Saturday, 25 October 2014

Financial hurricanes

I recently wrote a post on Pieria about the (sizeable) role of the Eurodollar market in the 2007-8 financial crisis, or rather in the credit boom that led to the crisis. In order to explain the vast increase in transatlantic two-way flows (round-trips) from 1997 to 2007, I used this diagram from Hyung Song Shin's 2011 paper on the "global banking glut":

But there's a problem. This diagram appears to show that all money lent by both US and European banks came from US households. Where did they get their money? It wasn't wages. We know that US wages have been stagnating for two decades. No doubt some will suggest it came from Asian savers - the "global saving glut" that is apparently caused by thrifty Chinese households. But how could thrifty Chinese households provide US households with money? Most Chinese households save in yuan. It is Chinese government and corporations that lend to the US, and it is not households they lend to. Mainly, it is the US government. No, the "Asian savers" argument won't wash either. Where US households obtained the extraordinary amounts of money that crossed the Atlantic in the decade before the financial crisis is a mystery. It grew on trees, perhaps?

No it didn't. It came from banks. To show this, I've produced a diagram of my own:

Shin's diagram is a "loanable funds" model, whereas mine is endogenous money. Note the two-way flows. Property (and derived securities) flow clockwise: money flows anti-clockwise. The red lines are the two regulatory boundaries: US (Basel I) and Europe (Basel II). The gap between them contained not only the Atlantic, but most of the shadow banking sector.

In my diagram the flows can start anywhere. All actors in this diagram should properly be regarded as part of the "pump" that maintained the two-way flow. In my earlier post I suggested that the principal driver of the pump was regulatory arbitrage by banks between the Basel I and Basel II regimes, with the shadow banking sector and money market funds facilitating. But the desire of borrowers for loans and households & corporations (particularly construction companies) for property sales are important too. Without these, the US banks would have lent much less and the European banks would have had much less funding.

However, although this is a circular flow, the quantities of money and property/securities circulating are not constant. As the money flows around this model, it expands: and correspondingly, property and securities also expand.

Money was created by US banks when they lent. The "Loans" arrow at the left hand side is always new money. Similarly, money was created by European banks when they purchased securities. The "Payment" arrow at the top right hand side is also new money.

Lending against property created not only new money, but also new securities. The loans were sold by US banks to securitizers, who pooled them, tranched them and created new securities, which they sold into the capital markets. In the "shadow banking" box is not only the securitization process itself, but also rehypothecation and leveraging of the ensuing RMBS products. The value of the securities that came out of the other side of that box was far higher than the value of the loans that went into it. The "Payment" arrow was enlarged both by the ability of European banks to create new money AND the ability of the shadow banking sector to leverage up property-backed securities.*

So the Eurodollar transatlantic flows grew enormously in the decade before the financial crisis, both money and property-backed securities. US lending against property expanded enormously, and there was as a result a construction bubble - the "Property" arrow at the bottom left-hand side itself expanded. But it expanded less than the other arrows. Most of the expansion of money was absorbed in price rises.

Normally, we would expect such a massive expansion of credit to have caused consumer price inflation to rise significantly. But it didn't. This period is known as the "Great Moderation", when consumer price inflation remained low and stable. For me, this is where the "Asian savers" theory gains traction. But the "savers" were not thrifty Chinese households. They were Asian governments, scarred by the Asian financial crisis of 1997 and anxious to protect themselves from damaging flows of capital by building up foreign exchange reserves. Instead of borrowing from Western countries, as they have done in the past - and suffered for it - they exported to them. I have observed before that the "Great Moderation" in the West is paralleled by the "Great Expansion" in the East. I would go further: I think it was caused by it. The massive expansion of low-cost imports to the West depressed consumer price inflation even though spending was increasing as a result of the credit bubble. I would venture to suggest that had there not been a credit bubble, this would actually have been a period of deflation. The stagnation of wages in many Western countries supports this line of argument.

