My latest article at Pieria is on the contradiction at the heart of banking:
"In my article on the slow death of banks, I suggested that banks maintained on life support would eventually become redundant as new forms of financial intermediation took their place. This is the first of two posts in which I discuss what those new forms might look like.
The key change that we are seeing is what we might call "disintermediation" - flight of both lenders (depositors) and borrowers from traditional deposit-taking lenders to other types of financial intermediary, many of them specialists in particular aspects of financial management networked to other providers that do different things. This has already happened to a large extent in the US, but the UK and European models of banking are founded on universal banks and it is difficult for many people even to imagine what a banking system deconstructed into its component parts looks like. But when you break down the traditional banking model, it becomes apparent that there is a fundamental conflict at the heart of universal banking that makes it untenable as a business proposition in the current climate....."
The remainder of this article can be found here.
Wednesday, 19 June 2013
Sunday, 16 June 2013
In the countries of the old
Germany is exporting people.
Well, Eurozone countries exporting people is hardly news. But Germany isn't exporting the same sort of people as other Eurozone countries. Other countries are exporting their young and their skilled. Germany is exporting its old.
Economically this makes complete sense. Germany has a lot of old people and a relative shortage of the young & skilled. So it imports young & skilled people and exports old ones. After all, exporting old people is surely better than killing them.
There's nothing new about this, of course. Britain has been exporting old people for years. Relatively well-off pensioners like to retire to the sun after years of tolerating British weather. The southern countries of Europe contain substantial populations of expatriate Brits, many of them retired and living on savings. The economic collapse of the southern European states has taken its toll on them, of course: many British retirees in Cyprus lost substantial amounts of money in the recent bank restructuring, and owners of Spanish properties have seen the value of their villas and apartments drop as property prices have collapsed. But most of the sun-seeking pensioners are still there and enjoying a comfortable - and increasingly cheap - retirement.
Christina Odone recently bewailed the end of her "dream" of a Mediterranean retirement. She was talking rubbish. Property prices around the Med have never been so low, and for British pensioners expecting to live on savings, moving to a country that is undergoing internal devaluation has to be a good bet. Savings go much further when prices are falling (though admittedly they haven't much, yet). And sunshine is still free and plentiful: the southern European economies might be depressed and miserable, but the weather is as cheerful as ever. A renewed inflow of well-off pensioners from Northern European countries could do wonders for the Southern European states. I foresee the growth of new industries dedicated to serving the needs of the elderly, and perhaps new retirement homes with sea views and golf courses could revitalise the construction industry. And as our expatriate pensioners get older, of course they will need care homes and personal care. The healthcare industry, too, could be revitalised - though expatriate pensioners would have to pay, of course. Health insurance would be essential.
Germany's pensioners don't seem to be quite so keen on sun as British ones, since they seem to be going to Eastern Europe more than Club Med. Perhaps that's because Eastern European countries are closer, or perhaps it's because of historic ties, or perhaps it's just that retirement homes and care workers are cheaper in Eastern European countries than in Greece. The way things are going, that will soon change.
Interestingly, some of the countries to which Britain and Germany export their old already have a demographic problem. They are exporting their young and skilled, leaving a residual population of old and sick - who are being joined by old and sick from elsewhere. They are becoming the countries of the old.
What will life be like in the countries of the old? I asked this question on twitter and was told "look at Devon". Or anywhere along the South Coast of England, really. Visit any English seaside town in Kent or Sussex and the population looks distinctly grey. The landscape is peppered with bungalows (retired people like bungalows because there are no stairs) and retirement homes. There are lots of little shops, tea rooms and golf courses. There might even be the occasional art gallery. But not much in the way of industry. You see, elderly people don't want to start businesses, and they don't want to work long hours: if they work, they want it to be a little part-time job that is not too strenuous. And once the majority of your population is old, the motivation to create new industries, grow existing ones, create employment and revitalise the economy just isn't there any more. It is young people who have the urge to take over the world and reshape it to their liking. Most old people just want a quiet life.
