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MMT meets Rey’s dilemma: a balance sheet view of capital flight (coming soon to an EM country near you)

Recently, a colleague emailed with the following set of questions: ‘a balance sheet approach to defending currencies. Do you know literature that explains in detail the globally interlocking balance sheets between central banks, commercial banks and what happens when a national government has to defend its currency? What is the role of national and foreign reserves and how do they travel these balance sheets in the process of trying to defend a currency? I came back to this question when discussing the Swedish fight to defend the Dollar-pegged Krona in the early 90s and the promise of MMT? Most particularly we wondered to what extent national governments can just issue Krona and use them to buy foreign reserves or what sets the limits exactly to this attempt?’

My MMT friends do have answers to these questions (and they do spend a lot of time defending MMT from critiques that it doesnt consider balance of payment constraints to monetary sovereignty). I thought I would answer these questions a la Minsky, with balance sheets, since that’s how I teach my undegrad students about exchange rate management in emerging/developing countries. I teach by setting those questions within the broader conversations about global liquidity, global financial cycles and Rey’s dilemma – independent monetary policy is only possible if countries manage capital flows (capital controls).

  1. Start with an economy in autarchy: central bank issues reserves to banking sector for settlement purposes (banks pay each other in reserves), banks lend, create bank deposits in the process.

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2a. Commercial bank borrows abroad from parent bank/interbank market (USD/EUR/JPY)

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(this scenario played out in Eastern Europe before Lehman, when foreign-owned banks would borrow from parent/interbank markets – ending up with the Vienna Initiative)

2.b Commercial bank funding via fx swap with non-residents

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Step 1 occurs where local banks are allowed to lend retail in foreign currency. If it looks like MMT 2.0, it is not exactly that – without legal restrictions, the only constraint on banks creating foreign money (eurodollars) is their foreign currency reserves (an exogenous money story a la monetarism).

Even with restrictions on the lending in foreign currency (skipping steps 1&2), banks typically intermediate non-resident demand for local currency bonds via fx swaps (see my paper here on growing appetite for EM securities as part of shadow banking reform agenda). This is big enough that BIS has recently proposed to approach fx swaps as missing debt. Note that this is a global liquidity story:  without capital controls, non-resident demand/bank borrowing abroad reflects funding conditions in US money markets (see Bruno and Shin’s risk taking channel of monetary policy).

3. Rey’s dilemma kicks in: central bank intervenes to stem currency appreciation (for mercantilist or macroprudential reasons)

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For this commercial bank, the central bank’s policy rate is no longer a binding constraint, since it obtains local base money (reserves) by selling its fx liquidity to the central bank, rather than in the local interbank money market. When interest rate differentials are significant, this eases cost of funding (in the macro literature, this is part of the debate on the effect of financial globalisation on the effectiveness of inflation targeting central banks).  It’s global liquidity, not domestic liquidity, that determines short-term money market rates.

4. To regain monetary control, central banks issue own debt.

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This operation is known as sterilisation: that is, ‘sterilising’ the impact of fx market interventions on domestic money market rates. Central bank issues own securities (or sells government bonds, or takes deposits) in order to absorb back the reserves it created when it paid for the fx liquidity it bought from banks. Note here that this does not solve Rey’s dilemma, since banks have full discretion over how much to place in central bank securities. Rather, for banks this is an attractive carry – borrowing cheap abroad, placing it in risk-free local securities (banks can hedge fx risk).

If you think this is a theoretical exercise, think again.

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5. The limits to monetary sovereignty: global liquidity conditions tighten, capital flight ensues.

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In step 1, non-residents sell local securities – potentially triggering liquidity spirals if large, unregulated local repo market exists.  Note that by step 5, local banks with no direct links to global finance also start to suffer as interbank liquidity tightens. Cant the central bank mitigate this by reverse sterilisations, that is, by again insulating fx market interventions from domestic money market dynamics? The lessons from the 1997 Asian crisis, according to the IMF, is to segment domestic money markets, that is, to prevent local banks from lending to (non-resident) speculators:

