Tuesday, 30 September 2014

Debt hysteria

I have been reading the Geneva 16 report, which came out yesterday. It's scary stuff. If you thought the world was reducing its debt pile - forget it:

The debt is still growing, but the world's GDP growth is slowing. Indeed as aggregate debt figures are usually quoted versus GDP, the two are connected. The debt pile grows faster as growth slows, simply because the denominator is falling.

The report looks at total debt/GDP - not just sovereign debt. This is refreshing: unrelenting media focus on sovereign debt as the principal problem misses the fact that in many countries the bigger burden is PRIVATE debt. However, it makes the figures even worse. Global debt, it seems, is a terrible problem.

None of this will come as a surprise to anyone, except perhaps the news that the world as a whole is actually accumulating debt rather than deleveraging. The deleveraging efforts by developed countries are being more than offset by the increasing debt of emerging markets, particularly China.

But as I read the report, I found myself wondering why there was no discussion of the other side of all this. Who are the owners of all this debt?

There is a simple answer to this. Households and corporations own this debt. It is the savings of households and the uninvested profits of corporations. Since the financial crisis, developed-country governments also own some of this debt, via their central banks. And in emerging markets, where  governments, corporations and households can be very closely related, exactly who owns the debt can be unclear.

The global debt glut described in this report, and the global saving glut described by Bernanke, are the same thing. The authors note that growth has been slowing in developed countries since 1980. Indeed it has - and during that time capital ownership and indebtedness have been increasing in tandem, as we might expect since they are opposite sides of the same coin. The report cites numerous analyses that show high debt levels - public AND private sector - tending to impede growth as resources that could have been turned to productive investment are spent on debt service. Secular stagnation is as much a consequence of over-indebtedness as it is of excess capital.

The owners of debt think they have saved prudently and accumulated safe financial assets to insure them against an uncertain future. They believe that their savings are PAST income, stored.  Bonds and bank accounts are simply their own money in another form. How very dare anyone suggest that their hard-earned savings should be lost in order to relieve the debt burden on others? Let the profligate debtors sort out their own problems. Prudent savers must be protected from loss.

But debt assets are not stored past income. They are actually claims on the FUTURE income of other people. When you buy bonds, you are spending, not saving. Your money goes to someone else and you have no right to its return. In return, you receive a promise. In a simple vanilla bond, the promise has two parts:
  • the promise that you will at some point in the future recover a nominal sum of money equal to the amount that you paid for the bond (note that this is not protected against inflation)
  • the promise of a stream of coupon payments that may or may not include compensation for expected inflation
There are huge variations on this theme, but they all boil down to the same thing. You spend money in the present in return for a promise of more money in the future.

The price of the bond is the value of that promise, and it depends on the trustworthiness of the borrower. If the borrower is regarded as trustworthy, the price is high. But if the borrower is regarded as untrustworthy - say they have recently failed to honour a payment promise - the price is low.

Similarly, bank accounts are not "your money, stored". They are a loan to the bank. You give the bank your money in return for a promise of future income (interest payments), and possibly other services such as safe storage and payments. You don't have any right to return of that money: what you have is a promise that if you ask for it back, the bank will honour your request if it can. 

Risk of loss due to default is a intrinsic part of lending. When you lend money - whether by buying bonds, putting money in a bank account, or lending directly to someone - you accept the risk that the borrower will fail either to make the promised payments or return your money. Your judgement of someone's creditworthiness governs the amount you will charge them for this risk: the interest rate on an unsecured loan to someone with a good credit history is typically far lower than on a loan to someone with a recent history of payment default. A good credit history is a very valuable intangible asset for a borrower. Destruction of trustworthiness as a result of default amounts to a serious loss of net worth.

