Author: Daniela Gabor

Confessions of a deficit denier

Guest Post

The phrase ‘deficit denier’ is thrown around as an insult almost on a par with the denial of major historic disasters. As an event I clearly cannot deny the existence of a budget deficit at the present time, nor deny that there have been budget deficits for the vast majority of my lifetime.

I am though a ‘deficit denier’ in two important respects. The first is that I (and many others) deny the proposition that the budget deficit is the ‘most important economic problem’ facing the UK. Think of the economic problems facing us – poverty, unemployment, need for a greener economy and tackling climate change, low productivity growth, current account deficit, lack of housing etc.— against which any budget deficit problem fades into near insignificance. Even if the budget deficit is regarded as an issue, it should be seen as a sign of imbalances in the rest of the economy, and it is those imbalances which need to be addressed. When the deficit rose sharply in late 2008 and into 2009 it reflected the imbalances, at that time particularly the collapse of investment and of consumer demand. At present a growing imbalance is the current account deficit, and it is that deficit which needs to be addressed.

The second denial concerns the need to eliminate the budget deficit as the end point of fiscal policy. The austerity brigade promote the view that government budgets have to be balanced or in surplus (as now proposed by Osborne). And some anti-austerity campaigners still adhere to some need to eliminate the budget deficit, even if it is the sense of St Augustine ‘Lord, grant me chastity and continence; but not yet.’ Let us first recognise that to some degree growth would reduce the budget deficit, notably as tax revenues rise, and that allowing recovery to continue would allow the deficit to fall. The usual rule of thumb is that a 1 per cent increase in output would reduce budget deficit by the order of 0.5 per cent of GDP. Hence it would appear that 8 per cent higher output would be sufficient to clear the present budget deficit. However, growth which continued (and did not just represent a recovery from recession) and which involved growth of productivity and real wages would lead to public expenditure being higher as public sector wages linked with private sector wages and pensions and other transfer payments indexed to wages. In that setting the deficit would only be significantly reduced with growth if public sector wages and pensions were reduced relative to private sector wages.

The appropriate target for the budget position (whether deficit or surplus) is to ensure that fiscal policy is consistent with the achievement of high and sustainable levels of employment which we could recognize as full employment. How big or small such a deficit (or surplus) would be clearly depends on what is happening elsewhere in the private sector – what is the levels of investment and savings, what is the scale of exports, imports and the current account position. The calculation of the necessary budget position is not an easy one to make, and the budget position so required shifts over time. It is also not an easy view point to put across. But, to coin a phrase, there is no alternative if high levels of employment are to be achieved.

Malcolm Sawyer



Repo confusions

Yesterday’s Google Alert on repo markets showed a confusing picture:

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The Reuters piece looks at the US repo market. Dealers and banks there are anxious about the spillovers of the potential Greek default (remembering Lehman triggered a run in repo) and this anxiety shows in higher repo rates.

The Bloomberg article talks about the impact that the shrinking Danish repo market has on the covered bond market. Declining use of repos by banks harms liquidity in the secondary covered bond market, and threatens Danish banks’ liquidity buffers. Bloomberg cites the Danish central bank and local banks common view that regulation is discouraging\ banks’ use of repos, with unexpected consequences for the rest of the financial sector. As banks return to being more like banks (relationship based) and less like (repo) market players, financial stability suffers.

The FT piece paints a very different picture. In contrast to the US, European banks and money market funds do not seem to be concerned about the financial stability implications of the Greek negotiations. The problem in European repo markets is how to get rid of your cash – as with negative bond yields, money market funds now have others to lend cash to them. The culprit, in this story, is the ECB, who charges banks on their reserve accounts, and thus distorts short-term money markets ‘driving our traders absolutely mad’.

There are several interesting questions arising from this comparative picture:

1. How come Greek tensions manifest in US, but not European repo markets? Is it about the exposure of US to European markets, about the time horizon for tightening, or some form of inexplicable European optimism for a Greek solution ?

2. How can we account for, and separate, the impact of unconventional monetary policy  and regulation on the repo markets? Bloomberg portrays the Danish central bank as unwilling to accept its contribution to repo contraction, whereas the FT piece has traders complaining about the ECB.

This last question is fundamental given that repo markets are systemic to shadow banking. The FSB has recognised this since 2009, but its attempts to reform repos – to transform a market governed by private rules into a market governed by public rules (on haircuts) – have been watered down considerably. The European Commission and the ECB are also going down the same route, now content with simply imposing Transparency and Reporting Requirements (although some exceptions will also apply there) without trying to change margining practices that are inherently fragile. The Capital Markets Union (CMU) project also stresses that there is a trade-off between regulation and a well functioning repo market.