Because a speculative attack requires the establishment of a net short position in the domestic currency, countries have employed a number of tactics to raise the costs of short positions. When sterilized intervention fails to stem capital outflows, short-term interest rates are allowed to rise, tightening conditions in financial markets and making it more costly for speculators to obtain a net short position by borrowing domestic currency. Frequently, however, an increase in short-term money market rates is transmitted quickly to the rest of the economy; it may therefore be difficult to sustain for an extended period, especially if there are weaknesses in either the financial system or the nonfinancial sector. When high short-term interest rates impose an unacceptable burden on domestic residents, countries may “split” the markets for domestic currency by requesting that domestic financial institutions not lend to speculators. Foreign exchange transactions associated with trade flows, foreign direct investment, and equity investments are usually excluded from such restrictions. In essence, a two-tier system is created that prevents speculators from getting domestic credit while allowing nonspeculative domestic credit demand to be satisfied at normal market rates. (IMF 1997)

Even if the central bank successfully protects local banks  from cross-border volatility triggered by global financial cycles, it can only defend the currency to the extent that it has foreign reserves. It will most likely not wait until it runs out. In the happy scenario, it draws on its swap lines to weather capital flight – but few central banks have that luxury (and ask yourself, how many will actually have it when Donald Trump needs to be consulted on this). The worst case scenario:  IMF/Troika/whoever will lend  – with heavy conditionality.

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The future of money – UWE student takes for Bristol Festival of Economics (alongside mine)

Daniela Gabor

Last month, I participated in an excellent panel on the Future of Money at the Bristol Festival of Economics.  In preparation for the event, UWE undegraduate students taking my course on Economic Theory and Policy worked together to produce two-sided briefs on what they thought to be the most interesting questions for the future of money, and distributed them in advance of the panel.   These briefs provided a great background to our conversation, exploring questions of digital money, endogenous money (and its heretics) and shadow money.

Given that we are economists with a certain respect for the power of (fair) competition, we had a contest for the best brief. The quality was excellent, so I chose three out of the seven to be distributed (see Money1 (1), Money2 and Money3).  Given the size of the audience, we could have easily distributed the rest as well (see Money Brief 4 , Money Brief 5Money at a glance 6Money Brief 7).

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My opening remarks focused on shadow money. Read them below.

Modern controversies about money typically focus on two topics – the power of banks to create money and the threats to this power posed by crypto-currencies. We suspect banks of yielding too much political power, having convinced states to enter a social contract that makes bank deposits into the ultimate money of the financial system. Bank of England recently confirmed this suspicion, in a widely discussed paper that confirmed what heterodox economists – Steve Keen here a famous example – have been saying for a long time.

There is somewhat of a paradox in this. If we consider the regulations that central banks have introduced since the crisis, they have not sought to limit banks’ power to create money. Rather, the new rules introduce by the Basel committee, and by the newly created Financial Stability Board, want banks to issue more of traditional bank deposits, and less of a new type of money, that I will call shadow money.

What is this shadow money? It is money created by banks and other financial institutions through the mysterious universe of shadow banking. If we accept the argument that a society’s money reflects the way in which the credit system is organised, then I think the future is shadow money.

Shadow money is, like all credit money, an IOU. Bank money is an IOU through which the bank promises to pay you a pound of cash for each pound in our bank deposit. You trust the bank that it will convert the deposit into cash at par if you wish to. The difference, however, is that the IOU in shadow money does not rely on trust, but on collateral. When a bank issues shadow money, it issues an IOU backed by tradable securities like government bonds, or corporate bonds, or other securities issued in shadow banking, like the famous CDOs.

Let me give you an example. You and I keep some of our wealth in a bank deposit because we trust the bank, or the deposit guarantee behind it, and because it is convenient for our daily payment routines. This is not the case for a pension fund, or an insurance company or what we call institutional investors and their asset managers. For them, traditional bank money is not an attractive option. The deposit guarantee is too small for what they consider ‘pocket money’. So the bank says ‘look, I will issue you an IOU that gives you the same kind of safety a bank deposit gives a small depositor. To create that safety, I will give you government bond collateral. I still get the interest payments on that bond but I will allow you to become the legal owner of that bond so you can sell it if I go bankrupt’. See how this clever legal arrangement behind shadow money is also advantageous for the bank – it can now fund that government bond with an IOU held by the pension fund.

The issuer of that bond – the government in our case – is also benefitting. Surely if banks and shadow banks have an IOU that allows them to borrow from institutional investors, it creates more demand and more liquidity for their government bonds. Liquidity is the magic word for governments wanting low and stable funding costs to run fiscal policies (at least until we get an MMT-inspired government). The seductive appeal of liquidity  applies to securities markets and their issuers more broadly – what we have here is clever system of organizing credit creation via capital markets. And it’s a big system – the cyryto-currency universe is worth roughly USD 200 bn. Shadow dollars, shadow euros and shadow yuan together amount to USD 20 trillion. That is, 100 times more (remember I wrote this before the Bitcoin frenzy).