Having said that, it is also clear that spending didn't increase as much as might have been expected. Spending would be a "leak" from the two-way flow in the diagram, reducing the flow and dampening the leverage. But most of the money seems to have stayed within the flow, driving up house prices to an unsustainable level.

Toxic cross-border feedback loops come in many kinds. This was a property-based one. The yen carry trade was a currency-based one, and once again, when it abruptly reversed the consequences were disastrous - although I don't think it was the sole cause of the financial crisis, it was certainly a significant contributor. Capital flows into Eurozone periphery countries prior to 2012 were a similar leveraging cross-border flow system that failed disastrously. So were the capital flows into Asian economies that reversed abruptly in 1997, causing the Asian crisis: I think QE-driven capital flows into emerging markets exhibit similar characteristics, and policy makers should be on their guard. Nor are these flow systems a new phenomenon: going back further, the Latin American debt crisis of the 1980s was the disastrous consequence of the failure of an enormous oil-based leveraging cross-border flow system.

It is difficult to see how conventional monetary policy could have dampened this leveraging cross-border flow without causing outright deflation in domestic consumer prices. And I would add that attempting to interrupt the flow once the system was fully developed - for example, by imposing capital controls - would have been dangerous. All the players in this game depended on the flow continuing. When it was suddenly interrupted, first in 2007 with the freezing of the ABCP market (top RH corner "Funding" and "Securities (collateral) arrows) and secondly in 2008 with the fall of Lehman (collapse of "shadow banking" box) followed by Reserve Primary breaking the buck (failure of "money market funds") box, the results were disastrous. All the players suffered, and many of them failed.

Policy makers need to watch for the formation of cross-border leveraging flow systems and act EARLY to dampen them. This requires international cooperation, of course: it is depressing that so far the only central banker who seems to have recognised the importance of global monetary policy coordination is India's Raghuram Rajan. It is also unfortunate that there is still no internationally-agreed approach to regulation of the financial system. But worst of all, fiscal authorities don't seem to see any need at all for coordination of national objectives. These flow systems are driven as much by competitive and nationalistic fiscal policy as they are by uncoordinated monetary policy and regulatory arbitrage.

Cross-border leveraging flow systems of the kind I have illustrated above are the storms and hurricanes of the financial system. We ignore them at our peril.

Related reading:

When the Nile floods fail
European banks and the global banking glut - Pieria
Currency wars and the fall of empires - Pieria

* I should emphasise that this diagram ONLY shows the Eurodollar flow. European banks were not the only purchasers of US RMBS and derivative products.

Friday, 24 October 2014

Bulgarian Stalemate

The latest in the Bulgarian bank saga. The audit report on Corporate Commercial Bank is out. It's very grim reading, but does that mean the bank will be closed down? Not necessarily.....

Find out more here. (Forbes)

Wednesday, 22 October 2014

Hypo Alpe Adria: the small bank at the centre of some very big storms

Two posts that centre on the troubled Austrian bank Hypo Alpe Adria. For a small bank in a small country, it is causing an AWFUL lot of trouble.

Firstly, the ongoing saga of HAA's Balkan network, which the Austrian government is attempting to sell. As the bidding enters its final stages, it becomes apparent that the eventual owner will be determined more by politics than money:
The present tension between the EU and Russia creates a difficult dilemma for the Austrian authorities. On the one hand, they should get the best deal for Austrian taxpayers, which would imply that they should accept the higher bid even though it involves a sanctioned Russian bank. On the other hand, allowing a sanctioned Russian bank to buy financial companies in the Balkans would seem contrary to the spirit if not the letter of EU sanctions....
Despite my earlier warning, a consortium backed by a sanctioned Russian bank is still in the running to buy HAA's Balkan network. Read about it here

Secondly, there is the little problem of HAA's subordinated debt and those Carinthian guarantees, about which I have previously written. Let the lawsuits begin! Oh wait, they already have:
So we now have two BayernLB-HAA lawsuits, not one: a petition to the Austrian Constitutional Court regarding the expropriation of 800m Euros of Carinthian-guaranteed loans, and a case in the Munich District Court regarding the non-payment of about 1.5bn Euros. Together, these amounts make up the 2.35bn Euros BayernLB was seeking to recover in the earlier lawsuit.
But BayernLB isn't the only actor in this drama. Dear me, no. We have the World Bank involved in a pari passu saga that could rival Argentina, a lovely spat between Germany and the EU over state aid rules, and the possibility that Germany may have to throw BayernLB to the Austrian wolves in order to recapitalize other Landesbanken after the ECB's stress tests. All documented in my latest post at Forbes.