You may insure against risk of default by demanding that the borrower pledge some of their assets as surety: this of course what pawnbrokers do, but it is also the foundation of all property lending and most lending in financial markets. A mortgage is a loan on which the lender has the right to seize an associated asset (property) in the event of default. A repurchase agreement (repo) is a loan on which the lender has the right to seize a certain amount of securities in the event of default. Since the financial crisis, secured lending has become far more widespread due to loss of trust. The world runs on pawnbroking.

The problem with this, of course, is that the assets pledged as surety may fall in value, as we saw in the subprime crisis. When this happens, the risk of default may or may not rise, but the risk of losses in the event of default rises. Suddenly the loan or the bond is not worth as much. And insurance policies such as CDS aren't foolproof either: insurers can go bankrupt if there are too many claims, as AIG and the monoline insurers discovered. Nor is deposit insurance wholly trustworthy: Iceland legally defaulted on deposit insurance obligations to overseas customers of its banks. There is no such thing as a completely safe debt asset.

Nevertheless, the world's savings are largely held in the form of the world's debt, and people like to believe that their savings are safe. Because too high a debt burden increases the likelihood of default, many people - including the authors of the Geneva 16 report - think that governments should reduce sovereign debt. There are four principal ways of doing this:
  • by running persistent budget surpluses.
  • by reducing the real value of the debt through inflation
  • by reducing the debt/GDP ratio through higher growth.
  • by outright confiscation of savings (financial repression)
The authors dismiss the third of these as there is no evidence that higher growth can eliminate a persistent debt overhang. Historically, they note, the second (inflation) has most frequently been used to reduce post-war sovereign debt burdens, often in combination with the fourth (financial repression). The first is the preferred choice of governments such as Germany and the UK, but in practice running sustained budget surpluses is extraordinarily difficult to do and arguably pointless if the private sector is also highly indebted.

For a government to run a persistent budget surplus requires that it takes in tax more than it spends. In the absence of a trade surplus, this means extracting money from the domestic private sector, which understandably does not want to give it up.* Running a sustained budget surplus when there is a trade deficit amounts to financial repression. But even if there is a trade surplus, a government surplus means lower saving for the private sector than it might desire. The Geneva 16 report points to substantial debt overhangs in the private sector. When the private sector is highly indebted, saving can take the form of paying off debt. If the government runs a surplus, therefore, it impedes deleveraging in the private sector, and may even force some sectors (typically the poor) to increase debt. Reducing the sovereign debt not only reduces saving in the private sector, it comes at the price of continued and possibly rising indebtedness. The report rightly notes that transferring debt from the private to the public sector, as the US has done, isn't deleveraging. But transferring it back again isn't deleveraging either. And as transferring it back again is likely only to be possible with extensive sovereign guarantees (the UK's Help to Buy, for example), whose debt is it really, anyway?

Reports such as this, that look on debt as a problem and ignore the associated savings, fail to address the real issue. The fact is that households, corporations and governments like to have savings and are terrified of loss. Writing down the debt in which people invest their savings means that people must lose their savings. THIS is the real "shock, horror". This is what people fear when they worry about a catastrophic debt default. This is what the world went to great lengths to prevent in 2008. The problem is not the debt, it is the savings.
If we really wish to reduce the global debt pile, we must either accept that the households, corporations and governments that currently own that debt must take losses, or find alternative investment vehicles. The problem, of course, is that potential replacements are either illiquid (property), risky (equities) or volatile (commodities). 

I don't think that trying to find substitutes among existing asset classes in any way solves the problem of "too much debt". Debt is dysfunctional. It places debtors in a one-down position in relation to creditors and creates moral hazard for both - creditors because they can claim their due even at the price of severe hardship for the other, and debtors because they believe creditors will balk at enforcing the terms of the contract. This dilemma is centuries old: in The Merchant of Venice, Shylock's "pound of flesh" was his rightful due when Antonio defaulted on his loan, but enforcing that right would have killed Antonio and made Shylock a murderer. Shakespeare rightly lampooned such a destructive relationship, but four hundred years later nothing has fundamentally changed: we might not murder defaulters, but we certainly make their lives extremely difficult. We need a fundamentally different way of viewing the investments that households, corporations and governments make.