This shadow money sounds really safe, you may be thinking. Why would regulators seek to limit its creation? The politics of this shadow money is both exceedingly intricate and fundamental to modern financial markets. Shadow money comes with two words that keep regulators awake at nights: leverage and interconnectedness. Going back to my example, it often occurs that the bank would be an intermediary between the pension fund who wants a safe IOU and a hedge fund who wants to borrow more to buy more securities. The hedge funds issued shadow dollars to the bank, and the bank issues shadow dollars to the pension fund. In this way, collateral has changed hands twice, it belongs to the hedge funds, but sits with the pension fund in case of default. They are all interconnected, and dependent on the hedge funds’ leverage decisions. If something goes wrong with the hedge fund, then everyone else stands to suffer.We get runs on shadow money.

Indeed, if you look close at how the global financial crisis unfolded, it started as a run on shadow dollars triggered by the collapse of Lehman Brothers – the familiar Gorton and Metrick story that proved influential in shaping how regulators think about regulating global (shadow) banking.  The run then travelled to shadow euros, where it evolved quietly but powerfully to engulf what we now call ‘periphery countries’ under the impotent eyes of the ECB, forced by its mandate to use the wrong cure (looking at you L-TROs) and make the crisis worse. Yes, this crisis is not a simple story of naive investors, fiscally irresponsible governments and European politics unable to credibly enforce rules stoping these governments. It was a crisis of shadow euros, despite ECB protestations.  It may soon resurge again in China, who is liberalising the production of shadow money in a bid to attract foreign investors and further RMB internationalisation (paper coming soon).

The future of shadow money is uncertain. One thing we know is that it takes a lot of room for manoeuvre for central banks to expand their crisis framework in order to stabilise shadow money. It is not a coincidence that the only that has done so formally – the Bank of England – is led by Mark Carney, who is also head of the Financial Stability Board. Bank of England has now formally assumed role of market-maker of last resort for systemic collateral markets (very different from lender of last resort), the only solution to stabilise shadow money outside prohibiting it all together (something the European Commission nearly – and accidentally – proposed when it planed to slap an FTT on shadow euros). The FSB & Basel III rules constrain it – and so the Trump administration is quietly making plans to free securities markets from the shackles of international regulation. To reduce the Minsky-type vulnerabilities, significantly magnified in this new world, we need a social contract around shadow money. It wont be a panacea, but it will make life a bit easier. This is not a mere question of better plumbing – it goes to the heart of ongoing discussions about the welfare state, inequality and our capacity to collectively provision for an uncertain future through the state, rather than through markets.

 

 

China’s shadow banking: New growth model or the next Lehman Brothers?

A debate between Christopher Balding and Daniela Gabor, moderated by Jo Michell

 

Thursday November 2nd 2017, 4-5.30 pm                                                                                    Faculty of Business and Law building Room 2X242                                                                      UWE Bristol, Frenchay Campus

Since the global financial crisis, shadow banking in China has grown rapidly as a result of financial repression, macro policy, and the politics of local-central government relationships. Is this the financial Wild West, the escape valve of a financial system repressed by the long hand of the state or a carefully engineered process to bring market forces into the financial system? How successful are China’s policies to transform shadow banking into securities-market based finance? Have they really addressed concerns about implicit state guarantees? And how do reforms fit with the need for deep and liquid securities markets if Reminibi internationalisation is to succeed?

Christopher Balding is an Associate Professor in Business and Economics at the HSBC Business School of Peking University Graduate School in Shenzhen, China. One of the leading experts on the Chinese economy and financial markets, he is a Bloomberg View contributor and advises governments, central banks, and investors around the world. He has contributed to Bloomberg, the Wall Street Journal, the Financial Times, BBC, CNBC, and Al-Jazeera. He tweets at @BaldingsWorld

Daniela Gabor is Professor of Economics and Macrofinance at UWE Bristol. Her research project ‘Managing shadow money’, funded by the Institute for New Economic Thinking since 2015, explores shadow banking in the US, Europe and China. One of the project papers, ‘Goodbye (Chinese) shadow banking, hello market-based finance’, will be published in Development and Change in December 2017. She is finalising a book manuscript on Shadow Money. She blogs at criticalfinance.org and tweets at @DanielaGabor

Jo Michell is Associate Professor in Economics at UWE Bristol. He has a PhD in Economics on from SOAS University of London, written about the Chinese banking and financial system. His research interests include macroeconomics, money and banking, and income distribution. He has published on macroeconomics and finance in peer reviewed journals including the Cambridge Journal of Economics and Metroeconomica. He co-edited the Handbook of Critical Issues in Finance with Jan Toporowski (Elgar, 2012).

