countries and 'low saving' trade deficit countries. Most of the speech was about world trade imbalances - all of which the BBC ignored in favour of one reference to saving in UK, by which he mainly meant the need to reduce the UK trade deficit, and if there is an implicit message it is that in regard to 'national savings rate' and not household savings per se directly. Therefore if there is political criticism at all implied, it is to structure the fiscal impulse and to time the deficit reduction with respect to the economy's external account!
The key policy phrase in King's speech is actually, "Looking ahead, monetary and fiscal policy together must help to bring about a switch of demand from private and public consumption to net exports and business investment as the recovery takes hold."
There is a real credit crunch story here, which is that this is a repeat example of what the central Banks were saying, if too subtly, almost quarterly in recent years to all banks in credit boom economies, to very sensibly advise them to shift their lending away from mortgages, finance, and consumer loans, to industrial sectors whose borrowing from banks remained static or falling for a decade, as did Government's borrowing and debt, while mortgages, financial services and general private debt tripled causing the asset bubble. Banks ignored the message, not seeing in it an order to rebalance their loan books to care for economic sustainability. For your information, to take one example, lending to all small businesses in UK (half of private sector jobs) is only 5% ratio to GDP when all domestic economy lending by banks is roughly 40 times bigger!

Stiglitz's Six Lessons?