I think the world is inching its way towards a model that replaces most debt with equity. We have already seen debt for equity swaps in distressed banks. Perhaps we need debt for equity swaps for sovereigns, too. Why not replace USTs with shares in USA Inc.? Let's stop calling it "sovereign debt". It's share capital. It's our collective investment in our own futures.**

Debt for equity swaps are also possible for households that have both assets and debt - an over-mortgaged homeowner, for example. Though I wouldn't want to take this too far. Someone whose net worth is less than their debts cannot offer a debt for equity swap. They are insolvent, and their debt needs to be written off, not restructured. We do not want to see a return of debt peonage. But there are other shared-equity models that could replace current debt-based ones: imagine, for example, well-off elderly sponsoring the tertiary education of young people and mentoring them during their studies and in the early part of their careers. Or, for that matter, young people investing in the care of the elderly in return for a share in their housing wealth.

Clearly there are limits to the equity-savings model: there would still be a role for some debt, and some losses will have to be accepted. But equity is (pardon the pun) a far more equitable investment than debt, since issuers and investors are equally responsible for the success of the investment. Yes, an equity investment is ostensibly higher risk than lending: but haven't we yet learned that the safety of debt is an illusion?

Indeed, is it not time we stopped trying to buy the illusion of safety to comfort ourselves at the expense of others? There is a world of opportunity out there. Let's stop cowering in the dark, get out into the sunshine and sow the seeds of the next Golden Age.

Related reading:

Deleveraging, what deleveraging? - Geneva 16 (CEPR)
The deadly quest for safety
Government debt isn't what you think it is
On risk and safety
The other side of debt

* To show this, here is the familiar sectoral balances equation:

(S-I) = (G-T) + (X-M)

where S = private sector saving, I = private sector investment, G = government spending, T = tax revenues, X = exports and M = imports. S-I is usually positive because not all saving is invested in the private sector: the residual is private sector holdings of government debt and money ("net financial assets"). At the present time, the excess of S over I is considerable.

Let's assume for the moment that trade is balanced, i.e. X-M = 0. It is easy to see that if the government runs a surplus, i.e. G-T < 0, S-I must decrease. In other words, the private sector's overall saving must reduce. If X-M > 0, then clearly S-I may not actually reduce. However, even with a positive trade balance, the government's surplus means lower saving for the private sector than would have been the case with a deficit. Therefore it is fair to say that the government's surplus is confiscation of the private sector's actual or intended savings - i.e. financial repression.

** I have to caveat this proposal. Issuing share capital to replace debt is not a solution to the Eurozone crisis. Since sovereign share capital is really only a version of currency, members of the Eurozone do not have the capacity or the authority to issue shares to replace debt. But there is no federal-level institution that could or would do this either. The denial of the right of sovereigns to issue their own share capital is one of the most poisonous aspects of the Euro project.


Monday, 29 September 2014

George Osborne's message to UK business: Pay People More!

Though I'm not sure that's quite what he meant. And I don't think his audience understood it either. But it's the implication of his latest freeze on working-age benefits.......
"The UK's Conservative Party, like its Labour Party and most of the media, is obsessed with deficit and – ultimately – public debt reduction. Never mind dreadful productivity, falling real incomes, high private sector debt burdens, under-employment and inadequate investment: public sector borrowing is THE economic problem of our time. The deficit is TOO HIGH. Public spending MUST BE CUT. And George is the man to do it.

"Osborne informed the Conservative Party Conference that, if re-elected, he would freeze working-age benefits for two years. Assuming inflation remains positive, this means a real-terms cut in benefits not only for the unemployed, but also for those in work who are receiving a range of benefits including earned-income tax credits, housing benefit and child benefit. It's a further squeeze on real incomes for low- to middle-income earners. This went down very well with his predominantly grey-haired, well-heeled audience, the vast majority of whom would not be affected. Austerity is always popular when it affects somebody else......
Enter the hapless John Cridland of the CBI, who (unintentionally) lifted the lid on what this plan would mean for UK businesses. More than his job's worth to say so, though....