For further inquiries, please email daniela.gabor@uwe.ac.uk

Philanthrocapitalists meet the world’s poor: international development in the fintech era

Daniela Gabor and Sally Brooks

“Within the global development landscape, few funding areas are hotter right now than financial inclusion” (Inside Philanthropy, May 2016)

“The significant progress in moving away from cash that Bangladesh has made in such a short amount of time is due to the government’s strong leadership, the innovation of the private sector and citizens’ openness to a digital future”  (The Better Than Cash Alliance)

On day one of this year’s World Economic Forum at Davos, OXFAM named US philanthropists Bill Gates and Mark Zuckerberg on the list of ‘just eight men own as much wealth as half of humanity’. Why, the question was then raised, are we bashing ‘philanthrocapitalists’ like Gates who had donated so much of their wealth to tackling global poverty?

Philanthropists, we argue in a new paper, are far more influential in international development than commonly understood. After the 2008 crisis, international development has embraced financial inclusion as the new development paradigm. With this, development interventions are increasingly organised through a new alliance of developing countries, international financial organisations, ‘philanthropic investment firms’ and fintech companies, what we term the fintech-philanthropy-development (FPD) complex. The FPD version of financial inclusion – know thy (irrational) customer – celebrates the power of technology to simultaneously achieve positive returns, philantrophy and human development.

‘Transform mobile behaviour into financial opportunity’

The premise is simple. Poverty can be tackled faster if the poor have better access to finance. And something unpredecented is happening with the world’s poor in Sub-Saharan Africa, Asia, Latin America and the Caribbean. Roughly 1.7 billion of the 2 billion without formal access to finance have a mobile phone. These generate ‘digital footprints’ that can be harnessed by big data and predictive algorithms to better understand, and thus include, the ‘unbankable’. Transforming mobile behaviour into financial opportunity.

The FPD origins can be traced back to the Alliance for Financial Inclusion. Created in 2011 with funding from the Bill and Melinda Gates Foundation (BMGF) and endorsement from G20 as key to achieving the sustainable development goals, AFI brought together policy makers from ninety developing countries united in their commitment to work with private actors and international development organisations (the World Bank) in order to ‘reach the world’s 2.5 billion unbanked’. By 2014, the Omidyar Network (backed by Ebay founder Pierre Omidyar) would become the second philanthropic investment organization officially partnered with AFI. That same year, AFI launched the Public Private Dialogue Platform (PPD), promising the private sector ‘an unprecedented opportunity’ to connect to policy makers who are regulating new and high growth markets. In 2015, Mastercard, Visa and the Spanish bank BBVA have become AFI members, with more partnerships to be formalized in the future. Meanwhile, the AFI acts an umbrella and incubator for a growing number of global and regional FI programmes such as the UNDP-Funded ‘Mobile Money for the Poor’ (MM4P) and ‘Shaping Inclusive Finance Transformations’ (SHIFT), among others.

Thus, the FPD complex sees the growing influence of a digital elite in development interventions. The public-private partnerships are predicated on the idea that technology and big data can play a critical role in advancing financial inclusion. For example, the Omidyar Network is investing in fintech companies whose strategic goal is to ‘disrupt traditional risk assessment’ by, for example, predicting customers ‘appetite for risk’ based on ‘patterns of calls and text messages’, or even inviting them to participate in online games and quizzes that generate behavioural data that can be fed into predictive algorithms. The promise is to connect lenders to upwardly mobile customers. Through these strategies of what Izabella Kaminska has called ‘financial intrusion’, consumers’ ‘digital footprints’ are being created, without their knowledge, and used or stored for future commercial use.

A cash-lite future

India’s recent demonetization initiative has received global attention. Widely judged as a misstep, the decision to withdraw 86% of all cash from circulation is typically explained as fight again shadow economy. But there is more to India’s initiative. It represents one (important) element of its adoption of  the FPD approach to development.