So "quiet" is exactly what these places are like. Which is fine for a coastal town. And Devon has always been a pretty quiet place anyway apart from the occasional bout of smuggling. But a whole country that is happy simply to potter along, providing a comfortable life for its elderly citizens but not aspiring to anything more vibrant? Whatever happened to "restoring competitiveness"? Surely a whole country should be looking for growth?
There seems to be no logical basis for this assumption. What is wrong with a country becoming a sleepy backwater, if its population is happy? And what is wrong with a country deciding that what it really does well is look after the old - and providing exactly the right calm, undemanding environment for people in their sunset years? Why shouldn't some countries simply opt to become enormous retirement homes?*
There is a snag, of course. Although there would, as I have mentioned already, be new industries popping up dedicated to serving the needs of the elderly, the elderly themselves wouldn't be working in those industries, generally. And these countries have a growing shortage of working-age people: after all, the reason why care homes are being built in these countries is that care workers are cheaper....if they can find better-paid work elsewhere they will of course migrate. And not just care workers. The bigger risk is to the more skilled services required by the elderly, particularly in healthcare. These countries might have to pay doctors and specialist nurses rather highly to get them to stay. Would the elderly population be wealthy enough to pay them?
Well, perhaps. The fact is that most wealth is held by the retired and those approaching retirement. The trouble is that the elderly have come to expect to hang on to their wealth and be supported by younger people through their taxes. But in countries where the majority of the population is elderly, clearly this is not possible. An alternative means of providing universal services such as healthcare would have to be found. I've mentioned health insurance already: but even the US, the world leader in insurance-dominated healthcare provision, recognises that geriatric services are the most expensive and difficult to insure. And not all elderly can afford health insurance anyway. So some form of taxation is going to be required to maintain universal healthcare and social support. As the majority of people would not be earning significantly, realistically this is going to involve taxing property and financial assets rather than earned income: indeed it might be necessary to give workers tax incentives to stop them leaving. So in the countries of the old, perhaps wealth taxation rather than income taxation will become the norm.
But supposing that despite tax incentives, there still aren't enough working-age people to look after all those elderly? After all, these countries don't just have a migration problem. They aren't breeding enough people to maintain their working-age population anyway. And as their population ages, the birth rate is bound to fall even more. In the countries of the old there will be few children.....
There is a solution, of course. Technology. "Telecare" and "telehealth" schemes are already being promoted in Britain as a solution to the shortage of carers: if robots can replace human carers, and computers can constantly monitor health and provide early warning of problems, there could be far less need for real people to work in the elderly care business, and costs could be much lower. The usual response to such a suggestion is "But the elderly need human interaction!". For me this confuses two things. Personal care and health care currently involve human beings, and have therefore for some elderly people become a substitute for real human contact. But they are not fundamentally about real human interaction at all. For me it seems entirely reasonable that personal care, particularly for the frail elderly who need 24-hour support, could be better done by robots than by humans who can be tired, distracted, embarrassed or grumpy. I have seen how tired my 80-year-old father has become now he is my mother's full-time carer: it seems to me that a few robots monitoring her and helping her would be a very good thing, not only for her but for him. The same applies to a good many routine healthcare functions: we are used to nurses monitoring long-term health problems, but there is no particular reason why this could not also be done by robots, though I think some human intervention would still be sensible (since robots would lack the intuitive skills that the best healthcare professionals have, which pick up problems that otherwise might have gone unnoticed).
Of course, a world of elderly care done entirely by robots, with elderly leading isolated lives and lacking human interaction could be horrible. I have no desire to see Romanian orphanages re-created in retirement homes. Realistically, human nature being what it is, there will be some horror stories.....but I hope that the majority of technological elder care will be better than that. And in the countries of the old, of course, the elderly don't have to be alone. One of the things that retired people have in abundance, unlike younger working people, is time. Yes, they may be busy - but they are busy with things they want to do, rather than with things that they have to do in order to earn a living and care for children. I would hope that one of the things that retired people would want to do is meet each other and support each other. In the countries of the old, perhaps elderly isolation could become a thing of the past.
