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…

 

Economics: science or politics? A reply to Kay and Romer

Romer’s article on ‘mathiness’ triggered a debate in the economics blogs last year. I didn’t pay a great deal of attention at the time; that economists were using relatively trivial yet abstruse mathematics to disguise their political leanings didn’t seem a particularly penetrating insight.

Later in the year, I read a comment piece by John Kay on the same subject in the Financial Times. Kay’s article, published under the headline ‘Economists should keep to the facts, not feelings’, was sufficiently cavalier with the facts that I felt compelled to respond. I was not the only one – Geoff Harcourt wrote a letter supporting my defence of Joan Robinson and correcting Kay’s inaccurate description of her as a Marxist.

After writing the letter, I found myself wondering why a serious writer like Kay would publish such carelessly inaccurate statements. Following a suggestion from Matteus Grasselli, I turned to Romer’s original paper:

Economists usually stick to science. Robert Solow was engaged in science when he developed his mathematical theory of growth. But they can get drawn into academic politics. Joan Robinson was engaged in academic politics when she waged her campaign against capital and the aggregate production function …

Solow’s mathematical theory of growth mapped the word ‘capital’ onto a variable in his mathematical equations, and onto both data from national income accounts and objects like machines or structures that someone could observe directly. The tight connection between the word and the equations gave the word a precise meaning that facilitated equally tight connections between theoretical and empirical claims. Gary Becker’s mathematical theory of wages gave the words ‘human capital’ the same precision …

Once again, the facts appear to have fallen by the wayside. The issue at the heart of the debates involving Joan Robinson, Robert Solow and others is whether it is valid to  represent a complex macroeconomic system (such as a country) with a single ‘aggregate’ production function. Solow had been working on the assumption that the macroeconomic system could be represented by the same microeconomic mathematical function used to model individual firms. In particular, Solow and his neoclassical colleagues assumed that a key property of the microeconomic version – that labour will be smoothly substituted for capital as the rate of interest rises – would also hold at the aggregate level. It would then be reasonable to produce simple macroeconomic models by assuming a single production function for the whole economy, as Solow did in his famous growth model.

Joan Robinson and her UK Cambridge colleagues showed this was not true. They demonstrated cases (capital reversing and reswitching) which contradicted the neoclassical conclusions about the relationship between the choice of technique and the rate of interest. One may accept the assumption that individual firms can be represented as neoclassical production functions, but concluding that the economy can then also be represented by such a function is a logical error.

One important reason is that the capital goods which enter production functions as inputs are not identical, but instead have specific properties. These differences make it all but impossible to find a way to measure the ‘size’ of any collection of capital goods. Further, in Solow’s model, the distinction between capital goods and consumption goods is entirely dissolved – the production function simply generates ‘output’ which may either be consumed or accumulated. What Robinson demonstrated was that it was impossible to accurately measure capital independently of prices and income distribution. But since, in an aggregate production function, income distribution is determined by marginal productivity – which in turn depends on quantities – it is impossible to avoid arguing in a circle . Romer’s assertion of a ‘tight connection between the word and the equations’ is a straightforward misrepresentation of the facts.

The assertion of ‘equally tight connections between theoretical and empirical claims’, is likewise misplaced. As Anwar Shaikh showed in 1974, is it straightforward to demonstrate that Solow’s ‘evidence’ for the aggregate production function is no such thing. In fact, what Solow and others were testing turned out to be national accounting identities. Shaikh demonstrated that, as long as labour and capital shares are roughly constant – the ‘Kaldor facts’ – then any structure of production will produce empirical results consistent with an aggregate Cobb-Douglas production function. The aggregate production function is therefore ‘not even wrong: it is not a behavioral relationship capable of being statistically refuted’.

As I noted in my letter to the FT, Robinson’s neoclassical opponents conceded the argument on capital reversing and reswitching: Kay’s assertion that Solow ‘won easily’ is inaccurate. In purely logical terms Robinson was the victor, as Samuelson acknowledged when he wrote, ‘If all this causes headaches for those nostalgic for the parables of neoclassical writing, we must remind ourselves that scholars are not born to live an easy existence. We must respect, and appraise, the facts of life.’

