Brexit voting patterns, education and geography

Rob Calvert Jump and Jo Michell

We have a “featured graphic” article on Brexit voting patterns and education forthcoming in Environment and Planning A. The electronic version is here, and an ungated pre-print is here.

It is by now well established that education is one of the most statistically important demographic factors in “explaining” the Brexit vote. It also has substantial predictive power. What has not been explored, to our knowledge, is the extent to which educational attainment and geography interact: scatter plots and regressions tell us how variables move together, but they don’t (usually) include information about geographical patterns.

The figure below demonstrates why such information might be important (hi-res version here). The maps show colour-coded Leave vote percentages by local authority. Black outlines denote authorities for which the proportion of the population with less than five GCSEs is below the national average of around 36%. The match between low GCSE attainment and Brexit votes is striking: only 4 of the 85 local authorities that voted Remain had lower than average high school educational attainment: Liverpool, Sefton, the Wirral, and Leicester (researchers have recently speculated that Liverpool’s Remain vote was influenced by the city’s boycott of The Sun) Conversely, there is only a single local authority, North Kesteven in the East Midlands, with better than average educational attainment and a Leave vote share of 60% or higher.

Map of Leave votes and educational attainment

Choropleth map and cartogram hex map of Leave vote share and educational attainment in England and Wales by local authority.

Areas of below-average educational attainment and strong Leave voting show a clear geographical structure: clusters extend from the east coast into Essex and Kent in the south, and into the West Midlands and the north west of England in the north. The correlation does not hold so well in Wales, Cumbria, Northumberland and County Durham, where several local authorities with below-average GCSE attainment returned Leave votes between 50% and 60%.

Simple bivariate correlations like this are of course likely to be confounded by other factors that covary with aggregate educational attainment: age is the most obvious. To test the extent to which this may be driving the result, we construct a measure of age-adjusted educational attainment, which adjusts for the age and sex structure of the local authority – the details are in the paper. The figure below shows how this measure correlates with Leave voting (hi-res version).

Map of Leave votes shares and age-adjusted educational attainment

Choropleth map and cartogram hex map of Leave vote share and age-adjusted educational attainment in England and Wales by local authority

Once age and sex are adjusted for, the extent to which low GSCE attainment is clustered strongly among parts of the east coast, the West Midlands and the North West is even more apparent. Again the match with strong Leave votes is striking. Adjusting for age and sex removes many of the local authorities returning Leave votes between 50% and 60% from the “below average” educational attainment category, although parts of Wales are still apparent “outliers”. The area of below average (adjusted) educational attainment also extends into Remain-voting East London and Manchester.

How should these patterns be interpreted in light of the various narratives seeking explain the Brexit vote? These can broadly be divided into those emphasising cultural divergence between socially liberal Remain voters and socially conservative Leave voters, and those emphasising economic drivers such as inequality, austerity, and the effects of globalisation. Since educational attainment is closely correlated with both social attitudes and economic success, our results could be invoked in favour of either set of narratives. We therefore caution against drawing any firm conclusions on the basis of these results. The distribution of strong Brexit votes and below average educational attainment does raise potential problems, however, for narratives of the vote based on an assumed North-South divide. More on this soon.

 

Kelton and Krugman on IS-LM and MMT

The MMT debates continue apace. New critiques — the good, the bad and the ugly — appear daily. Amidst the chaos, a guest post on Alphaville from three MMT authors stood out: the piece responded directly to various criticisms while discussing the policy challenges associated with controlling demand and inflation when fiscal policy is the primary macro stabilisation tool. These are the debates we should be having.

Unfortunately, it is one step forward, two steps backwards: elsewhere Stephanie Kelton and Paul Krugman have been debating across the pages of the Bloomberg and the New York Times websites. The debate is, to put it politely, a mess.

Krugman opened proceedings with a critique of Abba Lerner’s Functional Finance: the doctrine that fiscal policy should be judged by its macroeconomic outcomes, not on whether the financing is “sound”. Lerner argued that fiscal policy should be set at a position consistent with full employment, while interest rates should be set at a rate that ensures “the most desirable level of investment”. Krugman correctly notes the lack of  precision in Lerner’s statement on interest rates. He then argues that, “Lerner neglected the tradeoff between monetary and fiscal policy”, and that if the rate of interest on government debt exceeds the rate of growth, either the debt to GDP ratio spirals out of control or the government is forced to tighten fiscal policy.

Kelton hit back, arguing that Krugman’s concerns are misplaced because interest rates are a policy variable: the central bank can set them at whatever level it likes. Kelton points out that Krugman is assuming a “crowding out” effect: higher deficits lead to higher interest rates. Kelton argues that instead of “crowding out”, Lerner was concerned about “crowding in”: the “danger” that government deficits would push down the rate of interest, stimulating too much investment. Putting aside whether this is an accurate description of Lerner’s view, MMT does diverge from Lerner on this issue: since MMT rejects a clear link between interest rates and investment,  the MMT proposal is simply to set interest rates at a low level, or even zero, and leave them there.

So far, this looks like a straightforward disagreement about the relationship between government deficits and interest rates: Krugman says deficits cause higher interest rates, Kelton says they cause lower interest rates (although she also says interest rates are a policy variable — this apparent tension in Kelton’s position is resolved later on)

Krugman responded. This is where the debate starts to get messy. Krugman takes issue with the claim that the deficit should be set at the level consistent with full employment. He argues that at different rates of interest there will be different levels of private sector spending, implying that the fiscal position consistent with full employment varies with the rate of interest. As a result, the rate of interest isn’t a pure policy variable: there is a tradeoff between monetary and fiscal policy: with a larger deficit, interest rates must be higher, “crowding out” private investment spending.

Krugman’s argument involves two assumptions: 1) there exists a direct causal relationship between the rate of interest and the level of private investment expenditure, and, 2) the central bank will react to employment above “full employment” with higher interest rates. He illustrates this using an IS curve and a vertical “full employment” line (see below). He declares that “this all seems clear to me, and hard to argue with”.

250219krugman1-jumbo

At this point the debate still appears to remain focused on the core question: do government deficits raise or lower the rate of interest? By now, Krugman is baffled with Kelton’s responses:

It seems as if she’s saying that deficits necessarily lead to an increase in the monetary base, that expansionary fiscal policy is automatically expansionary monetary policy. But that is so obviously untrue – think of the loose fiscal/tight money combination in the 1980s – that I hope she means something different. Yet I can’t figure out what that different thing might be.

This highlights two issues: first, how little of MMT Krugman has bothered to absorb, and, second, how little MMTers appear to care about engaging others in a clear debate. Kelton, following the MMT line, is tacitly assuming that all deficits are monetised and that issuing bonds is an additional, and possibly unnecessary, “sterilisation” operation. Under these assumptions, deficits will automatically lead to an increase in central bank reserves and therefore to a fall in the money market rate of interest. But Kelton at no point makes these assumptions explicit. To most people, a government deficit implicitly means bond issuance, in correspondence with the historical facts.

So Krugman and Kelton have two differences in assumptions that matter here. First, Krugman assumes a mechanical relationship between interest rates and investment and thus a downward sloping IS curve, while Kelton rejects this relationship. Second, they are assuming different central bank behaviour. Krugman assumes that the central bank will react to fiscal expansion with tighter monetary policy in the form of higher interest rates: the central bank won’t allow employment to exceed the “full employment” level. Kelton assumes, firstly, that fiscal policy can be set at the “full employment” level, without any direct implications for interest rates and, secondly, that deficits are monetised so that money market rates fall as the deficit expands.

The “debate” heads downhill from here. Krugman asks several direct questions, including “[does] expansionary fiscal policy actually reduce interest rates?”. Kelton responds, “Answer: Yes. Pumping money into the economy increases bank reserves and reduces banks’ bids for federal funds. Any banker will tell you this.” Even now,  neither party seems to have identified the difference in assumptions about central bank behaviour.

The debate then shifts to IS-LM. Krugman asks if Kelton accepts the overall framework of discussion — the one he previously noted “all seems clear to me, and hard to argue with”. Kelton responds that, no, MMT rejects IS-LM because it is “not stock-flow consistent”, while also correctly noting that Krugman simply assumes that investment is a mechanical function of the rate of interest.

In fact, Krugman isn’t even using an IS-LM model — he has no LM curve — so the “not stock flow consistent” response is off target. The stock-flow issue in IS-LM derives from the fact that the model solves for an equilibrium between equations for the stock of money (LM), and investment and saving (IS) which are flow variables. But without the LM curve it is a pure flow model: Krugman is assuming, as does Kelton, that the central bank sets the rate of interest directly. So Kelton’s claim that “his model assumes a fixed money supply, which paves the way for the crowding-out effect!” is incorrect.

Similarly, Kelton’s earlier statement that Krugman “subscribes to the idea that monetary policy should target an invisible ‘neutral rate'” makes little sense in the context of Krugman’s IS model: there is no “invisible” r* in a simple IS model of the type Krugman is using: the full employment rate of interest can be read straight off the diagram for any given fiscal position.

Krugman then took to Twitter, calling Kelton’s response “a mess”, while still apparently failing to spot that they are talking at cross purposes. Kelton hit back again arguing that,

The crude, IS-LM interpretation of Keynes demonstrates that, under normal conditions, an increase in deficit spending will push up interest rates and lead to some crowding-out of investment spending. There is no room for a technical analysis of monetary operations in that framework.

Can this discussion be rescued? Can MMT and IS-LM be reconciled? The answer, I think, turns out to be, “yes, sort of”.