Friday, 17 October 2014

European banks and the global banking glut

My latest post at Pieria considers the sizeable role of the Eurodollar market in the unsustainable growth of credit that led to the 2007-8 financial crisis. 
In a lecture presented at the 2011 IMF Annual Research Conference, Hyun Song Shin of Princeton University argued that the driver of the 2007-8 financial crisis was not a global saving glut so much as a global banking glut. He highlighted the role of the European banks in inflating the credit bubble that abruptly burst at the height of the crisis, causing a string of failures of banks and other financial institutions, and economic distress around the globe. European banks borrowed large amounts of US dollars through the money markets and invested them in US asset-backed securities via the US's shadow banking system. In effect, they acted as if they were US banks, but in Europe and therefore beyond the reach of US bank regulation......
What was it that drove the expansion of the Eurodollar market and encouraged European banks to leverage up with US mortgage-backed securities?

Read the post here.

Sunday, 12 October 2014

Rochester & Strood: it's not about UKIP

 Rochester High Street. The shop that has become UKIP's campaign HQ is (appropriately) on the far right-hand side. Photo: Mabbs

This is not my usual sort of post. It is overtly political, completely biased and very angry. I can no longer simply comment dispassionately upon dysfunctional UK political parties and rapacious sensation-seeking media. They have come to my home town and are intent on destroying it. 

The decision by UKIP to set up their campaign in a quaint building on Rochester High Street was calculated to attract the maximum media attention. Surrounded by Dickensian shops and olde-worlde buildings, and within walking distance of a picturesque ruined castle and a lovely Norman cathedral, it was photographers' heaven. And the BBC fell for it. Every report so far on the Rochester & Strood by-election campaign has used either Rochester High Street or Rochester Castle as a backdrop. Well, the Castle is beautiful:

Rochester Castle. Photo: Survation

The result is that the media are giving the impression that Rochester & Strood is a an affluent upper-middle-class area similar to Windsor. And indeed, central Rochester, with its big houses, its expensive restaurants and its private schools, is exactly that. But the rest of the Rochester & Strood constituency is very different. Strood, on the other side of the Medway, is far poorer, as is evident from these pictures of Strood that I took today.

This picture is looking towards Rochester Bridge from Angel Corner. If you are wondering why "Angel", it is because there used to be a pub on the corner called the Angel. It is now an estate agent.

This picture is looking from Angel Corner east towards Frindsbury. On the right is the entrance to the new Aldi superstore. On the left is the entrance to Asda's car park. A quarter of a mile away is the largest Morrison's superstore in the South East, plus a sizeable Tesco. On the high street is an Iceland and a Wilkinson. Strood is, to be frank, Supermarket City.  Or Closed Pub City. Yes, that is a closed pub - one of many in this area. Supermarkets selling cheap booze have crowded out pubs. 

You can't see them in these photographs, but Strood also has a very good Asian supermarket, several Asian restaurants of various kinds and a lovely sari shop. It is, you see, ethnically diverse. I wonder if Mr Farage knows this?

But Strood itself is no more typical of the Rochester & Strood constituency than Rochester. By far the largest part of the Rochester & Strood constituency looks like this:

This is farmland on the Hoo Peninsula. The Rochester & Strood constituency is really very rural. Admittedly, the rural areas of this constituency have far fewer voters than the towns. But they extend a very long way. Rochester & Strood constituency covers a large area.

