Friday, 25 July 2014

No, it's not party time yet

It seems the UK is something of a poster child for economic recovery. The ONS reports that GDP has grown by 0.8% in Q2 and by 3.1% since Q2 2013. This is a pretty solid performance. And it's an important milestone, too: the UK's GDP is now back to its pre-crisis peak.

And the UK has become one of the few bright spots in the IMF's generally gloomy forecast for world growth. Upgrading the UK's growth forecast to 3.2% by the end of the year, the IMF said that the UK would maintain its position as one of the world's fastest-growing economies.

Predictably, the Coalition government and its supporters claimed this as success. George Osborne tweeted that the IMF's upgrade showed his economic plans were working:

And Matthew Holehouse,  political correspondent of The Telegraph, describes the IMF's upgrade as "a vindication of George Osborne's economic plan".

This frankly is stretching things WAY too far. This chart from Ben Chu of the Independent places the UK's economic performance in its G7 context:

How on earth is the second slowest recovery in the G7 "vindication" of George Osborne's policies? And it's not just because the UK had a very deep recession, either. Japan - yes, you know, that country we like to think is in an eternal slump - had a deeper contraction but has recovered faster despite the tsunami and Fukushima disaster. And Germany, whose contraction was nearly as deep as the UK's, exceeded its 2008 GDP peak in Q1 2011.

In fact this chart shows clearly the derailing of the UK's recovery in 2010 just after the Coalition came to power. Note that this is BEFORE the Eurozone crisis hit in 2011: the Eurozone crisis must have affected the UK economy, but it isn't a sufficient explanation. I've also argued that high energy prices explain quite a bit of the evident slowdown from late 2010 onwards. But it is hard not to conclude, as Simon Wren-Lewis and others do, that fiscal austerity delayed the UK's recovery. Far from a vindication of the Coalition's policies, the fact that the UK is only just back to its 2008 peak after four years of Osbornomics is quite an indictment. Whatever the reason, Osborne has actually presided over the slowest recovery since the Second World War:

And it is also far too soon to celebrate recovery. There is still a long way to go: wages are still falling in real terms, business investment is still weak and the UK's external position is poor. GDP may be back to its pre-crisis peak, but GDP per capita is still some distance below (thanks to FT Alphaville for this chart):

Best keep the lid on the bubbly for a bit longer.

Related reading:

Britain's long, weird recovery in 13 charts - FT Alphaville

The stocks and the flows

There have been calls for interest rate rises to discourage risky new lending. But the Resolution Foundation shows that it is the stock of existing debt that is the real problem. Household debt still stands at over 90% of GDP, and many of these households already have difficulty paying their mortgages: there is a real risk that raising interest rates would make their debts unaffordable, forcing them into default and the economy into recession. The Resolution Foundation has important recommendations for policy makers to reduce the risks of interest rate rises. But they don't go quite far enough....

Find out more here. (Pieria)

Wednesday, 23 July 2014

QE is fiscal policy

A new paper by Johnston and Pugh of the legal department of the University of Sheffield discusses the legality and the effectiveness of QE and its relatives, including the ECB's OMT "whatever it takes" promise.

The background to this is the German Constitutional Court's ruling that OMT amounts to monetary financing of government deficits and is therefore unlawful. Although the European Court of Justice is still to give its judgment in this matter - and is widely expected to dissent - the ECB is evidently doing its best to avoid outright QE, quite possibly because of questions over its legitimacy. The ECB has stated that in its opinion QE is legal, but then it said that about OMT too. The truth is that it is by no means clear that QE is legal in the Eurozone.

So the University of Sheffield's legal eagles have had a good look at the legality of both OMT and QE with respect to the Lisbon Treaty. And they concur with the German Constitutional Court. OMT does indeed amount to monetary financing of governments. So does QE. Both are therefore illegal under Article 123 of the Lisbon Treaty.

Article 123 of the Lisbon Treaty reads thus:

1. Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.

2. Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the European Central Bank as private credit institutions.

The UK has a specific restriction on the applicability of Paragraph 1 to allow it to continue to use the Treasury's existing "ways and means" overdraft facility at the Bank of England:

10. Notwithstanding Article 123 of the Treaty on the Functioning of the European Union and Article 21.1 of the Statute, the Government of the United Kingdom may maintain its ‘ways and means' facility with the Bank of England if and so long as the United Kingdom does not adopt the euro.