Indeed, the state agreed to play an important role in the harvesting and commodification of digital footprints, by opening up its direct relationship with the poor to fintech. A spinoff from the AFI, the Better than Cash Alliance, encourages developing countries to digitalize social transfers, thus reaching the ‘unbankable’ at a stroke through the long arm of the state. Housed at the UN as implementing partner for the G20 Global Partnership for Financial Inclusion, the Better than Cash Alliance promises that a ‘cash lite’ Finance for Development agenda would put the UN’s Sustainable Development Goals within reach (Goodwin-Groen 2015).

The Better than Alliance has proved adept at illustrating the benefits of a cash-lite future. Digitizing payments from government to people can save the government of Bangladesh US 146 million per year across 6 social safety net programs. India, a member since 2015, saves USD 2billion by paying cooking gas subsidies digitally.

While such savings appeal immediately to governments worldwide, a Bankable Frontier Associates report made clear what is at stake in the ‘journey towards cash lite’. For financial service providers, the opportunities for FI via digital payments do not arise from increasing use of bank deposits by the previously unbanked, since bank accounts are not ‘daily relevant’. Rather, opportunities ‘come from financial service providers using the digital information generated by e-payments and receipts to form a profile for each individual customer’. This digital profiling then enables providers to offer more appropriate and relevant products.

Thus, data and algorithms become critical to pushing the risk frontier in low-income countries, as fintech companies create, collect and commodify behavioral data, within an ‘ecosystem’ fostered by networks of philanthropic investors, development finance institutions and donors and policy makers in participating countries.

Another, potentially more problematic issue arises in this process. Traditional microfinance lenders mobilised peer pressure in ‘solidarity groups’ to discipline borrowers to be ‘good financial citizens’. In the fintech era of international development, the mantra is ‘know thy irrational customer’ via algorithms. Cignifi for instance promises to continuously track changes in customers’ mobile behaviour, as mobile phones generate data that capture users moving from ‘one behavioural state to another’. This would allow lenders to create choice architectures that nudge customers in the direction of desired behaviours to preserve mobile-data-based credit score.

While the ethics of nudge are increasingly being debated, digital financial inclusion combines the inherent opacity of nudge techniques with that of predictive algorithm design, technically complex and subject to commercial confidentiality, in ways that have remained remarkably free from scrutiny.

While these programmes have adopted the language of inclusion and access, the question is who is actually accessing whom? Since the 2008 financial crisis a tendency to see its victims, rather than the system that created it as most in need of correction, has become entrenched. Meanwhile the possibilities of ‘fintech’ together with discovery of the ‘nudge’ toolbox has created new opportunities for financial capital to reach ever more remote consumers. As if the crisis never happened, this is the sub-prime ‘moment’ recast, perversely, as development policy, turning poverty in the developing world into a new frontier for profit making and accumulation.

 

There is nothing “simple” about the European Commission’s securitisation proposal

On May 23, 2016, 83 scholars from Europe wrote to the European Parliament to call for a careful consideration of the European Commission’s proposals for a new market for STS securitisations, part of the Capital Markets Union agenda. Members of the ECON Committee of the European Parliament are currently working on this proposal. Read the full letter here  – Open letter to MEPs – STS securitisation.

 

 

Why isn’t the Commission talking about government debt?

One more cue to how controversial government debt markets are in Euroland these days.

The European Commission’s progress report on Capital Markets Union, manages to make no reference whatsoever to the issue of government bond markets, their life after the ECB’s QE (bound to end someday) and their critical role in capital markets integration. It’s all about securitisation, corporate bond market liquidity and covered bonds.

Compare this with early views on what it takes to create a market-based financial system in Euroland. In May 1999, Alexandre Lamfalussy, recently appointed head of EuroMTS  and former head of the European Monetary Institute (that would become the ECB), had this to say:

 “We’ve seen an accelerated move to a market-centric system from the bank-centric system that has tended to prevail in Europe,” Lamfalussy said in London last month. “I have no doubt that a market-centric system is more efficient, but there’s a question whether it is stable.” The key to stability, he concludes – for the pricing of corporate as well as public debt – is a liquid and transparent government debt market.’

This is a story of shadow money – the ongoing struggle to define a social contract for liabilities issued against sovereign collateral.

Who is writing the IMF’s recent history?

No, this is not a blog about the impossible triangle IMF-Commission-Greece. I am skeptical anything new can be said about it.

It’s about something perhaps more fundamental: the IMF’s willingness to confront its inglorious past on the free movement of capital.