Read on at Forbes. Such fun.


The economics of Ed

Ah, but which Ed?

You'll have to read the post to find out.....it's at Pieria.

All I will say here is that whichever Ed it is, the economics are woeful.

Enjoy. (I did!)



(you don't really want to know who is responsible for these photos, do you?)

Saturday, 27 September 2014

Eastern European risks for Austrian banks

Austrian banks have developed extensive lending networks in Central and Eastern Europe since the fall of the Iron Curtain. Most of them face deteriorating loan books and falling profits due to difficult economic conditions in Central and Eastern Europe, exacerbated by the Ukraine crisis. But none is more exposed than Raffeisenbank....

Read about Raffeisenbank's Eastern European woes here. There's an update on Erste Bank's Hungarian problem, too.

Tuesday, 23 September 2014

Delinquent Banks: Barclays and UBS

By "Delinquent Banks", I mean banks that have been fined and/or prosecuted for regulatory breaches and financial crimes.

Today's Delinquent Banks are Barclays. They are is of course seasoned delinquents, having been fined numerous times for various crimes and regulatory misdemeanors. But then so are all banks of any size.

So what exactly have they done this time?

Read on here.

Financial Conduct Authority building, London. Photo credit: FCA

Monday, 22 September 2014

The Scottish independence saga

I've collected here all my posts in various places on Scotland's quest for independence and related issues. It's quite a story - not least because my own views changed during that time. To start with, I was personally uninvolved: I didn't care whether Scotland stayed or went (though I wanted Nat West back). But as time went on, I became more convinced by the emotional arguments for independence - and less convinced by the economic case. In the end, head ruled heart and I came out in favour of "No". But it's not over yet.....

Scotland's currency conundrum
I was one of the first people to look at the currency question in some detail, in January 2012.  I realised that the currency could not be considered in isolation from other matters such as EU membership and even what "independence" really means in our globally interconnected world. All of those are therefore discussed in this post.

Scotland and the Banks
After the UK political parties ruled out a currency union, I looked at Scotland's remaining alternatives and the consequences for the banks. It was clear that Scotland's banks would have to leave Scotland.
Of Course Scotland Can Use The (Scottish) Pound
In this piece I argued that Scotland should convert its existing Scottish pound into a new Scottish currency.

Is an Independent Scotland Economically Viable? An Exchange
My debate with James Meadway of NEF on the economics of Scottish independence. By this time the banks had announced their intention to re-register in England after independence. The economic case fell apart at that point - though in my view the banks were always going to do that, so the economic case was always fatally flawed.

Independence and Union
My angry piece about the behaviour of both sides of the campaign in the run-up to the vote. And my head versus heart dilemma.

Splitting the Bank
Alex Salmond claimed a share of the Bank of England's assets after independence, including its store of gilts due to QE purchases, apparently with the intention of writing off Scotland's share of UK debt against them. In this post I explained why this would be impossible. (Wonkish).

What Scotland Should Have Done (And Still Should Do)
In this post I explain why the economic case for Scottish independence didn't hang together, and what Scotland now needs to do to make independence possible at some time in the future. 

In three posts (so far), I have also considered the consequences for the United Kingdom of the Scottish vote.

In February 2014 I predicted that a "No" vote would have far-reaching consequences for the UK. 

What next for the United Kingdom?
The promises made by the No campaign to win Scottish votes are already causing the UK to drift towards fundamental constitutional change. 

The English question
Towards a new federal model for the UK.....the case for an English parliament.

This isn't over either. Not by any means. I will add more posts here as I write them.