But in the view of Johnston & Pugh this does not exclude the UK from the GENERAL prohibition of monetary financing of fiscal deficits in Article 123. The "ways and means" overdraft was last used in 2008 at the height of the financial crisis: that borrowing has since been repaid and the UK has no current plans to use this overdraft facility. The question is therefore whether the Bank of England's QE programme has breached the prohibition of monetary financing to which the UK is subject as a signatory to the Lisbon Treaty. The Sheffield researchers think it has.

The reasons are not straightforward. Central bank purchases of own-government debt in the capital markets are not prohibited under the Lisbon treaty. Indeed they cannot be, because that would prohibit the main mechanism that EU central banks have historically used to control inflation, namely open market operations (sales & purchases of government debt) to maintain interest rates at a target level. This mechanism is currently in abeyance because of the presence of excess reserves in the banking system, but that does not mean it will never be used again in the future. QE also involves secondary market purchases of government debt. It is therefore easy to see QE as simply open market operations on a much larger scale. But the researchers argue that this is a misunderstanding of the nature and purpose of QE.

When government debt is purchased in a QE programme, the purpose is to control the market price of that debt. From the time that QE is announced until it is ended, the central bank effectively sets a floor on the price of government debt. This applies in both limited QE programmes, such as the Bank of England's, and unlimited, such as those in the US, Japan and Switzerland.

Forcing governments to fund themselves in the capital markets rather than obtaining funding from the central bank is supposed to ensure fiscal discipline. If governments over-spend, the thinking goes, capital markets will push up the cost of borrowing, forcing them to cut back spending and/or raise taxes. But if the central bank sets the price of government debt and stands ready to buy it in unlimited quantities, there is no discipline on the government. It can issue as much debt as it likes in the certain knowledge that there will always be a buyer. There cannot be a "buyer's strike" causing the price of debt to crash and yields to spike, as happened in Greece.

And this applies whether or not the central bank is actively purchasing securities. OMT has never been used - but its effect has been to force down yields on Italian and Spanish bonds, allowing their governments to maintain high debt/dgp levels without fear of default. There is no question but that the ECB did this to preserve the Euro. But it has undoubtedly also benefited the governments of those countries.

This is why the authors argue that QE is monetary financing of government deficits even though purchases are made from investors and banks, not directly from governments. QE amounts to an unlimited central bank credit facility. It is not the prohibition of government purchases that would be breached in an ECB QE programme, it is the prohibition of overdrafts and credit lines to governments.

And this raises a further issue. There has been huge debate about exactly how QE reflates the economy, though none of the explanations offered by economists and central banks have been conclusive: it has been claimed that QE influences the economy through portfolio effects (but substituting one safe asset for another doesn't have any effect on aggregate demand), suppression of the term premium (but it's probably very low anyway), increased liquidity in financial markets (doubtful, because QE contributes to collateral scarcity), increased bank lending (bank lending has been stagnant or falling), increased corporate investment (share buy-backs due to low borrowing costs are not investment). Most people agree that QE does support asset prices in a crisis, but its effectiveness as a long-term economic stimulus is questionable.

But the implication of Johnston & Pugh's work is that we have fundamentally misjudged the nature of QE. It has monetary effects, yes, but it is in reality a fiscal tool. It uses the central bank's ability to control market prices to enable governments to borrow and spend. This is why QE only works when the fiscal stance is expansionary. When the fiscal stance is contractionary - as it has been in most developed countries to varying degrees since 2010 - QE is ineffective.

Regarding QE as an enabler for fiscal expansion may explain a puzzle. Japan has by far the highest debt/gdp in the world, but it has very low borrowing costs. This can partly be explained by the fact that the Japanese are diligent savers, and much of their savings is held in the form of government debt: it could also perhaps be explained by the fact that investors are creatures of habit, retreating into traditional safe havens such as Japanese yen and JGBs when things get rough. But Japan has also been doing QE for far longer than any other country. Could the central bank's historical willingness to intervene in markets to control the price of Japanese debt be the reason why the JGB yield remains so low despite very high debt/gdp and poor economic growth?

But QE is also highly regressive. Doing fiscal expansion by the back door in this way virtually ensures that the money created does not go where it would have the most effect - it goes to those who least need it. The biggest beneficiaries of QE programmes are the rich, the value of whose assets rises when central banks intervene in this way - not just because the price of government debt rises, but because the price of other assets rises too due to substitution effects and the "reach for yield".

When government uses the central bank's suppression of bond yields as an opportunity to lock in low borrowing rates for the future and fund a fiscal expansion programme, then QE can be highly effective. But when governments fail to take advantage of central bank price control, QE can only benefit the economy through monetary channels which are both morally dubious and of questionable effectiveness. And when governments use QE as a cover for ill-considered fiscal austerity, QE actually transfers wealth from the poor to the rich. The weak monetary effects of QE might offset this effect to some extent, but the idea that QE can entirely negate the harmful effects of fiscal tightening in an economic downturn is not supported by the evidence. "Monetary offset" is a very nasty joke.