There are losses, of course. Migration of the old to other countries breaks the ties with their families and prevents them spending time with their grandchildren. Many will regret this. But then the same happens when the young migrate in search of work....after all, many never return. The fact is that our family ties are becoming progressively more attenuated. Even in my own family, all four of my parents' children left the place where we grew up, and we are now scattered all over the UK. And our children may end up scattered all over the world.
Yet the attenuation of family ties is mitigated by technology. Worldwide web applications allow people in different countries to communicate with each other by video link, send each other messages and share photographs instantaneously. International voice communications are still expensive but becoming cheaper, while data communication is cheap and abundant. And technology is improving - and becoming cheaper - all the time. In the countries of the old, the desire to keep in contact with distant families may encourage the elderly to start using the communications technology that they fear. And of course, as time goes on the elderly will not fear that technology anyway....after all, the currently middle-aged invented much of it.....
Technology both expands and shrinks our world, enabling people to live and work at considerable distances from each other while still remaining in close contact. And technology both depersonalises and personalises: things that are now done by humans may be better done by robots, freeing up humans to do what we do much better than robots - interact with each other at a personal level through conversation and shared activity.
The countries of the old could, of course, be terrible. But they could also be wonderful places. Places that the working people of the world love to visit....quiet havens, where humans, technology and nature are in balance.
And if it doesn't work....for example, if we decide we would rather keep our old people with us, in pods in the back garden.....well, there is always another future for countries that no-one wants to live in. For where humans no longer want to be, the wild things find homes. Kipling called it "letting in the jungle". It is no shame for us to abandon a place. Nature has plans for our ruins.
Related links:
Germany "exporting" old and sick to foreign care homes - Guardian
The movement of people (and its consequences) - Coppola Comment
The creeping desert - Coppola Comment
The zero-sum trade in people - Coppola Comment
Kill the old - FT Alphaville (and the other editions of Kill the Old, too)
And so the sun goes down on my villa by the Mediterranean - Cristina Odone (Telegraph) (paywall)
Can technology fill the elderly care gap? - Telegraph (paywall)
High-tech devices to meet housing and care needs of old people - FT (paywall)
The Second Jungle Book - Kipling
* Yes, I know this is the theory of comparative advantage. And yes, I know it supposedly doesn't work where capital and labour are fully mobile. But in this case, I think it might. Time for a fresh look at Ricardo, perhaps!
Well, Eurozone countries exporting people is hardly news. But Germany isn't exporting the same sort of people as other Eurozone countries. Other countries are exporting their young and their skilled. Germany is exporting its old.
Economically this makes complete sense. Germany has a lot of old people and a relative shortage of the young & skilled. So it imports young & skilled people and exports old ones. After all, exporting old people is surely better than killing them.
There's nothing new about this, of course. Britain has been exporting old people for years. Relatively well-off pensioners like to retire to the sun after years of tolerating British weather. The southern countries of Europe contain substantial populations of expatriate Brits, many of them retired and living on savings. The economic collapse of the southern European states has taken its toll on them, of course: many British retirees in Cyprus lost substantial amounts of money in the recent bank restructuring, and owners of Spanish properties have seen the value of their villas and apartments drop as property prices have collapsed. But most of the sun-seeking pensioners are still there and enjoying a comfortable - and increasingly cheap - retirement.
Christina Odone recently bewailed the end of her "dream" of a Mediterranean retirement. She was talking rubbish. Property prices around the Med have never been so low, and for British pensioners expecting to live on savings, moving to a country that is undergoing internal devaluation has to be a good bet. Savings go much further when prices are falling (though admittedly they haven't much, yet). And sunshine is still free and plentiful: the southern European economies might be depressed and miserable, but the weather is as cheerful as ever. A renewed inflow of well-off pensioners from Northern European countries could do wonders for the Southern European states. I foresee the growth of new industries dedicated to serving the needs of the elderly, and perhaps new retirement homes with sea views and golf courses could revitalise the construction industry. And as our expatriate pensioners get older, of course they will need care homes and personal care. The healthcare industry, too, could be revitalised - though expatriate pensioners would have to pay, of course. Health insurance would be essential.