What matters, as Geoff Harcourt correctly points out, is that the conceptual implications of the debates remain unresolved. Neoclassical authors, such as Cohen and Harcourt’s co-editor, Christopher Bliss, argue that the logical results,  while correct in themselves, do not undermine marginalist theory to the extent claimed by (some) critics. In particular, he argues, the focus on capital aggregation is mistaken. One may instead, for example, drop Solow’s assumption that capital goods and consumer goods are interchangeable: ‘Allowing capital to be different from other output, particularly consumption, alters conclusions radically.’ (p. xviii). Developing models on the basis of disaggregated optimising agents will likewise produce very different, and less deterministic, results.

But Bliss also notes that this wasn’t the direction that macroeconomics chose. Instead, ‘Interest has shifted from general equilibrium style (high-dimension) models to simple, mainly one-good models … the representative agent is now usually the model’s driver.’ Solow himself characterised this trend as ‘dumb and dumber in macroeconomics’. As the great David Laidler – like Robinson, no Marxist –  observes, the now unquestioned use of representative agents and aggregate production functions means that ‘largely undiscussed problems of capital theory still plague much modern macroeconomics’.

It should by now be clear that the claim of ‘mathiness’ is a bizarre one to level against Joan Robinson: she won a theoretical debate at the level of pure logic, even if the broader implications remain controversial. Why then does Paul Romer single her out as the villain of the piece? – ‘Where would we be now if Solow’s math had been swamped by Joan Robinson’s mathiness?’

One can only speculate, but it may not be coincidence that Romer has spent his career constructing models based on aggregate production functions – the so called ‘neoclassical endogenous growth models’ that Ed Balls once claimed to be so enamoured with. Romer has repeatedly been tipped for the Nobel Prize, despite the fact that his work doesn’t appear to explain very much about the real world. In Krugman’s words ‘too much of it involved making assumptions about how unmeasurable things affected other unmeasurable things.’ So much for those tight connections between theoretical and empirical claims.

So where does this leave macroeconomics? Bliss is correct that the results of the Controversy do not undermine the standard toolkit of methodological individualism: marginalism, optimisation and equilibrium. Robinson and her colleagues demonstrated that one specific tool in the box – the aggregate production function – suffers from deep internal logical flaws. But the Controversy is only one example of the tensions generated when one insists on modelling social structures as the outcome of adversarial interactions between  individuals. Other examples include the Sonnenschein-Mantel-Debreu results and Arrow’s Impossibility Theorem.

As Ben Fine has pointed out, there are well-established results from the philosophy of mathematics and science that suggest deep problems for those who insist on methodological individualism as the only way to understand social structures. Trying to conceptualise a phenomenon such as money on the basis of aggregation over self-interested individuals is a dead end. But economists are not interested in philosophy or methodology. They no longer even enter into debates on the subject – instead, the laziest dismissals suffice.

But where does methodological individualism stop? What about language, for example? Can this be explained as a way for self-interested individuals to overcome transaction costs? The result of this myopia, Fine argues, is that economists ‘work with notions of mathematics and science that have been rejected by mathematicians and scientists themselves for a hundred years and more.’

This brings us back to ‘mathiness’. DeLong characterises this as ‘restricting your microfoundations in advance to guarantee a particular political result and hiding what you are doing in a blizzard of irrelevant and ungrounded algebra.’ What is very rarely discussed, however, is the insistence that microfounded models are the only acceptable form of economic theory. But the New Classical revolution in economics, which ushered in the era of microfounded macroeconomics was itself a political project. As its leading light, Nobel-prize winner Robert Lucas, put it, ‘If these developments succeed, the term “macroeconomic” will simply disappear from use and the modifier “micro” will become superfluous.’ The statement is not greatly different in intent and meaning from Thatcher’s famous claim that ‘there is no such thing as society’. Lucas never tried particularly hard to hide his political leanings: in 2004 he declared, ‘Of the tendencies that are harmful to sound economics, the most seductive, and in my opinion the most poisonous, is to focus on questions of distribution.’ (He also declared, five years before the crisis of 2008, that the ‘central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades.’)

As a result of Lucas’ revolution, the academic economics profession purged those who dared to argue that some economic phenomena cannot be explained by competition between selfish individuals. Abstract microfounded theory replaced empirically-based macroeconomic models, despite generating results which are of little relevance for real-world policy-making. As Simon Wren-Lewis puts it, ‘students are taught that [non-microfounded] methods of analysing the economy are fatally flawed, and that simulating DSGE models is the only proper way of doing policy analysis. This is simply wrong.’