Sunday, 21 September 2014

The English question

I've just been listening with increasing annoyance to Angela Eagle, deputy leader of the Labour Party, speaking on devolution. She wants to drive down devolution "to the regions and to our major cities". This would of course only apply to England. Scotland already has its own Parliament and Wales and Northern Ireland have Assemblies: further devolution would give these country-level governments more power to manage their own affairs. But if the Labour Party get their way, England will be denied this. England, the largest country in the "group of four" that is the United Kingdom, would be the only country with no government of its own.

England is not just a name, and it certainly isn't just a "collection of regions". I get a little tired of people (mostly Americans, or Celts with chips on their shoulders) telling me that England has no culture and no history except an inglorious one as a failed colonial power. England has well over a thousand years of history as a unified nation: it is one of the most ancient nations of Europe, far older than Germany or Italy. We were all taught at school how Alfred the Great, in the eighth century CE, unified the warring Saxon clans. And although England was subsequently divided after the invasion of the Danes, that split was short-lived and England was reunified even before the invasion of the Normans in 1066 and the establishment of the Plantagenet dynasty. There were some nasty civil wars after that - the standoff between Empress Matilda and King Stephen, and the Plantagenet family dispute known as the "Wars of the Roses". But these never challenged the existence of a country called "England". The argument was always over who should run it.

Yet now, it seems, the Labour party wants to eliminate England. This is understandable: as this map shows, England is overwhelmingly Conservative, and the Labour party would struggle to gain any presence at all in an English parliament:

(map h/t @MarcherLord)

 But the Conservatives have similar problems in Scotland and Wales: they struggle to win any Westminster seats in either country and are in a tiny minority in both the Scottish parliament and the Welsh assembly. Is this a reason for breaking these countries up? Surely not. Neither, therefore, are the Labour party's problems in England a reason to break up an ancient nation.

Calls for England to be regionalised along the lines of historic kingdoms such as Cornwall and Northumbria, or the old Saxon/Viking territories of Wessex, Mercia and so on, are understandable, as is the call for great cities such as London and Manchester to run their own affairs. I don't have a problem with any of this. Devolution to regional and city level WITHIN England is sensible, though it could go too far: regionalising the NHS, for example, would be bonkers, since it would be bound to result in very variable standards of care across the country - already the case to some extent because of the budgetary problems of some NHS Trusts.  But I don't see  regional/city devolution within England as an alternative to the creation of an English parliament. I see it as a decision that an English parliament should be empowered to make. Westminster's job is to create and empower the English parliament, not meddle with the governance of English regions. 

The main objection to an English parliament seems to be the dominance of England at Westminster. This is of course an existing problem, which would become even worse with further devolution to Scotland and Wales. Some people want England regionalised so that there is parity of population among areas represented in what is inevitably going to become a federal parliament. But this is absurd. Scotland has twice the population of Wales, and both have higher populations than Northern Ireland: is anyone suggesting these, too, should be broken up so that Northern Ireland is adequately represented? No, they are not. The integrity of all three of these national governments is to be preserved despite the population imbalances. So it should be with England, too.

It is not England that should be broken up to create a UK federal model of governance. It is Westminster. I think the UK should become a federation of four nations, each with their own elected government, with a separate directly elected federal government. Westminster must undergo radical surgery: the number of MPs must be slashed, and it must become properly representative of the people of the UK. Reforming Westminster would involve regionalisation of the whole UK - not just England - along similar lines to the EU parliament. But the principal of subsidiarity should also apply: Westminster's powers should be limited to those matters that the four countries agree are best handled at federal level.

But I fear the changes to Westminster that this would involve are so great that political vested interests will ensure it never happens. The Labour party's stance is determined only by its worries about losing the 2015 election, while the Conservatives are clearly seeing the "English question" as an opportunity to shaft Labour and get back at the SNP. It's shabby, frankly.

The people of the UK deserve better. We need a proper debate about how we wish to be governed, rather than a package of ill-thought-out measures rushed through ahead of a general election.