Germany's pensioners don't seem to be quite so keen on sun as British ones, since they seem to be going to Eastern Europe more than Club Med. Perhaps that's because Eastern European countries are closer, or perhaps it's because of historic ties, or perhaps it's just that retirement homes and care workers are cheaper in Eastern European countries than in Greece. The way things are going, that will soon change.
Interestingly, some of the countries to which Britain and Germany export their old already have a demographic problem. They are exporting their young and skilled, leaving a residual population of old and sick - who are being joined by old and sick from elsewhere. They are becoming the countries of the old.
What will life be like in the countries of the old? I asked this question on twitter and was told "look at Devon". Or anywhere along the South Coast of England, really. Visit any English seaside town in Kent or Sussex and the population looks distinctly grey. The landscape is peppered with bungalows (retired people like bungalows because there are no stairs) and retirement homes. There are lots of little shops, tea rooms and golf courses. There might even be the occasional art gallery. But not much in the way of industry. You see, elderly people don't want to start businesses, and they don't want to work long hours: if they work, they want it to be a little part-time job that is not too strenuous. And once the majority of your population is old, the motivation to create new industries, grow existing ones, create employment and revitalise the economy just isn't there any more. It is young people who have the urge to take over the world and reshape it to their liking. Most old people just want a quiet life.
So "quiet" is exactly what these places are like. Which is fine for a coastal town. And Devon has always been a pretty quiet place anyway apart from the occasional bout of smuggling. But a whole country that is happy simply to potter along, providing a comfortable life for its elderly citizens but not aspiring to anything more vibrant? Whatever happened to "restoring competitiveness"? Surely a whole country should be looking for growth?
There seems to be no logical basis for this assumption. What is wrong with a country becoming a sleepy backwater, if its population is happy? And what is wrong with a country deciding that what it really does well is look after the old - and providing exactly the right calm, undemanding environment for people in their sunset years? Why shouldn't some countries simply opt to become enormous retirement homes?*
There is a snag, of course. Although there would, as I have mentioned already, be new industries popping up dedicated to serving the needs of the elderly, the elderly themselves wouldn't be working in those industries, generally. And these countries have a growing shortage of working-age people: after all, the reason why care homes are being built in these countries is that care workers are cheaper....if they can find better-paid work elsewhere they will of course migrate. And not just care workers. The bigger risk is to the more skilled services required by the elderly, particularly in healthcare. These countries might have to pay doctors and specialist nurses rather highly to get them to stay. Would the elderly population be wealthy enough to pay them?
Well, perhaps. The fact is that most wealth is held by the retired and those approaching retirement. The trouble is that the elderly have come to expect to hang on to their wealth and be supported by younger people through their taxes. But in countries where the majority of the population is elderly, clearly this is not possible. An alternative means of providing universal services such as healthcare would have to be found. I've mentioned health insurance already: but even the US, the world leader in insurance-dominated healthcare provision, recognises that geriatric services are the most expensive and difficult to insure. And not all elderly can afford health insurance anyway. So some form of taxation is going to be required to maintain universal healthcare and social support. As the majority of people would not be earning significantly, realistically this is going to involve taxing property and financial assets rather than earned income: indeed it might be necessary to give workers tax incentives to stop them leaving. So in the countries of the old, perhaps wealth taxation rather than income taxation will become the norm.
But supposing that despite tax incentives, there still aren't enough working-age people to look after all those elderly? After all, these countries don't just have a migration problem. They aren't breeding enough people to maintain their working-age population anyway. And as their population ages, the birth rate is bound to fall even more. In the countries of the old there will be few children.....