I wasn’t the only person pondering this question: several people on Twitter went back to this post by Nick Rowe where he tries to “reverse engineer” MMT using the IS-LM model, and comes up with the following diagram:

Rowe-IS-LM
Does this help? I think it does. In fact, this is exactly the diagram used by Victoria Chick in 1973, in The Theory of Monetary Policy, to describe what she calls the “extreme Keynesian model” (bottom right):

Chick-Theory-Monetary-Policy-scaled

So how do we use this diagram to resolve the Krugman-Kelton debate? Before answering, it should be noted that MMTers are correct to point out problems with the IS-LM framework. Some are listed in this article by Mario Seccareccia and Marc Lavoie who conclude that IS-LM should be rejected, but “if one were to hold one’s nose,” the “least worst” configuration is what Chick calls the “extreme Keynesian” version.

To see how we resolve the debate, and at the risk of repeating myself, recall that Krugman and Kelton are talking about two different central bank reactions. In Krugman’s IS model, the central bank reacts to looser fiscal policy with higher interest rates. Kelton, on the other hand, is talking about how deficit monetisation lowers the overnight money market rate. Kelton’s claim that a government deficit reduces “interest rates” is largely meaningless: it is just a truism. Flooding the overnight markets with liquidity will quickly push the rate of interest to zero, or whatever rate of interest the central bank pays on reserve balances. It is a central bank policy choice: the opposite of the one assumed by Krugman.

But what effect will this have on the interest rates which really matter for investment and debt sustainability: the rates on corporate and government debt? The answer is “it depends” — there are far too many factors involved to posit a direct mechanical relationship.

This brings a problem that is lurking in the background into sight. Both Kelton and Krugman are talking about “interest rates” or “the interest rate” as if there were a single rate of interest, or that all rates move together — the yield curve shifts bodily with movements of the policy rate. As the chart below shows, even for government debt alone this is a problematic assumption.

yc

Now, in the original IS-LM model, the LM curve is supposed to show how changes in the government controlled “money supply” affects the long term bond rate of interest. This is because, for Keynes, the rate of interest is the price of liquidity: by giving up liquidity (money) in favour of bonds, investors are rewarded with interest payments. But the problem with this is that we know that central banks don’t set the “money supply”: they set a rate of interest. So, it has become customary to draw a horizontal MP curve, allegedly representing an elastic supply of money at the rate of interest set by the central bank. But note that in switching from a sloping to a horizontal LM curve, the “interest rate” has switched from the long bond rate to the rate set by the central bank.

So how is the long bond rate determined in the horizontal MP model? The answer is it isn’t. As in the more contemporary three-equation IS-AS-MP formulation, it is just assumed that the central bank fixes the rate of interest that determines total spending. In switching from the upward sloping LM curve to a horizontal MP curve, the crude approximation to the yield curve in the older model is eliminated.

What of the IS curve? Kelton is right that a mechanical relationship between interest rates and investment (and saving) behaviour is highly dubious. If we assume that demand is completely interest-inelastic, then we arrive at the “extreme Keynesian” vertical IS curve. But does Kelton really think that sharp Fed rate hikes will have no effect on total spending? I doubt it. As Seccareccia and Lavoie note, once the effects of interest rates on the housing market are included, a sloping-but-steep IS curve seems plausible.

Now, does the “extreme Keynesian” IS-LM model, all the heroic assumptions notwithstanding, represent the MMT assumptions? I think, very crudely, it does. The government can set fiscal policy wherever it likes, both irrespective of interest rates and without affecting interest rates: the IS curve can be placed anywhere along the horizontal axis. Likewise, the central bank can set interest rates to anything it likes, again without having any effect on total expenditure. This seems a reasonable, if highly simplified approximation to the standard MMT assumptions that fiscal policy and monetary policy can be set entirely independently of each other.

But is it useful? Not really, other than perhaps in showing the limitations of IS-LM. The only real takeaway is that we deserve a better quality of economic debate. People with the visibility and status of Kelton and Krugman should be able to identify the assumptions driving their opponent’s conclusions and hold a meaningful debate about whether these assumptions hold — without requiring some blogger to pick up the pieces.

Misunderstanding MMT

MMT continues to generate debate. Recent contributions include Jonathan Portes’ critique in Prospect and Stephanie Kelton’s Bloomberg op-ed downplaying the AOC and Warren tax proposals.

Something that caught my eye in Jonathans’ discussion was this quote from Richard Murphy: “A government with a balanced budget necessarily denies an economy the funds it needs to function.” This is an odd claim, and not something that follows from MMT.

Richard has responded to Jonathan’s article, predictably enough with straw man accusations, and declaring, somewhat grandiosely, that “the left and Labour really do need to adopt the core ideas of modern monetary theory … This debate is now at the heart of what it is to be on the left”

Richard included a six-point definition of what he regards to be the core propositions of MMT. Paraphrasing in some cases, these are:

  1. All money is created by the state or other banks acting under state licence
  2. Money only has value because the government promises to back it …
  3. … because taxes must be paid in government-issued money
  4. Therefore government spending comes before taxation
  5. Government deficits are necessary and good because without them the means to make settlement would not exist in our economy
  6. This liberates us to think entirely afresh about fiscal policy

Of these, I’d say the first is true, with some caveats, the second and third are partially true, and the fourth is sort of true but also not particularly interesting. I’ll leave further elaboration for another time, because I want to focus on point five, which is almost a restatement of the quote in Jonathan’s Prospect piece.

This claim is neither correct nor part of MMT. I don’t believe that any of the core MMT scholars would argue that deficits are required to ensure that there is sufficient money in circulation. (Since Richard uses the term “funds” in the first quote and “means [of] settlement” in the second, I’m going to assume he means money).

To see why, consider what makes up “money” in a modern monetary system. Bank deposits are the bulk of the money we use. These are issued by private banks when they make loans. Bank notes, issued by the Bank of England make up a much smaller proportion of the money in the hands of the public. Finally, there are the balances that private banks hold at the Bank of England, called reserves.

What is the relationship between these types of money and the government surplus or deficit? The figure below shows how both deposits and reserves have changed over time, alongside the deficit.

uk-money-supply-deficit

Can you spot a connection between the deficit and either of the two money measures? No, that’s because there isn’t one — and there is no reason to expect one.

Reserves increase when the Bank of England lends to commercial banks or purchases assets from the private sector. Deposits increase when commercial banks lend to households or firms. Until 2008, the Bank of England’s inflation targeting framework meant it aimed to keep the amount of reserves in the system low — it ran a tight balance sheet. Following the crisis, QE was introduced and the Bank rapidly increased reserves by purchasing government debt from private financial institutions. Over this period, and despite the increase in reserves, the ratio of deposits to GDP remained pretty stable.

The quantity of neither reserves nor deposits have any direct relationship with the government deficit. This is because the deficit is financed using bonds. For every £1bn of reserves and deposits created when the government spends in excess of taxation, £1bn of reserves and deposits are withdrawn when the Treasury sells bonds to finance that deficit.

This is exactly what MMT says will happen (although MMT also argues that these bond sales may not always be necessary). So MMT nowhere makes the claim that deficits are required to ensure that the system has enough money to function.

It is true that the smooth operation of the banking and financial system relies on well-functioning markets in government bonds. During the Clinton Presidency there were concerns that budget surpluses might lead the government to pay back all debt, thus leaving the financial system high and dry.

But the UK is not in any danger of running out of government debt. Government surpluses or deficits thus have no bearing on the ability of the monetary system to function.

The macroeconomic reason for running a deficit is straightforward and has nothing to do with money. The government should run a deficit when the desired saving of the private sector exceeds the sum of private investment expenditure and the surplus with the rest of the world. This is not an insight of MMT: it was stated by Kalecki and Keynes in the 1930s.

If a debate about MMT really is at “the heart of what it is to be on the left” then Richard might want to take a break to get up to speed on MMT (and monetary economics) before that debate continues.

A belated reply to Fazi and Mitchell on Brexit

Bruno Bonizzi and Jo Michell

In a Jacobin article earlier this year, Thomas Fazi and Bill Mitchell argued in favour of a hard Brexit. We published a reply, also in Jacobin. Fazi and Mitchell (FM) responded with accusations of strawman arguments, false claims, bias and muddled thinking. We intended to write a reply at the time, but other commitments got in the way. However we believe that FM’s reply was sufficiently inaccurate – and in places, dishonest –  that a reply is required, even if belatedly.

Brexit predictions

In our Jacobin article we noted that pre-referendum predictions of immediate recession following a Leave vote were produced for political effect, while economists emphasised the likely longer run costs. FM dispute this interpretation, citing as evidence a letter signed by over 200 economists, warning of the likely economic effects of Brexit. One of us (Jo Michell) has some knowledge of this letter, having not only signed it but also having played a role in coordinating signatories – signatories which include a good cross-section of the UK heterodox economics community.

FM quote the letter as follows:

Focusing entirely on the economics, we consider that it would be a major mistake for the UK to leave the European Union …

The uncertainty over precisely what kind of relationship the UK would find itself in with the EU and the rest of the world would also weigh heavily for many years. In addition, there is a sizeable risk of a short-term shock to confidence if we were to see a Leave vote on June 23rd. The Bank of England has signalled this concern clearly, and we share it.

Compare FM’s edit with the original text of the letter below (our bold text).

Focusing entirely on the economics, we consider that it would be a major mistake for the UK to leave the European Union.

Leaving would entail significant long-term costs. The size of these costs would depend on the amount of control the UK chooses to exercise over such matters as free movement of labour, and the associated penalty it would pay in terms of access to the single market. The numbers calculated by the LSE’s Centre for Economic Performance, the OECD and the Treasury describe a plausible range for the scale of these costs.

The uncertainty over precisely what kind of relationship the UK would find itself in with the EU and the rest of the world would also weigh heavily for many years. In addition, there is a sizeable risk of a short-term shock to confidence if we were to see a Leave vote on June 23rd. The Bank of England has signalled this concern clearly, and we share it.