The villages are very different from the towns. Here's the centre of Hoo St. Werbergh, one of the larger villages:

And this is the little village of All Hallows, that would have disappeared under one of the runways of either the Cliffe or the Grain airport proposals:

You can just about see the weather vane on top of the little church. Some of these village churches have been converted into dwellings, like this one at St. Mary Hoo, just visible in the distance across the farmland in this picture:

Village churches aren't all Church of England, either. This, in Lower Stoke, is a Methodist chapel:

Nonconformist chapels can also be found in Strood and Frindsbury.

But although the area is very rural, it has an industrial dimension. This is the Isle of Grain:

More oil and gas than grain production these days. And the surrounding area is marshland. The northern tips of the Isle of Grain and the Hoo peninsula border the Thames estuary and are home  to thousands of wading birds. There are several nature reserves and bird sanctuaries in this area. How anyone ever thought building a major airport here was a good idea is beyond me. Birds are fatal to jet engines.

There is still a working power station at Grain - it's the building with the high chimney in the picture above. But until recently there was also a working power station at Kingsnorth, near Hoo St. Werburgh. You can see it at the right hand side of this photograph, taken from Grain:

Kingsnorth was a dirty coal-fired power station which was closed down in 2012 and is now being demolished. Nigel Farage complained today that it was closed down "by EU edict". Indeed it was. But he only tells part of the story. Plans by Kingsnorth's owners E.ON to extend it met with opposition from environmental campaigners, wildlife campaigners and even from Christian Aid and the World Development Movement. It was environmentally unsound. The Hoo peninsula may need jobs, but not that badly. Anyway, where were Mr. Farage's objections when first the Cliffe then the Grain airport proposals were ruled out, at least partly on environmental grounds? They would have brought far more jobs to the area - but the EU was not involved in the decision. Hmm. Special pleading by Mr. Farage, it seems.

If he really wants to complain about something, he could do worse than complain about the behaviour of the Army. This is the former Army village of Chattenden:

And this is what the Army left behind:

They also left this - the Lodge Hill Camp. It is part of a large area of former Defence estates enveloping Chattenden. The whole area is earmarked for 5000 dwellings, which will engulf and swamp Chattenden - a massive distortion to a tiny village in a very rural area. It amounts to a new town on the Hoo Peninsula. This is possible because 1) the area is not greenbelt 2) as these are ex-Defence lands they are brownfield, not greenfield.

I suspect the reason why this area is scheduled for so many dwellings is the fact that it is within easy commuting reach of London (since HS1 now goes through Strood station, cutting the journey time to London to 35 minutes from over an hour) AND is not greenbelt. Just about everywhere else that is both undeveloped and less than an hour from London is greenbelt. It's obvious, really. Just cover the entire Strood area and most of the Hoo Peninsula with houses. Instantly relieve London housing pressure without encroaching on greenbelt. Now the airport proposal has been dropped (again), there is no further obstacle to this - is there?

Well, there is. The same people who opposed the Grain and Cliffe airports and the extension of Kingsnorth also oppose carpet housebuilding. The Lodge Hill development, in particular, encompasses several environmentally sensitive areas. I would argue that its rural nature is also socially important, at least to the people who live there. Do they really want this turned into another commuter suburb of London?

I don't know what UKIP think they can offer the people of Strood and the Hoo peninsula. Most of the issues that affect us have more to do with London than the EU. When the Conservatives rang me the other day, they asked me what I thought were the three biggest local issues. My answers were:
  • The NHS. Medway Hospital is in special measures, and well deserved. It's a disaster. Among other things, it nearly killed my mother with a morphine overdose last year.
  • Overdevelopment. I have no objection to a reasonable number of houses being built locally. But it is not ok to relieve London housing pressure by dumping people here in their thousands, placing strain on local services and destroying the character of the area, simply to preserve those areas that have been designated as greenbelt. Apart from anything else, such a strategy will push up house prices here (historically they have been well below the South East average) pricing our young people out.
  • Local jobs. This area has a tradition of agriculture and small business. If it is to avoid becoming simply a large commuter ghost town, we need local jobs. We need to encourage businesses to take root and grow here.
So I challenge ALL the parties in this by-election. What can you offer the people of Strood and the Hoo Peninsula? How will you address our concerns?