Thus, the argument that regulation shrinks the repo market and constrains’ banks ability to act as market makers is very useful for delaying and defeating measures to regulate the market and bring it out of the shadows. When central banks start tightening, it may come to haunt them.

3. What are the broader consequences of increasingly organising the financial system around markets and market liquidity, as the CMU aims, in turn reliant on repo markets that not even the repo lobby knows much about?

The Capital Markets Union: faith in finance restored, contract with finance rewritten?

source: Finance Watch

source: Finance Watch

Things are changing in European finance. Recent proposals by the European Commission turn post-crisis thinking on the regulation of shadow banking on its head. After Lehman regulators around the world agreed to curtail banks’ involvement in shadow banking, but recent policy initiatives frame shadow banking not as a source of systemic risk but as a crucial prerequisite for restoring sustainable growth in Europe. The Capital Markets Union (CMU) proposals aim to transform shadow banking into stable market-based finance, linking investors and savers with growth and employment. As the consultation phase has come to an end, it is clear that the CMU agenda will revive the two markets systemic to shadow banking – securitization markets and repo markets (where banks borrow short term against collateral). Two concerns arise. First, in its current form, the CMU is unlikely to advance its stated objectives. Second, the CMU risk undermining other efforts to regulate (shadow) banking.

The CMU vision is securitisation-led growth, where tradable debt connects institutional investors with entrepreneurs in SMEs and elsewhere. Since European banks need to reverse the excessive pre-crisis expansion, market-based financing alone can meet the capital needs of companies throughout Europe. Revived securitisation markets are expected to free up bank balance sheets, create liquid mediums for institutional investors to hold; and spur SME lending and infrastructure investment.

However, the CMU is unlikely to achieve much vis-a-vis these objectives if it creates new and sharpens existing sources of financial instability. If “simple, transparent securitisation” is the panacea, why haven’t markets embraced it already? Could it be the opaque legal engineering and tranching that makes securitised products attractive to investors? In this perspective, recent suggestions that public bodies -such as the European Investment Bank –  could guarantee junior and mezzanine tranches of synthetic securitisation suggests that the concept of ‘simple, transparent’ securitisation may be loose its original intent, and socialise private risks (again).

Furthermore, where securitised products are funded through repo markets, systemic risk increases. If collateral is allowed to flow freely, as envisaged by the CMU, well-known effects of procyclicality and interconnectedness will increase considerably.

The CMU’s rethinking of shadow banking encourages us to think of market liquidity as a key prerequisite of financial market efficiency and economic growth. But recent crisis experience shows that market liquidity easily evaporates in times of crisis. This is why regulators have recognised that the complex, volatile market liquidity and excessive leverage funded in repo markets are two sides of the same coin. Freely flowing collateral would make liquidity more not less fragile. This is why the Financial Stability Board (FSB) has proposed a framework for reducing the systemic vulnerabilities of the repo-liquidity nexus.

Although the CMU ostensibly aims to reduce banks’ dominance in European finance, it risks achieving the opposite. Bank separation proposals are currently at risk because the banking industry is gently persuading policymakers that such measures would undermine its role as market makers and providers of market liquidity. Since the CMU increasingly organise European finance around market liquidity, it may inadvertently increase the systemic importance of banks.

Assuming that the CMU is irreversible, we urge careful thinking on three issues. First, how can new securitisation be organised so as to best promote transparency and contain systemic risks? A pan-European regulatory agency tasked with standard-setting and prudential oversight could prove essential. Direct supervision of European capital markets should not be considered an ”unhelpful distraction” that adds little to well-functioning national supervision, when national supervisory approaches are far from either convergent or consistent. On the contrary, it is worrying that European member states dismiss the cross-border nature of systemic risk only six years after the crisis of global finance. It is worth remembering that the same arguments about national supervision of large European banks left member states woefully unprepared for the crisis of European banking after Lehman.

Second, the CMU should be accompanied by fundamental reforms of European repo markets, adopting the original FSB proposals (universal minimum haircuts) that targeted the sources of procyclicality and excessive leverage across all types of securities financing transactions. Otherwise, the reporting and transparency framework proposed by European regulators will have limited structural impact. Last but not least, European regulators would be well-advised to consider the desirability of less liquid markets that create incentives for buy-to-hold investors.

Daniela Gabor and Jakob Vestergaard