Johnston & Pugh's conclusion is damning:
In this paper, we have seen that, whilst QE can be argued to amount in substance to monetary finance, it is likely that the courts would not rule it unlawful. However, if a central bank did not offer justifications couched in monetary policy terms, there would be a much more serious risk of the intervention falling foul of Art 123 TFEU. The law’s emphasis on justifications and deference to central banks may not be surprising, but it does mean that there is scope for monetary finance so long as nobody admits that that is what is happening. It also means that arguably, monetary policy is outside the rule of law. It would be better for everybody if the debate was more open. 
So QE and OMT are illegal under EU treaties, but for political reasons no-one will ever admit that. This is the reason for the entirely artificial separation of monetary and fiscal policy, the monetary justifications for QE, the pretence that central banks are independent, and the charade of "fiscal discipline". The central bank must monetize debt, because the alternative is sovereign debt default and collapse of the currency: but if the central bank loses credibility, the currency is junk.

There is an elaborate charade whose sole objective is preserving the central bank's credibility. When central banks are monetizing government debt, it is the electorate, not the market, that controls the fiscal authority's propensity to borrow and spend. But if an elected government blatantly uses central bank debt monetization as an excuse for high borrowing and spending, the credibility of the central bank is toast. So everyone has to pretend that QE and its relatives don't fund the government, and politicians and voters have to be persuaded that restricting government's ability to borrow and spend is in their interests. The inflation monster is routinely invoked to terrify electorates into voting for austerity-minded politicians, and if that isn't enough, then the bond vigilantes and public debt bogeymen are called in too. And it works: not only have voters across Europe apparently been convinced that fiscal austerity is necessary even when it is clearly harming their economies, they have also been convinced that elected governments can't be trusted to manage public finances responsibly and must be restrained by unelected, unaccountable bureaucrats with their own political agendas. What an appalling erosion of democracy.

But debt monetization should not have to be a back-door exercise. In their concluding paragraphs, Johnston & Pugh call for an open debate about carefully considered outright monetization to end the disastrous austerity/debt deflation/higher debt/more austerity spiral in the Eurozone:
We have serious doubts about the efficacy of QE as a means to reflating the economy in the aftermath of a debt deflation.....Increased fiscal spending by governments would be more likely to be effective, but is currently ruled out by a belief that governments must pursue austerity in order for their countries to escape the crisis. We agree with Adair Turner that the time has come for a meaningful discussion about whether monetary finance offers a better way out of the current economic malaise, and if so, what form that monetary finance should take.
I have considerable sympathy for their argument, certainly for the depressed Eurozone periphery countries. Outright monetization is prohibited because of the fear of Weimar-style hyperinflation: but as I've explained before, hyperinflation is always and everywhere a consequence of political chaos and loss of trust. Provided that central bank credibility is maintained throughout, outright monetization of excessive legacy government debt burdens does not have to mean hyperinflation. There is still a need for fiscal discipline and structural reform going forward to ensure that debt, once relieved, does not build up again. But a one-off monetization of the debt burdens of the Eurozone periphery would do much to help Europe out of its seemingly endless slump.

Related reading:

Sacred cows and the demand for money
QE myths and the Expectations Fairy
Inflation, deflation and QE
Slaying the inflation monster
Rethinking the monetization taboo - Adair Turner
Have central banks been breaking the law? - Telegraph

Monday, 21 July 2014

The not-so-new (but very uncertain) neutral

My latest post at Pieria considers the likely future path of interest rates and central bank reaction functions. History shows that central banks delay raising interest rates for too long after a recession, then panic and raise them too much, causing another one. Will they do this again? Probably....

Read the whole post here.

FOMC meeting. Photo credit: Wikipedia

The clash of micro and macro

As I said in a recent blogpost, failing to provide microfoundations for a macroeconomic argument doesn't make the macroeconomics wrong. Conversely, providing lots of lovely microeconomic detail - right down to the "I met a man" level - does not necessarily add up to a convincing macroeconomic argument. 