I leave the reader to decide where the line between science and politics should be drawn.

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.

Screen Shot 2016-02-11 at 17.26.17

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.

Screen Shot 2016-02-11 at 17.00.12

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.

Screen Shot 2016-02-11 at 17.01.05

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

 

2015: Private Debt and the UK Housing Market

This report is taken from the EREP’s Review of the UK Economy in 2015.

In his 2015 Autumn Statement, Chancellor George Osborne gave a bravura performance. He congratulated himself on record growth and employment, falling public debt, surging business investment and a narrowing trade deficit. He announced projections of continuous growth and falling public debt over the next parliament.

While much of this was a straightforward misrepresentation of the facts – capital investment has yet to recover from the 2008 crisis and the current account deficit continues to widen – other sound bites came courtesy of the Office for Budget Responsibility. The OBR delivered the Chancellor an early Christmas present in the form of a set of revised projections showing better-than-expected public finances over the next five years.

When, previously, the OBR inconveniently delivered negative revisions, the Chancellor responded by pushing back the date he claims he will achieve a budget surplus. In response to the OBR’s gift, however, he chose instead to spend the windfall.  This is a risky strategy because any negative shock to the economy means he will miss his current fiscal targets – targets he has already missed repeatedly since coming to office.

As it turns out, these negative shocks have materialised rather quickly. Since the Chancellor made his statement a month ago, UK GDP growth has been revised down, the trade deficit has widened and estimates of borrowing for the current year have increased.

ca-forecasts

In reality, the OBR projections never looked plausible. The UK’s current account deficit – the amount borrowed each year from the rest of the world – is at an all- time high of around 5% of GDP. Every six months for the last three years, the OBR forecast that the deficit would start to close within a year; every time they were proved wrong (see figure above).  Their current assertion – that the trend will be broken in 2016 and the deficit will steadily narrow to around 2% of GDP in 2020 – must be taken with a large pinch of salt.

The current account deficit measures the combined overseas borrowing of the UK public and private sectors. In the unlikely event that George Osborne was to achieve his stated aim of a budget surplus, the whole of this foreign borrowing would be accounted for by the private sector. This is exactly what the OBR is projecting. Specifically, they predict that the household sector will run a deficit of around 2% per year for the next five years. They note that “this persistent and relatively large household deficit would be unprecedented”.

This projection has been the basis of recent stories in the press which have declared that the Chancellor has set the economy on a path to almost-certain financial meltdown within the current parliament. This is too simplistic an analysis. Financial imbalances can persist for a long time. The last UK financial crisis originated not in the UK lending markets but in UK banks’ exposure to overseas lending.

But the Chancellor’s strategy entails serious financial risks. Even though there is no real chance of achieving a surplus by 2020, further cuts to government spending will squeeze spending out of the economy, placing ever more of the burden on household consumption spending to maintain growth.

The figure below shows the annual growth in lending to households. While total credit growth remains subdued, unsecured lending has, in the words of Andy Haldane, chief economist at the Bank of England, been “picking up at a rate of knots”.

debt-growth

Moderate growth in the mortgage market may conceal deeper problems: household debt-to-income ratios have fallen since the crisis but, at around 140% of GDP, remain high both in historical terms and compared to other advanced nations. The majority of new mortgage lending since 2008 has been extended to buy-to-let landlords. These speculative buyers now face the prospect of rising interest rates and tax changes that will take a large chunk out of their property income. Many non-buy-to-let borrowers are badly exposed: a sixth of mortgage debt is held by those who have less than £200 a month left after spending on essentials.

The Financial Policy Committee has noted that these trends “… could pose direct risks to the resilience of the UK banking system, and indirect risks via its impact on economic stability”.

What is often left out of the more apocalyptic visions of a coming credit meltdown is that underlying all this is an unprecedented housing crisis in which an entire generation are locked out of home ownership. Instead of tackling this crisis, Osborne is using the housing market as a casino in the hope of keeping economic growth on track during another five years of austerity. It is a high-risk strategy. His luck may soon run out.

The report’s authors include:

John Weeks on fiscal policy

Ann Pettifor on monetary policy

Richard Murphy on taxation

Özlem Onaran on inequality and wage stagnation

Jeremy Smith on labour productivity

Andrew Simms on climate change and energy

Jo Michell on private debt

The full report is can be downloaded here.

Information on EREP is available here.