2010-01-02T04:48:00.000-08:00

There have been times when white bearded Nobel prize-winning economist Joseph Stiglitz has taken on the mantle of Father Christmas in expressing a positive view such as over what should be done by World Bank for poor countries, and again now in respect of summing up where we have got to in learning from the Credit Crunch and the global recession it triggered.
In the China Daily, Joe Stiglitz summarised his view, “The best that can be said for 2009 is that it could have been worse, that we pulled back from the precipice on which we seemed to be perched in late 2008, and that 2010 will almost surely be better for most countries around the world. The world has also learned some valuable lessons, though at great cost both to current and future prosperity – costs that were unnecessarily high given that we should already have learned them.”
It would be a comfort to know that the world learns from mistakes - not so, in my view; the world so-called merely adapts to whatever the compelling circumstances of the time and place are and will otherwise repeat whatever is self-serving. Just as warnings of the crash ahead of time by the BIS, a few other central bankers and a handful of economists, and others here and there, these were discounted or lost in the noise in the trading rooms etc. Learning lessons requires playing politics and it remains a struggle to get the hard lessons accepted and then harder again to get these translated efficiently into succinct actions; there is no shortgae of resistence and red herring distractions, the 'blame game' is still being played.
"Better for most countries" is a debateable forecast given that there remains much unravelling, ever-yet widening ripples and aftershocks - businesses closing down and unemployment high or rising (except UK). Many countries, perhaps most, have gaping uncertainties about their external account and therefore of their growth prospects if any?
Brookings Institute recommended in a report late last year as a positive outcome that we could look forward to a massive trade deficit this year and next by emerging countries, sufficient to further narrow the trade deficit of the USA, and thereby replace it to help pull the rest of the world via export-led growth, what China, japan and Germany especially rely upon, however irresponsibly that is i.e. pull the rich world into better growth by improving its trade balances - a most unseemly paradox that the poor should, by getting deeper into debt, help smoothe the prospects for the rich, who will then finance that via more aid to poor countries!
But, anyway, what are the six so-called “harsh” lessons, according to Stiglitz?
1. Markets are not self-correcting, and without adequate regulation, they are prone to excess. We could just as easily say markets are prone to Bilateral vestibulopathy - a condition involving loss of inner ear on one or both sides that causes giddy, woozy, false sensations of movement, spinning, or floating i.e. unbalancing themselves or indulging in fashionable gyrations among different sectors.
Markets have what call a 'camera shake' that is roughly 1.5% price moves either way, up or down, whereby individual stocks have a 3% average price vibration daily given that market indexes are the aggregate of gains and losses. This fact is how dealers can make money by zero or minimum thought and by being in the thick of what is just inter-day and intra-day spreads & shakes - the more you leverage the more you make, that is until several days in a row go in the wrong direction. Regulation has yet to find a way to enforce quality and more stability; regulatory rules are more about accommodating losses and avoiding systemic risk, however forlorn that may be - and not about mintaining some securely safe balance in behaviour. Markets are self-correcting by their vibrations, but not within the limits that would leave government out of the recovery equation when recession strikes.
2. There are many reasons for market failures. Too-big-to-fail financial institutions had perverse incentives: Privatized gains, socialized losses. This is pandering somewhat to popular anger. There are also massive privatised losses and there will be socialised profits from government support of the banks - stepping into replace private finance in funding banks' funding gaps. Self-correction is a matter of boundaries and timeframes, but self-correct they do, just not as painlessly as would be politically tolerable.
3. When information is imperfect, markets often do not work well – and information imperfections are central in finance. This is a non-sequitur; perfect information would also be disasterous. It would be more sensible to say markets work best when information is less than perfect but not so imperfect that they behave suicidally, or some equally asinine further insight into the bleeding obvious.
4. Keynesian policies do work. Countries, like Australia, that implemented large, well-designed stimulus programs early emerged from the crisis faster. The US, UK and others have implemented what can be classed as Keynesian if by that is merely meant higher deficit spending adjusted to whatever will propel economies back to a path of net new job creation. Emerging from the crisis, faster or slower cannot be fairly judged simply. The Eurozone, for example, had a sudden deep recession and then regained positive ground, but is likely to face its 'normal recession' in 2011 and 2012 if it follows normal lagged response to US recession. The UK recession may have just ended, but in world terms of US$ terms its economy has shrunk to a level going forward far below what is reflected merely in the economic cycle measured in domestic currency. China may look invilate but its official data is subject to shameless positive spinning and it cannot continue to rely on export led growth as before - it is not an energy exporter and has not yet learned how to rely on its domestic demand. Keynesianism that Stiglitz refers to is at local level - country-specific - when in our 'globalized world' we need to gauge Keynesianism in world economy terms and few are thinking in those terms beyond G20 meetings and UN or IMF research papers.
5. There is more to monetary policy than just fighting inflation. Excessive focus on inflation meant that some central banks ignored what was happening to their financial markets. The costs of mild inflation are miniscule compared to the costs imposed on economies when central banks allow asset bubbles to grow unchecked. Central banks actually worry about much more than inflation; they worry about the stability and integrity of their national or currency zone financial markets i.e. about banks, currency rates, external obligations and government bonds. It was hard for them to address the property bubble when there were many rationalisations justifying tolerance of fast rising property values, which let us not forget was a boon to emerging markets trade balances and debts as well as underpinning so much of bank debt and solvency in OECD countries. It is the residual high value of property assets and low mortgage defaults in Europe that are furnishing a floor or basis for banking recovery. Moreover, central banks and many others would accept that asset bubbles are an inevitable part of economic cycles that in turn are inevitable, even desirable. Therefore, the concern is about not letting asset bubbles become excessive like the famous Dutch tulip mania of John Law's Mississippi Scheme or Scotland's Darien Adventure and the many bubbles since then - but this would require giving central banks a power that many would call despotic and politically or democtraticaly intolerable? Stiglitz wants a Keynesian less Monetarist, less inflation-obsessed economic policy thinking - fine, but lessons will no be leatned or new thinking instituted without a new macro-economic theory and who is coming up with that - no-one that I can see getting that out to become the new othodoxy. Keynesianism is certainly helpful, but today we need a new Keynes - where is he, or she? A new theory however developed out of reconstituting past theory and lessons learned will also need a new central conception of economic growth, one less based on micro-economic analogy such as Adam Smith's pin factory and one based more on economic systems such as the economy of cities and far more global in scope. My advice is to look at economists such as Francis Cripps and Wynne Godley and their adherents, at UN models and at macro-economic policy models, which in future will need to have fully-interconnected macro-financial models. Even then, what happens if all we get is a cynical knowing perfect information outlook about the world's macro-economy. The Credit Crunch may have been disarming and impoverishing for those, many of whom who had much to lose, but has been a boon to others, not least a major transfer of wealth and income from rich to poor countries - suely a great thing?
6. Not all innovation leads to a more efficient and productive economy – let alone a better society. Private incentives matter, and if they are not properly aligned, the result can be excessive risk taking, excessively shortsighted behavior, and distorted innovation. Again, twas ever thus, and why should it ever be otherwise. I admire Stiglitz for having a go, but cannot see how his six points are lessons we have learned or should learn, and it disheartens me when great economists slip into journalistic statements that cannot stand rigorous examination. Would our economics graduates have come up with anything less and would they not have been sent back to the drawing board by any viv committee if these 6 points were the sum net total of their theses?
Stiglitz has elsewhere estimated the cost of the war in Iraq and Afghanistant to the US budget or economy as over a number of years costing about $3 trillions, which is on the same scale (or more) than the government finance gross investment-cost of Credit Crunch bailout and banking recovery (see Vanity Fair, April 2008). Given that Credit crunch and wars are coinciding surely we cannot learn economy lessons from the one and not the other, and from whatever other major singularities that can be pointed to and given a mult-$trillion price-tag or butcher's bill?