A couple of months ago, in February 2016, the Fund released a working paper by Atish Ghosh and Mahvash Qureshi, of the Research Department. That paper traces the historical processes through which capital controls became anathema to policy communities around the world, including the IMF. It doesn’t hide behind pretty memes (capital flow management) and technical language: visceral opposition to capital controls,  it argues, arose from the free market ideology of the 1980s and 1990s! It’s the politics.

The IMF Research Department, that paper shows, doesn’t need to hide behind closed doors to read Keynes, Eric Helleiner or Kevin Gallagher* . It can now do it in the open.

Skeptics of IMF’s revolutionary transformations (and I am one, as I argued here for IMF’s view of capital controls and here for global banking), would point to the institutional pathologies of the IMF. The Research Department has far greater liberty to engage in/with heterodox  alternatives, but that doesn’t always translate into profound institutional change.

What is different here: Lagarde has just nominated Atish Ghosh, together with the Princeton historian Harold James, to ‘chronicle defining moments in the Fund’s history’.

Professor James and Mr. Ghosh will write the Fund’s official history from 2000 to 2015, a period characterized by the global financial crisis, the crisis in Europe, and the growing role of emerging and developing countries in the world economy — all defining moments in the Fund’s history

This history  will include the pre-2008 near fall in oblivion (‘assisted’ by Venezuela’s oil money helping large countries pay back the IMF), the Eastern European and then Greek/Irish/Portuguese adventures, Blanchard’s reign with shifts on capital controls, on DSGE ‘supremacy’, on fiscal multipliers, on ‘we need to build analytical capacity for understanding global finance’. Cant wait to read it.

Daniela Gabor

*odd that the paper does not reference Helene Rey’s dilemma, but small miracles…

 

UK Economy is more unbalanced than ever

This article is taken from EREP’s 2016 budget report.

At the end of February, Chancellor George Osborne made an admission: ‘the economy is smaller than we thought in Britain’. The tone has changed since November when, following the unexpected discovery of a spare £27bn by the OBR, the Chancellor triumphantly declared, ‘our long term economic plan is working.’ As it turns out, the UK economy is around one per cent, or £18bn, smaller than the OBR predicted, leaving the Chancellor with at least £5bn in missing tax revenues this year alone, and more in future years (estimated at £9bn per year by the Institute for Fiscal Studies). There is no chance he will keep to his own misguided fiscal rule.

EREP have consistently argued that the supply-side optimism implicit in the OBR forecasts was unwarranted. We were right. Economic indicators across the board have deteriorated significantly since the November forecast. Even the service sector, the single remaining engine of the UK’s imbalanced economy, is now showing signs of mechanical failure. The Markit UK services PMI – a key indicator of activity in the services sector – fell sharply in February. There is no chance that UK growth will be 2.4% in 2016, as claimed by the Chancellor in November.

Osborne’s tax shortfall is the result of much lower than predicted wages and prices. The broadest measure of inflation, the GDP deflator, has fallen to zero, while wage growth has slowed substantially to around two per cent – the OBR had predicted wage growth of three to four per cent over the rest of this parliament.

Despite weakening wage growth, retail sales have remained strong: the most recent figures showed year-on-year spending increases in excess of two per cent. Retail sales strength has driven in part by lower prices resulting from the sharp decline in oil prices. But while households in other major economies largely saved the windfall from lower oil prices, those in the UK spent it, and more. The UK household savings ratio, at 4.4% of disposable income, is now the lowest on record.

hh-s-ratio

And despite weakening wage growth, the UK economy is now entirely reliant on continued household consumption spending. Contrary to Osborne’s claim that growth ‘is more balanced than in the past’, the UK trade deficit is a drag on economic activity and business investment –  which only recently regained pre-crisis levels – fell sharply in February.

How have UK households increased spending despite wages remaining well below pre-crisis levels? Unsecured consumer credit is growing at around nine per cent per annum – the fastest rate since 2005. At over 140% of disposable income, UK household debt is higher than in the US, Japan or the largest European nations. Even the optimistic and now-discredited OBR forecasts predicted the household debt-to-income ratio would need to rise to 160% by 2020 for growth to be maintained and the deficit eliminated.

A recent report by the Money Advice Service – an independent body set up by the government – reports that 8.2 million adults in the UK – one in six of the population – are over-indebted. Among poorer regions, such as the Welsh valleys, the figure rises to one in four. The problem is particularly acute among young people, those in rented accommodation and those with children.

It is exactly these groups – working families and young people – whom the Chancellor will target in the next round of austerity. In the previous Parliament, austerity was targeted at the most marginalised: the sick, the disabled and the unemployed. Since these people have least voice in society, they are unable to put up resistance. Cutting the incomes of working families will be more difficult, as Osborne’s U-turn on tax credits shows.