Happy Christmas from the Office of Budget Responsibility

Image reproduced from here

The sectoral balances approach to economic forecasting has come under scrutiny recently. It is certainly the case that when used carelessly, projections based on accounting identities have the potential to be either meaningless or misleading. This will be the case if accounting identities are mistakenly taken to imply causal relationships, if projections are presented without a clear statement of the assumptions about what drives the system or if changes taking place in ‘invisible’ variables such as the rate of growth of GDP are not identified (balances are usually presented as percentages of GDP).

Used with care, however (or luck, depending on your perspective), the approach is not without its merits – as I have argued previously. If nothing else, the impossibility of escaping from the fact that in a closed system lending must equal borrowing imposes logical restrictions on the projections that can be made about the future paths of borrowing in a ‘closed’ macroeconomic system.

Which brings us to the Chancellor’s Autumn Statement and the OBR’s rather helpful projections. As Duncan Weldon notes, the OBR are likely to receive a rather warmly written card from the Chancellor’s office this Christmas. While true that the OBR have, in the past, been less than helpful to the Chancellor, one can’t help but wonder about the justification for announcing the OBR projections at the same time as the Chancellors’ statements. Why are the OBR projections not made known to the public at the same time that they are made available to the Chancellor?

But back to sectoral balances. The model used by the OBR produces projections which comply with sectoral balance accounting identities. Four are used: those of the public sector, the household sector, the corporate sector and the rest of the world. The most closely watched is of course the public sector balance. The headline result of the OBR forecasts is that the public sector will run a surplus by 2019. What has so far received less attention (at least since Frances Coppola examined the projections from the March 2015 OBR forecasts) is the implication of this for the other three balances. The most recent OBR projections are shown below.

Fig-1-November-2015

Since the government is projected to run a small surplus from mid-2019, the other three sectors must collectively run a deficit of equal size. The OBR projects that the current account deficit will fall from its current level of around five per cent of GDP to around two per cent of GDP. The UK private sector must be in deficit. Interesting details lie in both the distribution of this deficit between the household and corporate sectors, and in the changes in figures since the last OBR reports in March and July.

In order to show how the numbers have changed since the previous forecasts, I have collected the data series from all three releases into individual charts.

The OBR series from these three releases for the public sector financial balance are shown below. Other than postponing the date at which the government achieves a surplus (and some revisions to the historical data) there is little difference between the three releases.

Fig-2-Public

Changes to the projections for the current account deficit are more significant. The latest projections include improvements in the projected deficit of between 0.5% and 1% of GDP, compared with the July predictions. With the current account deficit at record levels in excess of 5% of GDP, I think it is fair to say the projections look optimistic. I note that in each of the three OBR series, the deficit starts to close in the first projected quarter. Put another way, the inflection point has been postponed three times out of three.

Fig-3-ROW

Things start to get interesting when we turn to the corporate sector. Here the projections have changed rather more significantly. Whereas the previous two data series showed the corporate sector reversing its decade-long surplus in 2014 and finally returning to where many think the corporate sector should be – borrowing to invest – the new series contains significant revisions to the historical data. As it turns out, the corporate sector has remained in surplus, lending one per cent of GDP in Q2 2015. The corporate sector is not now projected to return to deficit until Q3 2018.

Fig-4-Corporate

Since the net financial balance for any sector is the difference between ex post saving – profits in the case of the corporate sector – and investment, these revisions imply either falling corporate investment, rising profits, or both.

The data series for corporate investment are shown below. The historical data have been revised down significantly. Investment in Q2 2015 is 1% of GDP lower than previously recorded. (This is hard to square with Osborne’s statement that ‘business investment has grown more than twice as fast as consumption’.) The reduction compared to previous forecasts widens in the projection out to 2020. Nonetheless, it is hard to escape the conclusion that the projections are extremely optimistic. By 2020, business investment is expected to reach twelve per cent of GDP, higher than any year back to 1980.

Fig-5.Investment

What of business profits? These are shown in the table below, taken from the OBR report. It seems that corporate profit grew at 10% year-on-year in 2014-15, despite GDP growth of around 2.5%. While projected growth rates decline, corporate profit is expected to grow at over 4% annually in every year of the projection out to 2021 (in a context of steady 2.5% GDP growth). There is not much sign of GoodhartNangle in these projections.