Can you see what they did there?

The first substantial paragraph of the letter — conveniently deleted by FM – focuses on the long-term costs. Midway through the second paragraph, is the following sentence: “In addition, there is a sizeable risk of a short-term shock to confidence…” (our emphasis). The letter is clearly worded: we believe that Brexit entails long-term costs and, additionally, a risk of negative short-term effects.

FM also comment – referring to the first line of the letter – “And nothing ‘entirely’ economics about that. They were trying to influence the Referendum outcome in favour of Remain.”

Of course we were trying to influence the referendum outcome – that was the point of the letter – because, on the basis of the economics, we believe Brexit to be a mistake.

Finally, FM state, “This letter was published in the Times newspaper and so received widespread coverage.” This is genuinely funny. The (paywalled) letter was almost universally ignored by the UK press – to the point that Tony Yates’ frustration became a running joke on UK economics Twitter.

FM then highlight a report published by NIESR shortly before the vote. Again FM edit their quote carefully, removing the qualifier “albeit not unanimous” from the sentence “there is a degree, albeit not unanimous, of consensus that leaving the EU would depress UK economic activity in both the short term (via uncertainty) and the long term (via trade).” Aside from the quotation, FM devote no attention to the actual contents of the report, which summarises various Brexit macro modelling exercises, include the Treasury’s long term forecasts and both long and “near term” forecasts from the OECD, LSE and NIESR themselves. With the exception of the LSE modelling exercise, all are produced using NIESR’s NiGEM model.

What do the projections show? First note that the “near term” projections run until 2020, while the longer term projections run till 2030. The long-run projections of a hard Brexit do indeed predict a large hit to GDP. The shorter run scenarios suggest a smaller hit to GDP, of between 2.6% and 3.3%, by 2020. Does this prove, as FM argue, that economists “catastrophically failed in relation to the short-run impacts of the Brexit vote”?

At risk of stating the obvious, 2020 is four and half years after the referendum vote and beyond the Article 50 period: Brexit will have happened (this is the assumption in the projections, anyway). A 3% hit to GDP by 2020 seems perfectly plausible. But saying something is plausible is not the same as saying it is certain. In the case of both the economists’ letter to the Times and FM’s next piece of evidence, an Observer poll of economists, FM choose to ignore a crucial word: risk. Stating that there is a risk something will happen is not the same as saying it will happen. Fazi is a journalist. But Mitchell, an economics professor, really should understand the distinction between risk and certainty.

So, what of those statements that a hard Brexit increases the risk of a negative economic shock by 2020? Is the projection of 3% hit to GDP by 2020 in the wake a no-deal Brexit a “catastrophic failure”? How is the UK doing since the referendum?

GDP growth came to a halt in the first quarter of 2018 after declining steadily in the wake of the Brexit vote. Despite a bounce back in the summer, the UK growth rate is currently the lowest of the G7 economies. Of course, we don’t have the counterfactual — and since UK growth is pretty much entirely dependent on household spending, consumer credit and retail, this slowdown could have come at almost any point. But with the household savings rate and net lending now negative — and clearly unsustainable — further reductions in consumer demand seem inevitable.

What of manufacturing – the great hope of the pro-Brexit Left? Corbyn recently made the case that pound devaluation in the wake of Brexit will lead to a revival of manufacturing. But the UK pound has been depreciating for decades — alongside a widening current account deficit and a steady decline in manufacturing. Investment spending in car manufacturing has halved since the Brexit vote. Several major manufacturers including BMW, Siemens and Airbus have warned that they will cease manufacturing in the UK in the event of a hard Brexit. The Society of Motor Manufacturers and Traders (SMMT) issued a warning that 860,000 skilled manufacturing jobs are at risk in the event of a hard brexit. Leaked government reports predict that low-income, Leave-voting ex-manufacturing areas of the UK will be hardest hit by a hard Brexit. This week, the European boss of Ford warned that a no-deal Brexit would be “disastrous” for UK manufacturing. AstraZeneca has announced a freeze in manufacturing investment in the UK. We could go on.

Booming Brexit Britain?

In our original reply to FM, we took issue with their attempt to paint the post-referendum period as a boom. FM claim we have misrepresented them: “to their discredit, Bonizzi and Michell are just making stuff up when they make that claim about us.” Here is the section of FM’s original article we referred to:

UK exports are at their strongest position since 2000. As the Economist recently put it: “Britain’s long-suffering makers are enjoying a once-in-a-generation boom,” as the shifts induced by Brexit engender a much-needed “rebalancing” from boom-and-bust financial services towards manufacturing. This is also spurring a growth in investment. Total investment spending in the UK — which includes both public and private investment — was the highest of any G7 country during 2017: 4 percent compared to the previous year.

The reader can decide if we are “just making stuff up”.

Having attacked us for our interpretation of the above quote, FM even go on, without a hint of irony, to quote the same Economist sentence – arguing that pound devaluation and growing export demand has led to a “virtuous circle” in which manufacturers are experiencing a   “once-in-a-generation boom … manufacturing is seeing its strongest growth since the late 1990s …”

This reinforces a point we made in our Jacobin article: FM seem to have trouble with the distinction between levels and growth rates. Manufacturing may have grown strongly in 2017 – before going into reverse and contracting at the start of 2018 – but this is in large part the result of “base effects”. Because UK manufacturing is now so small – output is still below pre-crisis levels – even small increases register as large percentage growth rates. This is not the same thing as a manufacturing “boom”.

FM made the same error in their original piece when discussing investment, where they incorrectly stated that “Total investment spending in the UK … was the highest of any G7 country during 2017” – actually it was the lowest. Now, we are prepared to accept that FM believed they were claiming that investment growth was highest – it was just a typo – but that isn’t what they wrote. Upon investigation, we discovered that FM’s error was in fact the result of carelessly pasting together two directly quoted half-sentences from the FT. Pointing out this error is not sleight of hand, and discussing base effects isn’t “throwing in some cloud” – whatever that means. (It is also good form to use quotation marks when cutting and pasting someone else’s text.)

Defenders of mainstream macro?

Next up, FM try and paint us as defenders of mainstream economics, arguing that “Bonizzi and Michell’s defense of the economics professions is thus very hard to comprehend.” This comes at the end of a long and incoherent section in which FM conflate DSGE modelling, gravity models of international trade, support for austerity and a number of other things – while, of course, stating that “it was obvious to Modern Monetary Theory (MMT) economists as early as the late 1990s that a crisis was brewing”.

FM appear to think that, because we find negative long term Brexit predictions to be plausible, we are defending every failure of economics modelling and policy over the last three decades. Clearly they haven’t bothered to check our views on this. When they conflate these issues by writing, “same models, same approach, same catastrophic errors”, they demonstrate their ignorance. DSGE macro models and gravity models may both have important flaws – but they are not the same.

Trade graphs, EU utopianism, nativism and the Irish border

There are multiple further sections in FM’s reply – on the interpretation of trade graphs, the importance of racism and the far-right, and whether the EU is a “utopia”. These are as incoherent and inaccurate as the points refuted above. To give just one more example, FM state that “… the contention by Bonizzi and Michell that the EU is the only thing preventing the UK from plunging into a quasi-fascist dystopia is untenable.” – a contention that is nowhere to be found in anything we have written. Elsewhere, FM abandon even the pretence of debate, and resort to throwing in statements like, “Hello! Is anyone there?”

FM claim – inaccurately – that in their articles and book, they have covered all the points we raise. But we raised one issue in our Jacobin article that FM conspicuously ignore in their reply: the Irish border. We wrote:

The UK government’s current position of aiming to leave the customs union without creating a hard border in Ireland is akin to a Venn diagram in which there is no intersection between the circles. For this reason, Theresa May is currently proposing two incompatible approaches, both of which are unacceptable to the EU.

As has since become overwhelmingly apparent, those who want to argue for a hard Brexit need to spell out a solution to the Irish border issue. Perhaps now would be a good time for FM to tell us theirs?

Finally, we note that in their incoherent attempt to conflate mainstream economics and opposition to Brexit, FM quote Ann Pettifor. In response to FM’s attack on us, Ann tweeted the following: “Bill Mitchell & Fazi need reminding that it is rise of nationalism & even fascism in Europe that is the threat. Progressives should lead – not walk away & vacate political space to the Far Right.”

Fazi and Mitchell have not engaged with our arguments in good faith. Their attack is not a serious attempt to engage in debate or respond to the points we raised. In a number of places it is transparently dishonest. Anyone who follows Fazi and Mitchell’s lead on these crucial issues should take a long hard look.

The World Bank’s new Maximizing Finance for Development agenda brings shadow banking into international development – open letter

Last month, central bankers and politicians around the world remembered the global financial crisis and the lessons learnt in its wake. The consensus goes at follows: we have done a great deal to reform banks and protect tax payers from their aggressive risk taking but we haven’t done enough on shadow banking. At this point, the consensus fragments. Central banks claim that they need more power to deal with systemic risks stemming from the shadows, whereas politicians worry about the moral hazards involved in future rescues of shadow banks like Lehman.

We are all the more concerned that the same authorities have been actively promoting shadow banking in the Global South. Under headings such as Billions to Trillions and the World Bank’s new Maximizing Finance for Development (MFD) agenda, the new strategy for achieving the Sustainable Development Goals is to use shadow banking to create ‘investable’ opportunities in infrastructure, water, health or education and thus attract the trillions in global institutional investment.

Bringing shadow banking into development doesn’t just promote the privatization of public services, but may usher in permanent austerity along the lines of ‘privatizing gains, socializing losses’. More fundamentally, it seeks to re-engineer poor countries’ financial systems around capital markets that can attract global investors. This deliberate re-engineering of financial systems threatens progress on the SDGs. We call on governments and international institutions gathering in Bali for the WB/IMF, G20 meetings and the Global Infrastructure Forum to take a step back and assess carefully the developmental impact of the MFD agenda.