There is a solution, of course. Technology. "Telecare" and "telehealth" schemes are already being promoted in Britain as a solution to the shortage of carers: if robots can replace human carers, and computers can constantly monitor health and provide early warning of problems, there could be far less need for real people to work in the elderly care business, and costs could be much lower. The usual response to such a suggestion is "But the elderly need human interaction!". For me this confuses two things. Personal care and health care currently involve human beings, and have therefore for some elderly people become a substitute for real human contact. But they are not fundamentally about real human interaction at all. For me it seems entirely reasonable that personal care, particularly for the frail elderly who need 24-hour support, could be better done by robots than by humans who can be tired, distracted, embarrassed or grumpy. I have seen how tired my 80-year-old father has become now he is my mother's full-time carer: it seems to me that a few robots monitoring her and helping her would be a very good thing, not only for her but for him. The same applies to a good many routine healthcare functions: we are used to nurses monitoring long-term health problems, but there is no particular reason why this could not also be done by robots, though I think some human intervention would still be sensible (since robots would lack the intuitive skills that the best healthcare professionals have, which pick up problems that otherwise might have gone unnoticed).
Of course, a world of elderly care done entirely by robots, with elderly leading isolated lives and lacking human interaction could be horrible. I have no desire to see Romanian orphanages re-created in retirement homes. Realistically, human nature being what it is, there will be some horror stories.....but I hope that the majority of technological elder care will be better than that. And in the countries of the old, of course, the elderly don't have to be alone. One of the things that retired people have in abundance, unlike younger working people, is time. Yes, they may be busy - but they are busy with things they want to do, rather than with things that they have to do in order to earn a living and care for children. I would hope that one of the things that retired people would want to do is meet each other and support each other. In the countries of the old, perhaps elderly isolation could become a thing of the past.
There are losses, of course. Migration of the old to other countries breaks the ties with their families and prevents them spending time with their grandchildren. Many will regret this. But then the same happens when the young migrate in search of work....after all, many never return. The fact is that our family ties are becoming progressively more attenuated. Even in my own family, all four of my parents' children left the place where we grew up, and we are now scattered all over the UK. And our children may end up scattered all over the world.
Yet the attenuation of family ties is mitigated by technology. Worldwide web applications allow people in different countries to communicate with each other by video link, send each other messages and share photographs instantaneously. International voice communications are still expensive but becoming cheaper, while data communication is cheap and abundant. And technology is improving - and becoming cheaper - all the time. In the countries of the old, the desire to keep in contact with distant families may encourage the elderly to start using the communications technology that they fear. And of course, as time goes on the elderly will not fear that technology anyway....after all, the currently middle-aged invented much of it.....
Technology both expands and shrinks our world, enabling people to live and work at considerable distances from each other while still remaining in close contact. And technology both depersonalises and personalises: things that are now done by humans may be better done by robots, freeing up humans to do what we do much better than robots - interact with each other at a personal level through conversation and shared activity.
The countries of the old could, of course, be terrible. But they could also be wonderful places. Places that the working people of the world love to visit....quiet havens, where humans, technology and nature are in balance.
And if it doesn't work....for example, if we decide we would rather keep our old people with us, in pods in the back garden.....well, there is always another future for countries that no-one wants to live in. For where humans no longer want to be, the wild things find homes. Kipling called it "letting in the jungle". It is no shame for us to abandon a place. Nature has plans for our ruins.
Related links:
Germany "exporting" old and sick to foreign care homes - Guardian
The movement of people (and its consequences) - Coppola Comment
The creeping desert - Coppola Comment
The zero-sum trade in people - Coppola Comment
Kill the old - FT Alphaville (and the other editions of Kill the Old, too)
And so the sun goes down on my villa by the Mediterranean - Cristina Odone (Telegraph) (paywall)
Can technology fill the elderly care gap? - Telegraph (paywall)
High-tech devices to meet housing and care needs of old people - FT (paywall)
The Second Jungle Book - Kipling
* Yes, I know this is the theory of comparative advantage. And yes, I know it supposedly doesn't work where capital and labour are fully mobile. But in this case, I think it might. Time for a fresh look at Ricardo, perhaps!