Fig-6-Profits

So, to recap: by 2020 we have government running a surplus just under 1% of GDP, a current account deficit of 2% of GDP and a corporate sector deficit around 1% of GDP. Those with a facility for mental arithmetic will have already arrived at the punchline – the household sector will be running a deficit of around 2% of GDP. In fact, given data revisions, the household sector appears to be already running a deficit close to 2% of GDP – a deficit which is projected to remain until 2021 (see figure below).

Fig-7-HHAs a comparison, note that in the period preceding the 2008 crisis, the household sector ran a deficit of not much over 1% of GDP, and for a shorter period than currently projected.

The OBR has this to say on its projections:

Recent data revisions have increased the size of the household deficit in 2014 and we expect little change in the household net position over the forecast period, with gradual increases in household saving offset by ongoing growth of household investment. Available historical data suggest that this persistent and relatively large household deficit would be unprecedented. This may be consistent with the unprecedented scale of the ongoing fiscal consolidation and market expectations for monetary policy to remain extremely accommodative over the next five years, but it also illustrates how the adjustment to fiscal consolidation assumed in our central forecast is subject to considerable uncertainty.  (p. 81)

Perhaps there is something to the sectoral balances approach approach after all. One can only wonder what Godley would make of all this.

Jo Michell

Central banks have to get off the liquidity death star before they can destroy it

Death_Star

Streetwise Professor warns that clearing and collateral mandates create a ‘sort of liquidity death star’ because collateral-based funding (through repo markets) creates systemic liqudity vulnerabilities: margining leads to spikes in demand for liquidity, that in turn forces sales in illiquid markets, with further price volatility and margining. The mechanics of fire-sales and liquidity illusions are well known to regulators since Lehman (read Tarullo here), though the solution – clearing houses – doesn’t do away with the problem since it increase reliance on collateral sourced through repo markets.

Two further points.

  1. Central banks cannot fight the liquidity death star until they get off it. For a central bank to fight the liquidity death star, the Professor argues, it will need to ease collateral constraints by expanding the definition of ‘good’ collateral. This, of course, was the first measure that central banks across the world took after Lehman. But accepting ‘bad’ collateral won’t solve liquidity problems as long as central banks’ extraordinary lending relies on the same collateral practices that created (funding and market) liquidity problems in the first place.

Since the late 1980s, central banks have increasingly used repos to implement monetary policy, lending against collateral    instead of outright purchases of government bonds (the traditional form of open market operations). The turn to repos in monetary policy implementation prompted central banks to adopt the collateral risk management practices used by repo markets – the graph below shows that as the ECB took over from national central banks, it marked the beginning of a new regime for lender of last resort, where ECB marks collateral to market, and calls margin on a daily basis*.

Screen Shot 2015-10-26 at 06.44.06

Consider this scenario. When liquidity demand spikes and collateral constraints tighten, financial institutions turn to central banks. As good lenders of last resort seeing the death star approaching, central banks lend against ‘bad’ collateral.  But at the same time,  to protect themselves against credit risk, central banks mark-to-market and call margin if that ‘bad’ collateral falls in market price. Central bank margining means that a financial institution borrowing from the central bank against bad collateral faces the same funding pressures that it would experience in private funding markets.  This is exactly what happened to European banks during the sovereign debt crisis – with ECB making large margin calls at the height of the crisis in 2012.  The traditional crisis intervention – providing banks with funding liquidity – becomes pro-cyclical.

Screen Shot 2015-10-26 at 06.44.54

The money view – developed by Perry Mehrling and others – provides important insights. A crisis of market-based finance needs central banks to be much more than lender of last resort. As  dealers, or market-makers of last resort, central banks need to support the monetary quality of collateral-based liabilities, that is, to support (collateral) market liquidity. This is what OMTs did in Europe. A much messier world of central banking, as Mario Draghi well knows.

2. The repo ‘paradox’ – the growing post crisis collateral-based regulatory regime has not been matched by significant regulation of repo markets. At global level, the FSB has watered down plans to impose minimum (through the cycle) haircuts on all collateral – including government bonds. Latest plans leave out repos between banks and repos with government collateral. There is little left after that. In Europe, the Commission and Parliament have finally agreed on transparency requirements for repo markets, without any structural regulations. With the Capital Markets Union plans in full swing, transparency is as far as Europe will go.

Daniela Gabor

*for more on the ECB and the European repo market, read Gabor, D. and C. Ban (2015) Banking on bonds, Journal of Common Market Studies