By reducing working peoples’ incomes, Osborne is attempting push the burden of debt onto the household sector. The strategy will fail – without wage growth, consumer spending will eventually be constrained, dampening growth and pushing Osborne’s deficit-reduction strategy yet further off track. That deficit reduction is not really the ultimate aim of Osborne’s strategy is made plain by his intention to continue cutting tax for those on higher incomes.

There is no long-term economic plan; Osborne’s strategy is one of redistribution by taking from those who least can afford it. As the latest figures show, his strategy has backfired.

 

The report’s authors include:

Ann Pettifor & Jeremy Smith on “The British economy is even “smaller” than the Chancellor asserts”

John Weeks on the Chancellor’s “Growing record in fiscal mismanagement”

Jo Michell on “A weakening economy, reliant on consumption and debt”

Graham Gudgin & Ken Coutts on “A history of missing fiscal targets”

Richard Murphy on “Tax in the 2016 budget”

Information on EREP is available here.

The ECB as lender of last resort….or on the short memory of central bankers

ECB President Draghi speaks to France's Central Bank Governor Noyer and ECB Member of Executive Board Praet in Barcelona

Peter Praet, member of the Executive Board of the ECB, gave an interesting speech on the ECB’s lender of last resort (LOLR) activities in crisis on February 10, 2016.

The ECB, he argued, had a two-folded approach: a ‘monetary approach’ LOLR and a ‘credit approach’ LOLR.

The ‘monetary’ LOLR, following the classic advice from Walter Bagehot, lent European banks base money (reserves) if these banks had acceptable collateral. The purpose:

to create new reserves, on demand, for cash-stripped banks with viable business models, and thus to help these banks go through an emergency liability substitution operation without being forced to make large- scale fire sales of assets that would lead to insolvency

This approach, he suggests, was used in the first phase of the crisis, immediately after Lehman, when banks became reluctant to lend to each other, and in the second phase, the European sovereign debt crisis. In his account, the ECB bears no responsibility for either, the crisis being rather a combination of the confidence fairy and the sovereign-bank loop, somehow only ‘diabolical’ in Europe:

The second phase of the crisis came as a consequence of a much more targeted and disruptive loss of confidence: the sovereign debt crisis. This was special to Europe; it brought on the development of redenomination risk and thereby threatened the integrity of our currency. Banks’ exposures to selected governments came under intense market scrutiny and entire national banking systems lost access to wholesale funding.

The ‘credit’ approach involved the provision of emergency liquidity assistance – the now famous ELA. In contrast to the ‘monetary’ LOLR, this involves a more discretionary approach, whereby national central banks assume the responsibility, and the potential costs, for supporting banks without eligible collateral.

Imagine that Praet decides to read his own research before writing this speech. He chooses a 2008 paper he wrote with Valerie Herzberg, entitled ‘Market liquidity and banking liquidity’, while both were at Bank of Belgium. Here is a copy-paste of their arguments:

  1. Interbank funding is itself becoming increasingly dependent on market liquidity as a growing proportion of interbank transactions is carried out through repurchase agreements.
  2. This increasing reliance on secured operations means that (European) banks are mobilising a growing fraction of their securities portfolio as collateral.
  3. Banks are increasingly mobilising their traditional government and corporate bond portfolios to finance less liquid, but higher yielding forms of assets that again can be reused as collateral.
  4. In periods of stress, margin and collateral requirements may increase if counterparties have retained the right to increase haircuts or if margins have fallen below certain thresholds.
  5. Asset liquidity may no longer depend on the characteristics of the asset itself, but rather on whether vulnerable counterparts have substantial positions that need liquidating.

This, we argue with Cornel Ban in our paper ‘Banking on bonds’, is the untold story of the European sovereign debt crisis. Not a story of a confidence fairies and redenominations risks, but of rapidly growing European repo markets before the crisis (1 above), of European banks mobilizing their portfolios of European government debt as collateral (2 and 3), of runs on collateral markets, including the government bond markets of the European periphery (4), that reflected more the funding pressures of large banks involved in US shadow banking than the fiscal probity of sovereigns (5). The European sovereign debt crisis was a story of fragile collateral in market-based banking, rather than the convenient eruption of redenomination risk.