The MFD agenda will be tested in infrastructure, with plans spelled out in the “Roadmap to Infrastructure as an Asset Class”, under Argentina’s G20 presidency. These plans promote shadow banking in two ways.

First, the World Bank plans to use securitization to mobilize private finance. The WB would bundle infrastructure loans, its own or across the portfolios of multilateral development banks, issue senior and junior tranches to be sold to institutional investors with different risk appetites. Securitization, we learnt from Lehman’s collapse, is a shadow market easily prone to mis-incentives, aggressive leverage, aggressive promotion of underlying loans onto customers that cannot afford them. It generates systemic interconnectedness and fragility. Yet none of these issues have been addressed in the MFD plans. Instead, the MFD, through the so-called Cascade Approach, asks poor countries to use scarce fiscal resources and/or official aid to ‘de-risk’ bankable projects, by for instance providing guarantees/subsidies for demand risk or political risk. Since the WB will retain a share of the junior tranche, poor countries may easily be pressured to keep up de-risking payments or guarantees, even if it means cutting essential social spending.

Second, the MFD agenda doesn’t just express an ideological preference for private provision of public goods. It also purports to change poor countries’ financial systems around liquid capital markets that can attract global institutional investors. But the WB’s recipe for engineering liquidity in local securities market requires the promotion of the same shadow markets (the repo and derivative markets) that turned Lehman’s collapse into a global financial crisis. It is also a recipe for reduced policy autonomy. As the IMF recognizes, encouraging poor countries to join the global supply of securities exposes them to the rhythms of the global financial cycle over which they have little control, as shown by recent events in Argentina.

We call on the World Bank Group to recognize that the preference for the private sector should not be automatic, but rather chosen only when it can demonstrably serve the public good. When it meets this test, we call for the WBG to develop an analytical framework that clearly sets out the costs of de-risking and subsidies embedded in the MFD agenda in a way that allows a broad range of stakeholders, including civil society organizations and other public interest actors, to closely monitor results as well as fiscal costs in order to ensure transparency and accountability.

Should the MDBs adopt the proposals for securitization of development-related loans, it should first develop a credible framework that protects the SDG goals from the systemic fragilities of shadow banking. But this will not be enough. To ensure that it does not shrink developmental spaces and that is advances sustainable development, the MFD agenda should only be adopted in conjunction with (a) a well-designed framework for project selection that is aligned with the global sustainable development goals and the Paris Agreement; (b) a careful framework for managing volatile portfolio flows into local securities markets and (c) a resilient global safety net.

List of signatories

Daniela Gabor, Professor of Economics and Macrofinance, UWE Bristol

Ewald Engelen, Professor of Financial Geography, University of Amsterdam

Daniela Magalhães Prates, Professor of Economics, University of Campinas, Brazil

Gunther Capelle-Blancard, Professor of Economics, University of Paris 1 Pantheon-Sorbonne

Pablo Bortz, Professor of Macroeconomics, IDAES-National University of San Martín, Argentina

Kevin Gallagher, Professor of Economics, Boston University

Alicia Puyana, Professor of Economics, FLACSO Mexico

Laurence Scialom, Professor of Economics, University of Paris Nanterre

Jayati Ghosh, Professor of Economics, Jawaharlal Nehru University, India

P. Chansrasekhar, Professor of Economics, Jawaharlal Nehru University

Ilene Grabel, Professor of International Political Economy, University of Denver

Cornel Ban, Reader in International Political Economy, City University

Carolina Alves, Girton College and Faculty of Economics, University of Cambridge.

Jérôme Creel, Associate Professor of Economics, Sciences Po, Paris.

Kai Koddenbrock, Interim Professor of International Political Studies, University of Witten-Herdecke, Germany

Nuno Teles, Professor of Economics, Federal University of Bahia, Brazil

Marco Veronese Passarella, lecturer in Economics, University of Leeds

Jesus Ferreiro, Professor of Economics, University of the Basque Country UPV/EHU

 Elisa Van Waeyenberge, Senior Lecturer in Economics, School of Oriental and African Studies, UK

Phil Mader, Research Fellow, Institute of Development Studies, Sussex.

Manuel B. Aalbers, Professor of Economic Geography, KU Leuven/University of Leuven, Belgium

Cédric Durand, Associate Professor of Economics, Université Paris 13

Sandy Hager, Senior Lecturer in International Political Economy, City University London

Ben Fine, Professor of Economics, School of Oriental and African Studies, UK

Galip Yalman, Assoc. Prof. Dr. (EM), METU

Hansjörg Herr, Professor of Economics, Berlin School of Economics and Law

Vincenzo Bavoso, Lecturer in Commercial Law, University of Manchester

Kate Bayliss, Senior Research Fellow, University of Leeds

Melissa García-Lamarca, Postdoctoral researcher, Universitat Autònoma de

Barcelona, Spain

Andreas Nölke, Professor of International Political Economy, Goethe University

Duncan Lindo, Research Fellow, University of Leeds

Brigitte Young, Professor of International Political Economy, University of Muenster, Germany.

Christoph Scherrer, Director, International Center for Development and Decent Work, University of Kassel

Hans-Jürgen Bieling, Professor of   Political Economy, University of Tübingen

Eve Chiapello, Professor of Economic Sociology, EHESS Paris

Dr Caroline Metz, University of Manchester

Birgit Mahnkopf, Prof. Em. of International Political Economy, Berlin School of Economics and Law

Alessandro Vercelli, Professor of Economics, University of Siena

Susanne Soederberg, Professor of Global Development Studies, Queen’s University

Ipek Eren Vural, Associate Professor, Department of Political Science and Public Administration, Middle East Technical University, Ankara

Yamina Tadjeddine, Professor of Economics,  Université de Lorraine

Thomas Wainwright, Reader, School of Management, Royal Holloway, University of London.

Anders Lund Hansen, Associate Professor Department of Human Geography, Lund University

Malcolm Sawyer, Emeritus Professor of Economics, University of Leeds, UK

Jeff Powells, Senior lecturer in economics. University of Greenwich

Raquel Rolnik, University of São Paulo – Brasil.

Jo Michell, Associate Professor, University of the West of England

Jan Kregel, Professor of Economics, Levy Economics Institute

Irene von Staveren, Professor of Pluralist Development Economics, International Institute of Social Studies, Erasmus University Rotterdam

Stavros D. Mavroudeas, Professor (Political Economy), University of Macedonia

Ray Bush, Professor of African Studies and. Development Politics, University of Leeds

Lucia Shimbo, Professor of Architecture and Urban Planning, University of São Paulo.

Sérgio Miguel Lagoa, Assistant Professor, ISCTE- Instituto Universitário de Lisboa, Lisboa

Carlos Rodríguez González , Professor, University of the Basque Country (UPV/EHU)

Ingrid Harvold Kvangraven, Lecturer in Politics, University of York.

Ewa Karwowski, Senior Lecturer in Economics, Hertfordshire Business School, University of Hertfordshire

Anamitra Roychowdhury, Assistant Professor in Economics, Jawaharlal Nehru University

Hannah Bargawi, Senior Lecturer in Economics, SOAS University of London

Natalya Naqvi, Assistant Professor in International Political Economy, London School of Economics and Political Science

Firat Demir, Professor of Economics, University of Oklahoma, USA

Gilad Isaacs, University of the Witwatersrand, South Africa

Rohan Grey, Cornell University

Yannis Dafermos, Senior Lecturer, UWE Bristol

Kamal Mitra Chenoy, Professor, Jawaharlal Nehru University

Anuradha Chenoy, Professors, formerly Jawaharlal Nehru University

Kathleen McAfee, Professor, International Relations, San Francisco State University

Jan Priewe, Prof. Em. Economics, HTW Berlin, Germany

Piotr Lis, Associate Professor in Economics, Poznan University

Yavuz Yasar, University of Denver

Joscha Wullweber, Professor of International Politics, University of Vienna

Paula Freire, Santoro, Urban Planning Professor, São Paulo University

Manfred Nitsch, Professor emeritus of Economics, Freie Universität Berlin

Bunu Goso Umara, Borno State Public Service, Nigeria

Barbara Fritz, Professor, Institute for Latin American Studies, Freie Universität Berlin

Sally Brooks, Research Fellow, University of York

Danielle Guizzo Archela, Senior Lecturer in Economics, UWE Bristol

Feyzi Ismail, SOAS University of London

Florence Dafe,
 Fellow in International Political Economy, Department of International Relations, London School of Economics and Political Science

Alan B. Cibils, Professor of Political Economy, Universidad Nacional de General Sarmiento, Buenos Aires, Argentina

Rama Vasudevan, Associate Professor of Economics, Colorado State University

José Caraballo-Cueto, Associate Professor, University of Puerto Rico at Cayey

Debarshi Das, Associate Professor, Economics, IIT Guwahati, India

Genarro Zezza, Associate Professor of Economics, University of Cassino, Italy

Sara Stevano, Senior Lecturer in Economics, UWE Bristol

Dirk Bezemer, Professor of Economics of International Financial Development, University of Groningen, Holland

Barry Herman, Visiting Scholar, The New School for Public Engagement

Bruno Bonizzi, Lecturer in Political Economy, University of Winchester

Servaas Storm,  Senior Lecturer, Delft University of Technology, The Netherlands

Mona Ali, Associate Professor of Economics, State University of New York at New Paltz

Ajit Zacharias, Senior Scholar and Director, Distribution of Income and Wealth Program, Levy Economics Institute of Bard College