Friday, 14 June 2013
Under the radar
This is the interesting story of how the Co-Op Bank got itself into a terrible mess without anyone noticing.
The Co-Op Bank was originally created by the Co-Operative Group, a mutually-owned retailer, primarily but not exclusively to serve the needs of its members. It painstakingly created a brand image around ethical banking and customer service, and aimed to occupy a small unique niche in the UK's high street retail banking landscape. To describe it as a "mutual" in the same way as a building society is misleading. It is not. It is a wholly-owned subsidiary of a mutual, and it is a bank. That is in theory a significant difference.
But in the run-up to the financial crisis, the differences between banks and building societies had become increasingly blurred. Many building societies had converted to banks - floating themselves on the financial markets - and in turn been swallowed up by larger banks. And many of the remaining building societies were acting much more like banks, borrowing large amounts of wholesale funds and doing commercial lending and commercial real estate lending in addition to their traditional residential mortgage lending. Even their mortgage lending was becoming riskier as they lent to less creditworthy borrowers at ever-higher loan-to-value percentages. Short of capital because of their mutual status - and a widespread belief at the time that capital wasn't important anyway - some of them became as highly-leveraged as banks.
In the fallout from the Lehman failure in 2008, followed by the nationalisation of RBS and Lloyds/HBOS, these highly-leveraged building societies got into serious difficulty. One (Dunfermline Building Society) failed and was nationalised. Another (Kent Reliance) was bought by the private equity firm J.C. Flowers. Some were forcibly merged with others - the Nationwide, the UK's largest building society and now its fifth largest lender, swallowed three smaller building societies. And one - the Britannia building society - was bought by the much smaller Co-Op Bank in a deal reminiscent of the RBS takeover of NatWest.
At the time there were no public indications that the Britannia was in trouble. Indeed some people questioned the merger because it didn't seem a particularly good deal for the Britannia's members and staff. Whether, behind the scenes, government did know that the Britannia was in trouble and forced through a merger as part of its strategy of avoiding building society sector meltdown, we may never know. What is clear is that the Co-Op's CEO, Peter Marks, and the Britannia's CEO Neville Richardson, were very happy with the deal. The Co-Op Bank's CEO lost his job in the merger and was replaced with Richardson, who ran the enlarged Co-Op Bank for the next two years. He eventually left in a management shakeout in 2011.
And it was in 2011 that the true state of the Britannia's finances started to emerge. In the 2011 accounts, the Co-Op put £1.45bn of the loans it had inherited from the Britannia on "watchlist". This meant that they were not actually in default but were considered likely to default at some time in the future. And sure enough, in 2012 the Co-Op was forced to account for £0.5bn of new impairments on its ex-Britannia loan portfolio as corporate loan defaults doubled. This, along with provisions for claims on mis-sold PPI insurance, wiped out the Co-Op Bank's entire profits.
In November 2012 the Bank of England's Financial Policy Committee - flexing its newly-acquired regulatory muscle - announced that a number of UK banks were short of capital. And in February 2013 it emerged that the Co-Op bank was one of them. At that time the extent of the capital shortfall was unclear but it was thought to be of the order of £1bn. Since then the estimates have risen and the hole is now around £1.8bn. Because of the mutual status of the Co-Op Bank's parent, plugging this hole was never going to be easy. Mutuals are owned by their members, not by external shareholders, so raising new capital via the financial markets is nigh on impossible to do (though subordinated debt - convertible to equity - can be raised). Consequently, mutuals usually rely on organic growth, cost-cutting and/or divestments to improve their capital position.
Despite concerns about the Co-Op Bank's weak balance sheet, negotiations with Lloyds Banking Group for acquisition of the Verde branches continued. Once again, it seemed, the Co-Op Bank was intent on swallowing something much larger. Acquiring the Verde branches would have trebled its balance sheet size and placed it among the UK's largest lenders. The Verde branches were better capitalised than the Co-Op Bank and came with their own version of the LBG IT platform which the Co-Op Bank would have to adopt. Because of this the Co-Op Bank scrapped its own IT upgrade programme, writing off £1.5bn of sunk cost.