So here is Chris Dillow taking Tim Montgomerie to task for claiming that the UK's remarkable employment performance is due to the Coalition government's welfare reforms. Montgomerie isn't the only one making this claim: Fraser Nelson does so too in more detail, in an op-ed in the Telegraph. Both Tim and Fraser say that the Coalition's welfare reforms, by forcing lots more people into work, have somehow created a massive jobs boom. Say's Law, applied to labour markets? Hmm. Maybe I'm a bit fonder of microfoundations than I thought. I want to know where these workers really come from - the increase looks too much to be entirely due to benefit reforms. And I want a proper explanation of the jobs boom. Simply saying "there are more workers, therefore there are more jobs" doesn't do it for me. 

Here is Giles Wilkes providing a pretty good explanation for the increase in workers. No, it isn't just benefit reforms. A quarter of a million or so pensioners have returned to the labour market, for starters - and no-one is suggesting that benefit cuts are forcing them back to work (though the Bank of England might be).  Tax changes have improved incentives to work at the margin, which would draw some people into the workforce. Tax credit changes have forced some people to work longer hours in order to qualify. And above all, the squeeze on living standards caused by falling real incomes in recent years, on top of a horrible shock to both incomes and wealth, has forced people who weren't working to do so and part-timers to increase their hours. 

But what about that increase in jobs? Well, Giles says that as the supply of labour increases, we would expect its price to fall, encouraging employers to create more jobs at lower wages. And as Chris points out, the effect of pushing people into work by making life on benefits either impossible or totally miserable is to force down wages. I know I have said this many times already, but it's worth repeating it. Workfare depresses wages not just for those being forced to earn their benefits, but for everyone. So it may be that making life on benefits more miserable does increase jobs, but at the cost of lower wages. And the re-entry to the workforce of people who have a basic income (pensioners, married women with children) is also likely to depress wages, since these people don't usually face the benefit withdrawal trap that forces people to choose between benefits and employment, so can afford to take lower-paid work.

So to paraphrase Chris's conclusion: if welfare reform significantly increases the supply of labour, and all that labour can be productively employed, then in the absence of strong economic growth, welfare reform depresses wages - which might not be the message the Conservatives really want to give. They would do better to point to improving economic conditions as the principal driver of rising employment. Despite Fraser's claim that Coalition welfare reforms are popular, the macro argument seems more likely to win votes than the micro policies.

But Simon Cooke nevertheless criticises Chris Dillow for ignoring the human stories underlying rising employment. To him, the macro argument that improving economic conditions and/or falling wages are the primary cause of rising employment implies that micro policies aimed at helping individuals into work are a waste of time and money. And he disputes this, using as examples some of the real human stories that he has encountered in his work as a local politician. I don't think many people would disagree with his conclusion: getting the long-term unemployed into work is indeed hard, not least because of the barriers that society - often with the best of intentions, such as protecting the public from possibly dangerous ex-cons - puts in their way. We should respect those who devote time and energy to helping these people into work.

But Simon's argument that there is a fundamental disconnect between macro and micro policies does not follow. Chris's macro argument actually supports Simon's micro policies: if economic conditions improve and/or wage levels fall, then helping the most disadvantaged people into work becomes easier. The Work Programme seems to be doing a decent job, though it is much less clear that Help to Work justifies its cost. But it has been greatly hampered by the prolonged economic downturn. As the economy improves, the Work Programme's results will improve too - though admittedly, some of the people it will "help into work" would have found work anyway. Sometimes improving economic conditions really is all that is needed.

The Coalition has rightly been criticised for trying to force people to work who were not able to do so, for completely fouling up the administration of the fitness to work tests, and for some frankly pointless and even harmful policies (the "bedroom tax" springs to mind). But the biggest problem is that they tried to do all of this at a time when economic conditions were utterly unhelpful. If Giles is right, then the changes intended to "make work pay" (tax changes as well as benefit reforms) have actually pushed down wages and made life harder not just for the thousands who were forced into work, but for millions. That is quite an indictment of a government.

Saturday, 19 July 2014

U.S. sanctions on Russia are financial warfare

At Forbes:
On June 17, the US announced further sanctions against Russia because of its support for rebels in the Ukrainian civil war. The new sanctions are widely considered to be tough. But they are also difficult to understand. The extent of their legal and practical application is by no means clear. Yet – they are very clever. However they are interpreted, they are bad news for Russia.
Find out here how they should be interpreted and why they amount to financial warfare.

Thursday, 17 July 2014

Espirito Santo: complexity, opacity and moral hazard

There is absolutely nothing holy or spiritual about Portugal's Espirito Santo Group. It's a complex, opaque structure much of which is incorporated in a tax haven and part of which is suspected of fraud. It's impossible to regulate and some of the funding relationships are distinctly odd. And it includes a bank. Moral hazard de luxe. 

But haven't we seen this before? Oh yes. Read about it here