Vincent Guermond, Queen Mary University of London

Susan Engel, Senior Lecturer, Politics & International Studies, University of Wollongong
Australia\
Erdogan Bakir, Associate Professor of Economics, Bucknell University, USA

 

Shalu Nigam, Freelance researcher, activist and and advocate, India

Jo Walton, Research Fellow, University of Sussex

Redge Nkosi, Exec Director and Research Head at Firstsource Money (Researchers in Money, Banking & Macroeconomics),  South Africa

Sabri Öncü, Chief Economist, Centre for Social Research and Original Thinking

Fulya Apaydin, Assistant Professor, Institut Barcelona d’Estudis Internacionals

Daniele Tori, Lecturer in Finance,  The Open University

Erkan Erdil, Professor of Economics, Middle East Technical University

Robin Broad, Professor of International Development, American University, Washington DC USA

Giulia Zacchia, Sapienza University of Rome
Carolyn Sissoko, PhD, JD
Siobhán Airey, Marie Skłodowska-Curie Research Fellow, University College Dublin, Ireland
Radha Upadhyaya, Research Fellow, IDS, University of Nairobi
Maria Dyveke Styve, University of Bergen, Norway
Mange Ram Adhana President, Association For Promotion Sustainable Development, India
Carolyn Prouse, Assistant Professor of Geography, Queen’s University

Lorena Lombardozzi, Lecturer in Economics, The Open University

Andrea Lagna, Lecturer in International Management and Innovation, Loughborough University

Nick Bernards, Assistant Professor, University of Warwick

Ismail Lagardien, The University of Witwatersrand School of Governance

Nicolas Pons-Vignon, Senior Researcher, School of Economics and Business Sciences, University of the Witwatersrand

Bonn Juego, Postdoctoral Researcher in Development & International Cooperation, University of Jyväskylä, Finland

Pal Tamas, Hungarian Academy of Sciences, Social Science Research Centre, Hungary

 

If you wish your name to be added, please email your institutional affiliation to daniela.gabor@uwe.ac.uk, we will continue to update the list of signatories.

Should we fear the robots? Automation, productivity and employment

Special session at the British Academy of Management conference

Monday 3 September, 12.30-14.00, Room 2X242

Bristol Business School, UWE, Coldharbour Lane, BS16 1QY

A panel discussion on productivity, automation and employment, with

Frances Coppola, Finance and Economics Writer

Daniel Davies, Investment Banking Analyst

Duncan Weldon, Head of Research, Resolution Group

Chaired by Jo Michell, UWE Bristol.

Since the 2008 crisis, UK productivity has stagnated. At the same time, fears are growing that robots will challenge humans for an ever wider range of jobs. This panel brings together leading economists to discuss these apparently contradictory trends – and what should be done about them.

This is a special session so all are welcome. Conference registration is not required.

The full conference programme can be downloaded here

For more details please contact Jo Michell on jo.michell@uwe.ac.uk

 

 

 

Lira’s Downfall is a Symptom: the Political Economy of Turkey’s Crisis

Guest post by Ümit Akçay (Ph. D., Berlin School of Economic and Law) and Ali Rıza Güngen (Ph. D., Turkish Social Sciences Association)

Turkish Lira lost almost 45 per cent of its value against the U.S. Dollar in 2018. The losses accelerated notably in recent months and particularly in the second week of August, which included the two days in which Lira lost the most against USD since the 2001 crisis.

Suddenly, it became “all about Turkey” as the Bloomberg commentators said and many pundits expressed their opinions about the reasons as well as the dire consequences of a currency crisis.

The first stage of the international financial crisis in 2008-09 was followed by the Eurozone crisis (2010-12). Increasing volatility in the markets of global South, which began by 2014 can be seen as the third stage in such a periodization. We believe that the downfall of Turkish Lira against this background is a symptom of macroeconomic problems and the policy responses of the last decade. In other words, Turkey’s 2018 crisis occurred as a combination of the impact of the tightening global dollar liquidity conditions, the choices of policymakers particularly in recent years and the inability to formulate a new economic model to overcome the crisis of accumulation, unfolding right now in Turkey.

Impact of the financial tightening

The world’s biggest financial crash in the 21st century turned into then Eurozone crisis by 2010. In these years, the policy response by the Central Banks of the core capitalist countries helped periphery achieve high rates of growth. The capital inflows initiated a short-lived economic boom in Turkey and the country was the second fastest growing one in the world, following China during 2010-11. The AKP governments benefited from cheap credit period until 2013 and strived to spread further the financial modes of calculation among its electorate.[1]

A low interest rate policy was key to the neoliberal populist model of Erdoğan. Its limits were first tested with the end of Fed’s quantitative easing that marked the end of the capital bonanza. As economic growth slowed after 2013, throwing into question the model of neoliberal populism, the agenda of AKP shifted towards a new model with developmentalist elements.[2] The idea of transition to a presidential regime was put on hold, as economic policy makers started putting more effort in devising alternative mechanisms for finance and hybrid development strategies. Policy makers underlined the need to deepen Islamic bond markets and draw in the savings of households to the financial sector, by enabling the creation of new investment instruments. Islamic think tanks questioned central bank independence and targeted central bank’s sole objective of providing price stability. Accordingly, consultants of then Prime Minister (and President from 2014 onwards) and policy makers wanted to create deepener financial markets to help corporations with financing problems on the one hand and devised strategic incentives to key sectors producing intermediary goods in order to minimize current account deficit, on the other hand. This brand of import substitution lacked a detailed plan, but the idea behind the industrial policy by the AKP governments was related to enabling high value added production and minimizing import dependency in key sector. These attempts however, did not structurally transform the economy in a few years.

Thus, the recovery of advanced capitalist countries pushed Turkish authorities to pursue new bottles for putting their old wine. The tightening of financial conditions for periphery would make it harder for the Turkish firms to find cheap sources of finance. We see that the similar concerns are now voiced over the emerging market contagion, though the exposure to dollar drain by many peripheral countries are more manageable than Turkey. 

The causes of downfall

One narrative of the Turkish crisis attributes the chaos in the currency markets to the “one man rule” consolidated last year. Accordingly, Erdoğan’s grasp of absolute power, symbolized by the 2017 constitutional referendum and his electoral success in 2018 elections, made Turkey rely on one man’s decisions and skirmishes. New presidential powers of the President inevitably made things worse, suffering from democratic retrenchment during the state of emergency. The spat with Trump is well located in this narrative, as a final episode.

The mirror image of the dissident argument is voiced by the Islamo-fascist cadres. Using the escalation of tensions with the U.S. as an alibi, these policymakers portray the recent crisis as an extension of the “economic war” launched by the West. Otherwise, it is suggested Turkey is on its glorious path to become a leading economy in not only her region but also on the global stage.

Neither perspective underlines the impact of recent economic measures upon the Turkish turbulence. Since 2013, the Turkish economy has faced a bottleneck, which paralysed the top level AKP cadres. As we mentioned above, current account deficit continued to grow and the level of financial deepening was not enough to overcome the dependency of the economy to capital inflows for new investment as well as rolling over debt. The 2016 coup attempt and the contraction of the economy in the third quarter of the year added insult to the injury.

This bottleneck can be resumed as follows: attracting capital inflows requires increasing interest rates. This however would stifle domestic demand in medium term as well as result in economic activities further losing pace. One, albeit limited response, was the state-sponsored credit expansion of 2016-17. In turn, falling interest rates would provide an incentive for domestic consumption, but it will result in further depreciation of Lira. Depreciation of TL would also mean increased burden for corporations heavily indebted in foreign exchange. Thus, this bottleneck has also been a manifestation of a deep-rooted crisis of capital accumulation regime of Turkey.

The cost of postponing interest rate adjustment and renewing state sponsored credit expansion became much more notable in 2018, when TL continued to depreciate despite a 5 per cent interest rate hike (see Figure). The FX liabilities of the real sector reached 339 billion USD by May 2018. Before the elections in June 2018, current account deficit to the GDP ratio exceeded 6 per cent and the money needed to rollover private and public sector debt for the coming 12 months surpassed 180 billion USD. The desperate search for new funds did not yield any result and the portfolio flows financing the deficit economy of Turkey lost pace by 2018.

Screen Shot 2018-08-16 at 12.36.48

Turkish Lira gained some ground in the third week of August but the level of depreciation against USD from the 6th of August to the 14th was above 25 per cent. Stagflation is ahead and thousands of firm will go bankrupt as the FX liabilities cannot be managed against the backdrop of this depreciation.

What’s next?

We believe that the capital accumulation regime in Turkey, which benefited from capital inflows in 2002-07 and 2010-13 came to a definite end in 2018. AKP was successful in managing the ensuing social tensions by resorting to increasingly authoritarian techniques. By suppressing labour organizations, deferring strikes, assuming partial costs of the newly employed staff in particular and intervening into the economy via bypassing the parliament in general, policy makers served the major business groups as well as the SMEs under the state of emergency (July 2016 to July 2018). It seems that they can no longer go on as they used to.

Entertaining new-developmentalist ideas in the post-2013 era, such as selective incentives to the sectors producing intermediary goods did not result in a detailed road map for overcoming the crisis, which was then at the doorsteps. Since rapid growth continued thanks to capital inflows and the construction sector did not lose its steam, the policy makers relied on doing more of the same. It is partly because of the fact that the collapse of the economy in late 2008 was managed easily; the top level economic managers do not have a model or economic package for the coming months. They seem to rely on the regime’s tools to suppress mass discontent, praying that foreign capital will flow into wage-suppressed sectors and Turkish corporations will take huge steps in due course to produce technology intensive products. Keeping fingers crossed, however, will not be sufficient to have an easy access to a new path of prosperity and high economic growth.