More importantly, we argue, the ECB increased stress in collateral markets exactly as Praet predicted in point 4: in its lender of last resort operations, the ECB increased margin and collateral requirements, made margin calls, and in general worsened funding conditions at critical junctures in the crisis, both for European banks and European sovereigns.

Thus, we show that the ECB has played a critical role in trying to energize the integration of national repo markets in the Eurozone in the early 2000s. It decided to treat all Eurozone governments as equal collateral for its collateral framework – the terms on which it lends, via repo operations, against collateral. With this, it hoped private repo markets would follow suit, and accelerate integration of European financial markets. Anticipating objections that this effectively encouraged fiscal indiscipline in Europe (objections so loudly formulated by 2005 by Willem Buiter that Trichet was forced to defend the ECB’s collateral decisions in the European Parliament), the ECB adopted the risk practices of repo market participants: daily mark-to-market, margin calls and haircuts.

In doing so, the ECB could argue that its collateral policies had no substantive impact on government bond markets for two reasons. First, banks had little incentive to use government bonds to borrow from the central bank, since its repos carried higher haircuts than private repo transactions (where haircuts were zero for government debt) and ECB-held collateral could not be re-used in the repo market. Second, the ECB stressed that its collateral policie accommodated market views of credit quality. If markets distrusted Germany, its bonds would fall in market value. Like any repo market participant, the ECB would mark German collateral to market and make margin calls. Rather than disrupt, the ECB argued that its collateral policies reinforced private market discipline.

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By trying to strike a delicate balance between its financial integration priorities and its independence, the ECB made a radical departure from how central banks in EMU countries had previously managed lending operations, including lender of last resort. These central banks rarely marked to market and never made margin calls when lending to banks (except the Dutch central bank), and few used initial haircuts.

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By 2012, the ECB recognized that market collateral practices matter, but refused to include its own practices in that analysis. Vitor Constâncio noted that ‘the decline in collateral values translates in additional collateral calls possibly compounded with higher haircuts and margins requirements. A system in which financial institutions rely substantially on secured lending tends to be more pro-cyclical than otherwise’. He could have added: ‘ a system in which the central bank relies substantially on secured lending tends to be more pro-cyclical than otherwise’. The graph below is illustrative – it shows that the ECB was making increasingly large margin calls throughout 2012, and those calls only diminished once it announced OMT.

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Short memory vs. politics and accountability? Had Praet followed through with his 2008 analysis, he would have had to make the ECB an active actor in the crisis. The dominant narrative that he reproduces in his 2016 speech –  that it miraculously came to the rescue of inept governments in the periphery – does not hold under scrutiny of his 2008 predictions. The European public – including governments – would have good reason to hold ECB accountable for its disruptive role in the European crisis.

China’s economy at a crossroads

With impecable timing, we are organising a one day conference on China in Copenhagen, on January 26. The blurb below, program and registration here.

Since the global financial crisis, it is becoming increasingly apparent that China matters for the stability and growth of the world economy. Yet questions of how, why and to what extent have not been settled. Pessimists predict a hard landing that will spread deflationary pressures across the world, while optimists retain their faith in the ability of China to learn from its experiments and keep the engine running. In this conference, we engage regulators, academics and market participants in a conversation that explores critical questions of macroeconomic rebalancing, debt and currency management, RMB internationalization, monetary policy and capital account liberalization.

Speakers
Christopher Balding, Peking University, HSBC Business School
Luke Deer, Post-Doctoral Research Fellow, University of Sydney
Daniela Gabor, Associate Professor, University of West England
Tao Guan, Senior Fellow at CF 40, former Director-General of Balance of Payments Department, State Administration of Foreign Exchange (SAFE)
Patrick Hess, Senior Financial Market and China Expert, European Central Bank
Hu Hongbo, First Political Secretary, Chinese Embassy of Copenhagen
Yang Jiang, Senior Researcher, Danish Institute for International Studies
Zhang Jun, Director of China Centre for Economic Studies, Fudan University
Annina Kaltenbrunner, Lecturer, Leeds University Business School
George Magnus, Associate at Oxford University’s China Centre
Allan von Mehren, Chief Analyst and Head of International Macro, Danske Bank
Anders Svendsen, Chief Analyst, Emerging Markets Division, Nordea
Niels Thygesen, Professor Emeritus, University of Copenhagen
Jakob Vestergaard, Senior Researcher, Danish Institute for International Studies
Ming Zhang, Director, Department of International Investment, Institute of World Economics and Politics, Chinese Academy of Social Sciences (CASS), Beijing