And I challenge the media, too. This by-election is not about UKIP versus the Conservatives. It is about the people of Rochester & Strood. It is about our lives and our future. Do some proper journalism, for goodness sake, rather than feeding UKIP the publicity they crave. Find out what this place is really like. Talk to real people, not just the well-heeled folk of Rochester but the Asian community of Strood, the small businesspeople, the farmers out in the rural areas. Find out what people are really concerned about - and talk about that, not about Nigel Farage's hopes of world domination or David Cameron's worries about re-election. They don't matter. We do.

Friday, 10 October 2014


The resounding victory of Douglas Carswell in the Clacton by-election has caused something of a stir. Carswell, formerly a Conservative MP, resigned his seat after defecting to the UK Independence Party (UKIP), then stood as UKIP's candidate in the ensuing by-election. His success at the polls gained UKIP their first Westminster seat. 

It is far from clear how much of Carswell's victory was due to his personal popularity - by all accounts he had 15,000 personal pledges of support - and how much was due to support for UKIP. But another by-election on the same day, in the Heywood & Middleton constituency in Rochdale, suggests that rising support for UKIP, or perhaps more accurately falling support for the main parties, might have been a considerable factor. In Heywood & Middleton, Labour barely scraped back in. They won with a margin of only 617 votes - with UKIP in second place. Both the Conservatives and Lib Dems were trounced.

Meanwhile, across the Thames from Clacton, the constituency of Rochester & Strood - where I live - is preparing for its own by-election after the defection of Mark Reckless to UKIP. Like Carswell, Reckless has resigned his Westminster seat and is standing for UKIP in the by-election: the candidate selected by UKIP to stand in the 2015 general election, Dr. Mark Hanson, generously stood aside to make way for Reckless. Reckless does not have the personal popularity of Carswell, but North Kent is among the most Eurosceptic places in Britain:

(heat map h/t @MineForNothing)
It is therefore quite possible that Reckless will win. A recent Survation poll showed UKIP support up by 40% at the expense of the other main parties;
The local Conservatives in Rochester & Strood are worried. They are already on the campaign trail. Yesterday, they rang me. Ostensibly this was to find out about the local and national issues that most concerned me, but really it was to find out my voting intentions both for this by-election and for the general election.  I refused to be drawn on my voting intentions for the main parties. But I did say I would not be voting for UKIP. And in this post, I want to explain why.

Firstly, let me make it clear that my refusal to vote for UKIP does not indicate support for the main parties. I am unimpressed with all of them, and utterly sick of the deficit mania that is gripping politicians and media. The Conservatives need to realise that their figures don't add up: the Liberal Democrats need to be reminded that the deficit is not the economy: and Ed Balls needs to remember that he once knew some economics.  The tax and spending proposals of all three parties demonstrate either total ignorance of the reasons why the UK's fiscal deficit is not reducing as planned, or - more likely - wilful ignoring of the truth for political reasons.

Gavin Kelly of the Resolution Foundation, a rare voice of sanity, reminds us that what politicians say before an election and what they do afterwards are often - thankfully - very different things:
 And let’s not forget that fiscal timetables tend to be malleable. Regardless of anything that gets pledged pre-election, don’t be surprised if greater pragmatism emerges afterwards.
And he suggests that the bleak picture painted by all three parties in response to the deficit panic may, after the election, give way to something rather rosier:
It’s possible to sketch out a picture of the next Parliament that is less gruesome than we might think. Steady, job-rich GDP growth. The eventual resumption of pay rises as unemployment continues to fall. A very slow and gradual path of interest rate increases following rises in living standards, assisted by stable inflation and a housing market tamed by tougher regulation rather than the need for higher mortgage rates. And a timetable for chipping away at the deficit that extends over the parliament.
I'd buy that. But sadly no party is offering it. Until one of them does, I am firmly on the fence. For the first time in my adult life, I am faced with the prospect of being disenfranchised at the forthcoming election because I cannot agree with the policies of any of the main political parties.