In a nut shell, the recent currency crisis of Turkey clearly shows that Erdoğan government is at a crossroads now. Erdogan may choose the ‘more of the same’ option and implement a standard IMF type stabilization programme that has been demanded by the dominant capital fraction in the ruling block. This option requires elimination of the most ‘zombie firms’ that were bailed out by the government after 2016 contraction. Of course, it will come with a huge political cost in the wake of the local election that will be held in March 2019.

Alternatively, Erdoğan may follow a new-developmentalist framework and initiate a kind of import substitution industrialization strategy. We should underline that there is no clear blueprint or a concise plan for a new-developmentalist project, although there are some initial attempts and ad hoc initiatives of various ministries. A full-fledged transition to a new developmentalist path would require a more substantial change in the ruling block against the interest of currently dominant fraction of capital, and a change in the mode of integration of the Turkish economy in financialised globalisation which may necessitate to impose capital controls.

Thus, Turkey’s current problems are far more complicated than the increasing interest rates or Erdoğan’s ideological approach as suggested by the international media outlets. The currency crisis now set the country as a stage for further socioeconomic turbulences. The opposition in Turkey has to struggle not only against Erdogan’s authoritarian populist rule, but also technocratic neoliberal authoritarianism, creeping in IMF’s structural reform suggestions.

Ümit Akçay (Ph. D., Berlin School of Economic and Law) and Ali Rıza Güngen (Ph. D., Turkish Social Sciences Association)

 

[1] Güngen, Ali Rıza (2018) “Financial Inclusion and Policy-Making: Strategy, Campaigns and Microcredit a la Turca”, New Political Economy, 23 (3): 331-347.

[2] Akçay, Ümit (2018) “Neoliberal Populism in Turkey and Its Crisis”, Institute for International Political Economy Berlin, Working Paper No: 100/2018, http://www.ipe-berlin.org/fileadmin/downloads/working_paper/IPE_WP_100.pdf

 

Graph showing UK public sector net borrowing

Labour’s economic policy is not neoliberal

At what point does over-use of a term as an insult render it meaningless? Richard Murphy tested the boundary yesterday when he accused John McDonnell’s economic advisor James Meadway of delivering “deeply neoliberal, and profoundly conventional thinking”. This was prompted by a negative comment James made about Modern Monetary Theory (MMT).

In response, Richard posted a list of MMT-inspired leading questions which, wisely in my opinion, James declined to answer. Richard then accused James – and by implication Labour – of not standing up to “the bankers” (including Mark Carney) and remaining wedded to conventional/mainstream/neoclassical/neoliberal thinking (Richard seems to regard these as equivalent terms). Labour is therefore signed up, in Richard’s view, to deliver “more Tory economic policy” and “more austerity”.

This is, to put it politely, nonsense.

At the heart of the debate is the decision taken by Labour, early in Corbyn’s leadership, to adopt a fiscal rule. This commits a Labour government to balancing the books on current spending with a rolling five year target, subject to a “knockout” when interest rates are close to zero. The rule has been a source of contention since it was announced. (I expressed misgivings about its announcement.)

My preference would be for a bit more wriggle room. The two dangers that must be balanced when setting fiscal policy are insufficient demand and private sector unwillingness to finance public deficits. Insufficient demand results in unemployment or underemployment, weak wage and productivity growth, and inadequate social provision. The dangers on the flipside are unsustainable borrowing costs and, particularly if this is countered using the power of the central bank, inflation. The relative weighting given to financial market conditions and inflation in the UK is almost always too high. But this doesn’t mean the correct weight is zero, as less-sophisticated advocates of MMT sometimes appear to think.

The first danger arises when the desired saving of the private sector exceeds private sector investment. In such a situation, achievement of “full employment output” requires a government deficit – give or take the current account. Standard macroeconomics largely assumes this problem away by arguing that, outside of the zero lower bound, interest rates can always be set at a level which will induce the optimal level of demand. Consequently, monetary policy is the only tool required. I disagree with this view: I think it’s quite possible for economies to be demand-constrained and thus require fiscal demand management across a range of possible interest rates.

But on balance I think the fiscal rule has enough flexibility to allow a Labour government to maintain sensible levels of aggregate demand. In any recession in the foreseeable medium-term future it is hard to imagine that interest rates will not be cut to near zero. In this case the rule will be suspended and fiscal policy can be used “with all means necessary”. Second, the rule doesn’t preclude significant increases in government investment spending – a central part of the Labour policy programme. Government investment spending is likely to have strong multiplier effects and should help to rebalance demand in the UK’s consumption-driven economy. Finally, the rolling five year window allows for adapting the pace of current spending to negative economic shocks.

I can also see good political reasons for the rule. It provides an immediate rebuttal to those who try to perpetuate the deeply dishonest but highly successful Tory strategy of depicting Labour as the party of fiscal irresponsibility. As I understand it, the rule was formulated by Simon Wren-Lewis and Jonathan Portes, two highly credible progressive economists. Simon has been one of the most consistent and articulate critics of Tory austerity. To accuse them, as Richard is doing, of “delivering neoliberal thinking” is ludicrous.

Aside from the straightforward inaccuracies, there is a deeper problem with Richard’s argument. He equates, as do some MMT advocates, radical or progressive policy with fiscal policy. There is no question that Labour’s economic programme would mark a decisive shift in macro management: it would be the end of austerity. (Austerity was never really about managing demand and debt, in my opinion: it was cover for the ideological aim of shrinking the state.) But the truly radical aims in Labour’s programme – although not yet fully fleshed out – are on the supply side: structural reforms, but not of the sort pushed by the IMF.

There is merit to this approach, in my view. Yes, the UK economy is demand-constrained. Aside from the direct human costs, austerity has almost certainly done long-run damage to the supply-side. It must end. But over the longer run the UK faces profound challenges from an ageing population, wide geographical disparities, and the potential risks and benefits of automation. It makes sense to focus on the supply side: to have an industrial strategy. A progressive supply-side policy is not an oxymoron. (I remain concerned about how such a programme can be reconciled with a hard Brexit, as some on the Left advocate.)

I have more sympathy with MMT than James. I see it essentially as a US-focused political campaign based around a single policy: the job guarantee. I am not convinced by the policy, but it is the focus of progressive economic and political action in the US. Stephanie Kelton has done an excellent job of debunking simple deficit scaremongering. But to claim, as Richard is doing, that rejecting MMT means accepting wholesale neoliberal orthodoxy is silly – as are several of the views that Richard attributes, without justification, to James.

The left deserves a better standard of economics debate.

Argentina: From the “confidence fairy” to the (still devilish) IMF

Guest post by Pablo Bortz and Nicolás Zeolla, Researchers at the Centre of Studies on Economics and Development, IDAES, National University of San Martín, and CONICET, Argentina.

In recent days, it has become customary to recall the issuance of a USD 2.75 billion 100-year bond in June 2017. This was the most colourful event of the short-lived integration of Argentina into international capital markets, beginning in December 2015. Last week, Argentina returned to the front pages of the financial press when the government requested financial assistance to the IMF amidst capital flight and a run against the peso that authorities were struggling to stop.

This is the most recent episode in the typical cycle of an emerging economy entering financial markets, suffering a balance of payments crisis and adopting an IMF-sponsored stabilization program. It starts with the claim that we are now a respected member of the international community, with presence in the Davos forum, and the promise that this time, finally, the international “confidence fairy” will awaken and investment will flood the country because of all the profit opportunities this forgotten economy has to offer. When the fairy proves to be an hallucination, we find ourselves at the steps of the IMF, facing demands, as always, for fiscal consolidation and structural reform.

When explaining this story, it is important to have some background on the Argentineans’ fascination with the dollar, and on some very recent political history. Because of its history of financial crises and its underdeveloped capital markets, there are very few savings instruments available to the non-sophisticated investor: real estate, term deposits, and dollars. Real estate prices are denominated in dollars, but you need a lot of dollars (relative to income) to buy a house. So buying dollars is pretty much a straightforward investment in uncertain times, i.e. most of the time.

Added to that, Argentina has a higher degree of exchange rate pass-through than other developing countries. The main exporters also dominate the domestic market for cooking oil and flour; oil and energy prices are dollarized; and exchange rate movements are very closely followed at times of wage bargaining. Unlike other emerging countries, and despite the sneering of some government officials, in a semi-dollarized (or bimonetary) economy such as Argentina exchange-rate pass-through is alive and kicking, which discourages large devaluations.

It is important to remember that the previous administration of Cristina Fernandez de Kirchner had implemented pervasive capital and exchange controls, which led to the development of a (relatively small) parallel market, with almost a 60% gap between the official and the parallel exchange rate. As soon as the Macri government took power in December 2015, it lifted all exchange rate controls. The official exchange rate (10 pesos per dollar) moved towards the parallel (16 pesos per dollar), and it is one of the reasons for the increase in the inflation rate, from 24% in 2015 to 41% by the end of 2016.

The new authorities also made two big moves. One was cancelling all the debt with vulture funds with new borrowing. This officially marked the return of Argentina to international capital markets. The second move, by the central bank (now lead by Federico Sturzenegger, an MIT graduate and disciple of Rudi Dornbusch), was the adoption of an inflation-targeting regime, with a mind-set that preferred freely floating exchange rates, and not much concern for current account deficits[1].

But looking at the external front, one may even be forgiven for asking: why did this crisis take so long to burst? Argentina was haemorrhaging dollars for many years, and with no sign of reversal: since 2016 the domestic non-financial sector acquired an accumulated amount of USD 41 billion in external assets. During the same period, the current account deficit totalled another USD 30 billion, in the form of trade deficit, tourism deficit, profit remittances by foreign companies and increasing interest payments.

The well-known factor that allowed all these trends to last until now is the foreign borrowing spree that involved the government, provinces, firms, and the central bank, including the inflow from short-term investors for carry trade operations. In the case of debt issuance, since 2016 the central government, provinces and private companies, have issued a whopping USD 88 billion of new foreign debt (13% of GDP).  In the case of carry trade operations, since 2016 the economy recorded USD 14 billon of short-term capital inflows (2% of GDP). The favourite peso-denominated asset for this operations were the debt liabilities of the central bank called LEBAC (Letters of the Central Bank).  Because of this, the outstanding stock of this instrument has now become the centre of all attention.

It is important to understand the LEBACs. They were originally conceived as an inter-bank and central bank liquidity management instrument. Since the lifting of foreign exchange and capital controls and the adoption of inflation targeting, the stock of LEBACs grew by USD 18 billion. Moreover, the composition of holders has changed significantly since 2015: At that time, domestic banks held 71% of the stock, and other investors held 29%. In 2018 that proportion has reverted to 38% banks/62% to other non-financial institution holders, which includes other non-financial public institutions (such as the social security administration) (17%), domestic mutual investment funds (16%), firms (14%), individuals (9%), and foreign investors (5%). This is shown in Graph 1 and Table 1. That means that a large part of all the new issuance of LEBAC is held by investors outside the regulatory scope of the central bank, especially individuals and foreign investors. This represents a potential source of currency market turbulence because these holdings could easily be converted into foreign currency, causing a large FX depreciation.

LEBACs

Holders of LEBACs, May 2018 %
Financial institutions 39%
Non-financial public sector 17%
Mutual Investment Funds 16%
Firms 14%
Individuals 9%
Foreign investors 5%

Source: Authors’ calculation based on Central Bank of Argentina

What was the trigger of the recent sudden stop and reversal of capital flows? Supporters of the central bank authorities point towards the change in the inflation target last December, when the Chief of Staff Marcos Peña (the most powerful person in cabinet) and the Economy Minister Nicolas Dujovne moved the target from 10% to 15%. In light of the change in the target, the central bank started to gradually lower interest rates from as high as 28,75% to 26.5%, while inflation remained unabated, giving rise to rumours about the government’s internal political disputes. However, inflation remained stubbornly high even before the change in the target; and there were also some minor foreign exchange runs both before and after that announcement. In the meantime, the government did reduce the budget deficit. The problem is not of fiscal origin: one has to look to the external front.

Other analysts point towards the reversal of the global financial cycle of cheap credit, which has led to devaluation of emerging markets’ currencies across the board. The turning point, in this interpretation, was when the 10-year rate on US Treasury bonds reached the 3% threshold. In a similar vein, others highlight a tax on non-residents’ financial profits that was going to come into place on May 1st, that triggered the sell-off by foreign investors. Indeed, the run was primarily driven by foreign hedge funds and big banks (notably, JP Morgan) closing their positions in pesos and acquiring dollars. However, the impact on Argentina dwarfed the devaluations, reserve losses and interest rate increments in other developing countries.

Finally, some blame the patently disastrous response of the central bank to the first indicators of a capital flight. The run accelerated in the last three weeks. The CB initially sold all the dollars that foreign banks demanded, in an attempt to control the exchange rate, without increasing interest rates. Then the devaluation accelerated, and the central bank started to increase the interest rate, to 30, to 33, and finally to 42%. Its intervention in the exchange market was equally erratic.[2]

These points have some validity, but are insufficient to explain the full extent of the run.  The reason is that investors could enter the country and could leave it without no restriction whatsoever. The main problem is the total deregulation of the financial account and the foreign exchange market, for domestic and foreign investors. The government borrowed heavily in international markets and the central bank offered large financial gains, while the external front deteriorated and domestic non-sophisticated investors were demanding dollars at increasing speed. The most infamous and egregious measure of all is the abolition of the requirement that exporters sell their foreign currency in the foreign exchange market. Instead of having an assured supply of dollars, the central bank is now forced to lure them with a high interest rate. In such a context, where capital can move freely, anything and everything is an excuse to cash in and get out. It is therefore a mistake to focus only on individual issues. The problem is the setting – the whole policy framework.  Now, the central bank is caught between only two alternatives when choosing interest rates: either to encourage carry-trade operations, or to suffer steep devaluations.

The decision to ask for an IMF loan was in the offing for some time but was rushed during the run against the peso. The government’s first intention was to obtain a Flexible Credit Line, the best (or the least evil) of all the IMF facilities, because it provides a decent amount of money with few conditionalities, or at least its minor cousin, the Precautionary and Liquidity Line (PLL), with less money but still not many conditionalities. The IMF, instead, told Argentine negotiators that there was no room for the PLL, and they would have to apply instead for the dreaded Stand-By Arrangements. All the international support and “credibility” that the Argentine government claimed to have was of no use when it came to the moment for banking on it.

But resorting to an IMF loan was not an unavoidable decision.[3] There were other ways to obtain dollars and to cap the foreign exchange run. The government could have forced exporters to sell their foreign currencies; they could have negotiated a swap agreement with some major central bank; or they could have erected barriers to capital outflows.

The report also shows what is to be expected from now on. The IMF will ask for tough measures on labour market flexibility (which was already on the government table), further cuts to public employment, wages, transfers and pensions, and lifting of the greatly reduced trade barriers. The devaluation has already happened, but it should be mentioned that previous devaluations failed to encourage exports, while they only fostered inflation.

It is impossible to forecast what will happen in 2019. On the economic front, there are at least four big risks. The first is a recession, because of the negative impact of devaluation on private consumption. The second refers to an acceleration in the inflation rate and its distributive effects. Nobody expects now that the 2018 inflation rate will be below the 2017 number (25%), and with further devaluations, inflation could spiral to new highs. A third risk, which will be persistent throughout the year, is the eventual demand for dollars by the non-bank LEBAC holders. The fourth one is a possible (though not likely) bank run. Banks have USD 22 billion of deposits denominated in dollars. Any bank-run will directly hit reserves.

This very short experience is another example of the typical boom-and-bust cycle of emerging economies borrowing heavily in foreign currency with totally deregulated financial flows and foreign exchange markets, while experiencing growing current account imbalances. If one were to obtain some “new” corollaries, we would have to point to the failure of the inflation-targeting policy framework in a semi-dollarized economy with no capital controls. The IT regime did not reduce contract indexation; exchange rate flexibility did not reduce the pass-through. And relying on the “confidence fairy” is no path to development; it is rather a highway to hellish institutions. We Argentineans thought we had rid ourselves of that devil.

 

[1] The inflation target, however, was set at very optimistic levels, was never achieved in the two years since the adoption of the IT regime, and was changed last December, something that many say had an influence in recent events.

[2] Some say that this behaviour was not a bug but a feature, since it allowed foreign banks to profit in their investments and leave the country at favourable interest rates. Others, in a less conspirative but equally perverse logic of action, say that the erratic initial response was an attempt by the central bank to prove the wrongfulness of the Ministry of Economy’s approach and regain full control of monetary policy. The unfolding of events is consistent with this argument, with the caveat that even after regaining political power, the central bank proved to be still unable of stopping the run for three weeks.

[3] In fact, when the news of the SBA came, the run actually accelerated, because one of the expected IMF conditions was a devaluation of between 10 to 25%, according to the last Article 4 Consultation Report. That might help to explain why the government wasted a loan from the BIS in less than 2 weeks.

 

The global dollar footprint – larger than you think?

Following a long and brain-fog inducing Twitter conversation (as one participant put it)  triggered by this excellent post by Brad Setser on the role of institutional investors in Taiwan’s indirect fx management regime, I remembered I had a pretty wonkish draft blog critiquing a BIS paper on fx swaps and missing dollar debt. In our twitter conversation, we were trying to work through the steps taken by Taiwanese insurance companies to hold USD assets while hedging fx risks, and the implications for BoP positions. The examples in the BIS paper are, I think, useful to order that sequence.

The BIS paper, by Claudio Borio and co-authors, argues that currency derivatives have allowed large volumes of Eurodollars to go missing from the balance sheets of financial institutions outside the US. If we were to properly account for this missing debt, then non-banks’ global dollar debt would double to USD 21 trillion. This is roughly equal to the value of global trade in 2017.  How do USD 10 trillion go missing?

The BIS paper builds on the following example the following. An investor wishes to buy foreign currency securities with domestic cash (the Taiwanese insurance companies in Brad’s post) but does not wish to run fx risk. That say Japanese (substitute Taiwanese if you wish)  investor  has three options:

  1. Spot + forward: buy USD spot with yen, use USD to purchase the US corporate bonds, and sell the same amount of USD forward.
  2. FX swap: swap yen for USD with a promise to reverse the transaction at a later point, purchase the US corporate bonds.
  3. USD Repo: keep the yen, finance USD corporate bonds by borrowing in the USD repo market, incurring outright debt.

The BIS paper warns that the first two strategies generate ‘missing debt’. Accounting rules demand repos to be recorded on the balance sheet do not impose the same recording requirements on fx swaps/forwards, except for mark-to-market values that capture the move in exchange rates[1]. This obscures the picture of global (dollar) liquidity, with serious implications for a future where central banks increase interest rates and unwind unconventional monetary policy measures.

The BIS paper provides a clear analytical framework for tracing how global dollar liquidity is created through cross-border interactions between banks and shadow banks, often in the underbelly of Eurodollar markets.

Yet I believe it is wrong in arguing that the global dollar footprint is larger than you think. Accounting conventions rightly treat repos as new debt because repos are special monetary instruments, shadow money created in the process of lending via securities markets. FX swaps are not. Treating fx swaps as hidden debt, as BIS does, leads to double-counting, while simultaneously it obscures the central role that private banks play in creating global dollar liquidity, wielding their power to create bank money via fx swaps and shadow money via repos.