And this brings me to UKIP. Many people are fleeing to UKIP (and to a lesser extent the Greens) because they reject the policies of the main political parties. But this is like a rebound relationship: it is founded on disappointment in old love rather than discovery of new love. Many of them would return to the main parties if the policies were changed. The problem is HOW they would need to be changed in order to attract them back.

One of the less welcome effects of prolonged economic difficulties is the rise of nationalism. We are seeing it all across Europe at the moment. You would think it would be most prevalent in the most deeply depressed countries. But that's not the case. The most vociferous nationalist movements are actually in countries that are not (yet) depressed. And this is because people resort to nationalism as a way of hanging on to what they have when they feel it is under threat.

UKIP is a nationalist party. It appeals to people who want "Britain for the British". People who, like my partner, resent the fact that national utilities and large businesses are owned by "foreigners". People who, like the friend who came to see me yesterday, believe that people are coming into this country to freeload on the NHS (but forget about the Club Med Britons, many of them elderly, who "freeload" on the health services of Southern European countries). People who believe that immigrants are costing the country money in benefits, when in fact immigrants are net contributors to the fiscal purse. People who believe that we should "shut the doors" to prevent "foreigners" coming in, taking our jobs and our houses, sponging off our benefits and our health service, breeding like rabbits and crowding out the "indigenous British". Where I live, a lot of people think like this. And since the financial crisis, more people have turned to this sort of nationalistic thinking. UKIP's message is reassuring for people who feel threatened: "This country is ours and we aren't going to share it with anyone".  I sympathise, but I believe they are wrong.
Balkanisation doesn't create prosperity (if you don't believe this, just look at the Balkan economies). Sharing is what makes the world prosperous. Immigration benefits both the immigrants and the country that receives them: it may also benefit the sending country, if migrants remit funds to their families left behind. It is an effective way of improving the prosperity of everyone. The UK's high immigration level has, on balance, benefited it. Yes, there are always people who lose out: it is no accident that the most anti-immigration parts of the UK are areas with high unemployment and areas where local services have been put under strain by high levels of immigration. But this is a matter for fiscal policy to resolve. It is not a reason to close the doors.

UKIP is not only anti-immigration, it is also anti-EU. But membership of the EU has, on balance, benefited the UK. Just as I felt the Scots were wrong to seek to leave a successful union, I feel equally strongly that Britain would be wrong to leave the EU, even though by many measures it is less successful a union than the UK and is seriously threatened by the sheer idiocy of European politicians. The EU needs reform, not rejection. The UK has been instrumental in reforming the EU before and it can, and in my view should, do it again. Counting ourselves out, when we have such extensive trade and business links with the rest of the EU, would be madness.

In any sharing arrangement, however mutually beneficial, people tend to notice what they have to give up more than what they gain. When times are good, they tolerate this, though they may grumble. But when times are hard, people become resentful of giving up to others what they consider to be rightfully theirs. And they start to blame those others for their current difficulties. This is what drives nationalism. At its extreme, it destroys families, friendships and communities. It sets neighbour against neighbour, community against community, country against country. It is fundamentally destructive and it should be resisted, not welcomed.

This is why I will not vote for UKIP.

Wednesday, 8 October 2014

QE has (nearly) ended, but how will the Fed unwind it?

This post is about the US, obviously - though the same considerations apply in the UK as well.
The Fed’s large-scale asset purchases (LSAPs, popularly known as QE) have been tapering off for some time now and are expected to end this month. But even though the Fed won’t be making any new purchases, it will still have the largest balance sheet in history. All the securities it has purchased in three rounds of QE and Operation Twist are sitting on its balance sheet. And the banking system is awash with the excess reserves created as a consequence of those purchases.

It is clear now that monetary base creation on this scale does not cause runaway inflation, as was feared by many. And it does appear to have prevented the US from experiencing severe deflation in the aftermath of the financial crisis. But as the US economy recovers, the question arises whether the Fed should start shrinking its balance sheet – unwinding QE.
So should it unwind QE, and if so - how?

Read on here.