Fx swaps are not new funding, repo is

The BIS paper illustrates the argument with balance sheets, where gross and net are carefully distinguished (figure 1). The gross shows rights and obligations to pay explicitly. In cases 1 and 2, the Japanese investor swaps Yen cash (C) for USD, with a promise to reverse the transaction later, that is, to pay back USD (Fx) and receive yen (F). Accounting rules render that promise invisible in net terms, simply showing on the balance sheet that the Japanese investor funds USD corporate bonds with net worth (E). In contrast, the repo promise to pay back USD (by repurchasing the corporate bonds) remains on the balance sheet.

These are three repo-like transactions with different collateral – yen cash (1&2), and USD corporate bonds (3) – raising USD funding for USD securities. The problem, BIS argues, is that only the USD repo is recognized on the balance sheet.

Figure 1 BIS illustration of fx swaps and repos, gross and net

Screen Shot 2018-05-03 at 14.38.08At first sight, this is a compelling argument, in Mehrling’s money view tradition that ‘an obligation to repay is a form of debt’. But not all obligations to pay are created equal or have the same monetary role.

Surprisingly, in the example above, there is no repo on the balance sheet. Instead of representing the repo as new IOU, the example shows the corporate bond (Ax) as a liability against yen cash (C). Yet repos are not strictly reducible to the collateral security because the corporate bond is an (encumbered) asset for the investor, financed via a new IOU repo liability (figure 2). If bank deposits are the money of financial systems organised around relationship banking, repo deposits are the money of global financial systems organised around securities markets.

Screen Shot 2018-05-03 at 14.39.15

The repo is a securities financing transaction structured legally as a sale and promise to repurchase corporate bonds, and in accounting terms as a new IOU issued to borrow cash against corporate bond collateral. Critically, the collateral securities do not leave the investor’s balance sheet. She marks these encumbered and books the transaction as financing. It is this separation between the legal and economic treatment of collateral that allows the Japanese investor to remain the economic owner of the corporate bond (Ax), entitled to (any) coupon payments and bearing the risks associated with it. The buyer of collateral treats the repo IOU as a cash-equivalent (a safe asset), whose par value is preserved by mark-to-market of collateral and margin calls. Accounting for repos on the balance sheet allows regulators and market participants to get a clear idea of the Japanese investor’s leverage (see the notorious Lehman’s Repo 105).

The fx swap does not have a similar monetary role. Compare the gross positions in the fx swap and repo in Figure 2. Both record promises to pay back USD. But there is no yen (F) asset at the investor’s disposal for the life of the fx swap – F simply records the yen that will return to the Japanese investor when the swap matures. In contrast, with the repo, the investor still has yen cash (C) at her disposal to invest in other assets. Only the repo gives investors access to new funding via money creation. In contrast, the fx swap involves (twice) exchanging IOUs already created by institutions other than the Japanese investor.

Is the difference here just (subtle) semantics? Through the swap, the investor gets the dollar corporate bonds that can be repo-ed. Is yen cash (C) in Case 3 different from the repo-able corporate bonds in Cases 1&2? Both can be used for further investment. Yet the investor can only use Ax it obtained via the fx swap if it repos it out. The now encumbered A*x remains on the balance sheet, and the investor has new cash against a repo liability (see Figure 3). It is the repo that generates additional balance sheet capacity from the unencumbered Ax. No repo, no leverage.

Screen Shot 2018-05-03 at 14.40.43

This matters more broadly for our understanding of money in modern financial systems. Monetary thinking going back to Keynes and Hayek via Minsky stresses that capitalism is a system characterized by continuous efforts to invent new liabilities that credibly promise par convertibility into money without state support. State support for par convertibility between private promises to pay (think bank deposits) and higher forms of money (banknotes, gold) is costly. It comes with constraints (bank regulation) and shifting price incentives (interest rate policies). It is against these constraints that capitalist finance constantly seeks to economize on money proper. In that sense, repos are the innovation of a financial system increasingly organised around securities markets and business models reliant on daily variation in the price of securities. Repos are shadow money that allows the Japanese investor to economise on her yen cash, to fund securities by issuing a new liability, shadow dollars. The moneyness of repo IOUs rests on an intricate process of collateral mark-to-market valuation that preserves par convertibility between repo deposit and bank deposits. While the fx swap may rely on similar margining practices to preserve the agreed exchange rate between the two currencies, at its core it is swap of assets, of IOUs created by someone else (yen for dollar cash).

The BIS paper recognizes this: ‘in case 3, the agent has the freedom to use the domestic currency cash to buy another domestic currency asset rather than having it tied up in a forward claim’. Precisely. With the fx swap, the investor has given up yen for USD, and will get it back at par when the swap matures. While the repo allows the investor to take position in dollar securities without prior funding, the fx swap does not generate additional balance sheet capacity, but rather, a series of transformations of the yen cash. If the investor had to borrow that yen cash via say commercial paper – it already had to leverage to get the yen it would swap for dollars. Counting the fx swap as leverage would be double counting.

What if the Japanese investor is a bank?

The BIS paper identifies three types of institutions in the fx swap/fwd markets: non-financial customers, financial customers and dealer banks. Dealer banks trading with financial customers generate the largest volumes (around USD 25.5 trillion), followed by interdealer (USD 25 trillion) and dealers trading with non-financial customers (USD 7.5 trillion). What changes if the investor above is a Japanese bank (see Pozsar for a money view discussion of the hierarchy of market-making in the fx swap market)?

Japanese bank swapping with a non-bank customer

Assume that a Japanese bank agrees an fx swap with a dollar-rich Japanese corporation (Figure 4). Its starting position, is yen cash – since this is the bank, cash means Bank of Japan reserves. The Japanese bank wields its power to create yen money in the fx swap market: in exchange for dollars, it creates a yen bank deposit for the Japanese corporation. It holds the dollars with its New York bank until it purchases the corporate bonds. The fx swap means a deposit swap a la Pozsar**.

 

Screen Shot 2018-05-03 at 14.56.18

On a net basis, the fx swap has expanded the balance sheet of the Japanese bank, and the yen money supply, solely because the bank uses its money creating power to execute the swap. When the swap matures, the yen money supply contracts. It is the money creation power of the Japanese bank that makes the fx swap and the repo equivalent in their impact on the balance sheet. In one case, Ax is funded with shadow dollars, in the other with new yen bank money.

Japanese bank with a US office swapping with US bank (interdealer)

 In this case, the Japanese bank’s office in the US swaps its yen cash (held in Bank of Japan reserves) for dollar cash (US Fed reserves), thus acquiring means of payment for the dollar corporate bonds (Ax). Note here that the fx swap involves swapping IOUs issued by central banks. FX swaps in this case means a reserve swap a la Pozsar.

Screen Shot 2018-05-03 at 14.59.10 

An example

Compare the behaviour of Japanese and Australian banks in dollar swap markets, pictured in the BIS paper and the graph below (which infers swap positions as residual once dollar net positions are extracted from banks’ balance sheet statements). Japanese banks are the largest borrowers of dollars via fx swaps, whereas Australian banks are among the largest lenders of dollars via fx swaps.

Screen Shot 2018-05-03 at 15.00.42

Japanese banks’ search for yield has increasingly targeted dollar assets. Rich with yen liquidity from Bank of Japan’s QE, they swapped yen into dollars to lend directly, through capital markets, and until recently, through (repo) interbank markets. With the reform of US money market funds in October 2016, Japanese banks have started to use repos for net funding of their dollar assets. In contrast, Australian banks’ dollar footprint, driven by carry trades, manifests as a form of match-book dealing in the repo-swap space. Australian banks first borrow dollars through (repo) interbank markets to lend these via swap markets in exchange for Australian dollars (AUD). This carry allows them to fund high-yielding AUD assets with cheap USD and hedge fx risk via the swap. Here the problems with the ‘fx swaps are functionally equivalent to repos’ argument become immediately apparent. Australian banks need to borrow USD first to swap into AUD.

Japanese banks’ growing swap positions raises another important, if mostly neglected question. How do their swap counterparts use their increasingly sizable yen holdings? BoJ paper identified several USD suppliers in the yen/usd swap market: sovereign wealth funds, reserve managers of emerging countries, asset managers. For these, there is a simple safe-asset arithmetic: yen obtained via swaps, even if placed in negative yielding Japanese government bonds, can provide similar or higher returns than US government securities. Yet BoJ worries that this is not a crisis-proof arithmetic. Dollar swap lenders are not a stable source of dollar funding. Taper-tantrum like tensions prompt reserve managers to shift their dollars from swaps to US Treasury bills or the Fed’s Reverse Repo Facility, whose immediate liquidity they require to defend their own currencies. Japan has already experienced sharp declines in inward bond investments when dollar swap lenders withdraw from the swap market. In a future where Bank of Japan reduces its footprint in the JGB market, the pro-cyclicality of fx swap-related demand will pose significant challenges.

In sum, fx swaps and repos are not equivalent transactions. At first sight, they seem to be the same animal: promises to pay at par supported by a similar process of preserving par via collateral management that creates mark-to-market funding pressures, firesales and liquidity spirals. The FX swap exposes investors to liquidity and rollover risk where the maturity of the asset purchased and the swap differ. The BIS is right to worry about such systemic issues, and what these imply for the Federal Reserve’s role in global dollar markets. But the similarities end there. Repos generate new funding for securities, whereas fx swaps do not, except when banks use their power to create settlement-money in the fx swap market.

* Henceforth, the text uses fx swaps as shorthand for both fx swaps and forwards.

**It is worth noting that although Pozsar shows fx swaps on the balance sheets of the various actors involved in the fx swap market, this is poetic licence. His discussion demonstrates clearly that fx swaps involve swaps of money proper rather than the creation of new liabilities.

[1] These are typically small, increasing to 15 % of notional amounts in moments of crisis.