In April 2013, to everyone's consternation, the Co-Op Group decided to pull out of the Verde deal. The Co-Op's statement was terse:
The departure of the Co-Op Bank's CEO, Barry Tootell, immediately after the downgrade was no surprise to anyone. But it left the Co-Op Bank leaderless at a time when the Co-Op Group was also about to undergo a change of leadership, with Euan Sutherland from Kingfisher Group taking over from Peter Marks.
The Co-Op's difficulty raising capital was the subject of considerable debate. In its statement, Moody's observed that the Co-Op Group's subordinated debt holders might have to take losses. Predictably, the value of those bonds promptly crashed. But Moody's suggestion that the Co-Op Bank might get taxpayer support was promptly squashed by both the Co-Op Group and by the government. Divestment of parts of the business was the focus of most debate. Many people pointed out that the Group was unlikely to raise the needed capital by selling its insurance businesses and would have to look at other divestments. Robert Peston suggested that the Group might even consider selling its bank, because otherwise it might have to divest key parts of its retail business. Frankly this was ridiculous. The present climate is hardly a good one for selling a seriously damaged bank stuffed full of toxic loans: the Co-Op Group would have had to retain a considerable proportion of those loans in order to make the bank remotely attractive to a buyer. And the Co-Op Bank's unusual position in the UK's market made a sale problematic: customers were not likely to be happy with a private equity takeover like Kent Reliance, selling to a high street bank would probably fall foul of competition rules, and the larger mutuals were already suffering from a bad case of indigestion after the last round of takeovers and mergers.
Fortunately the new Co-Op Group's CEO moved swiftly to squash any ideas of a sale, appointing Niall Booker as CEO of the Bank and deputy CEO of the Group. Booker's entire career had been spent in retail and corporate banking, and his most recent job had been restructuring HSBC's North American division after the subprime crisis. Clearly he had experience of rescuing damaged banks. And this was followed up with the appointment of Richard Pym as part-time Chairman of Co-Op Bank in addition to his role as chairman of UKAR, the holding company that manages the run-down of the residual Bradford & Bingley and Northern Rock bad assets. To me these appointments could not make it clearer that the Co-Op intends to keep its bank. And this view is supported by Co-Op statements to date.
So where does this leave us? And how is it that the Co-Op Bank's dreadful situation slipped under the radar? I have a number of thoughts on this.
It is all too easy for customers, regulators and politicians to be lulled into a false sense of security by bank management that is determined to hide the real state of affairs. The Co-Op Bank to my mind has systematically deceived everybody. It is unfortunate that a bank which commands such loyalty among its customer base should now have such a tarnished image. I hope that the new team cleans up its act. Because if it does not, it does not deserve the support of its customers. And the UK's banking sector would be the poorer for the loss of such a distinctive brand.
But there is also a wider issue here. This is far from being the first time that a bank has been brought to its knees by acquisitions, smiled upon by regulators and encouraged by politicians, that have turned out to be toxic. Indeed the Co-Op is only the latest in a very sorry list that includes LBG's acquisition of HBOS, RBS's acquisition of ABN AMRO, Barclays' acquisition of part of Lehman and a whole swathe of unwise and toxic mergers among banks in other countries such as Spain. To my mind it is not acceptable that distressed financial firms are rescued at politicians' behest by other financial firms while regulators turn a blind eye and laws are changed or waived to enable deals to go ahead - but that is what happened both in the headline-grabbing bank meltdown of 2008 and in the subsequent building society collapse of 2009. And as RBS, LBG and now the Co-Op show us, we still end up paying. They may have been prevented from collapsing, but they aren't able to support the economy. RBS and LBG have been restricting new lending, particularly to businesses, for the last five years. And the Co-Op Bank has now closed its doors to new business customers. The damage done by the Britannia merger will reverberate for years to come as both the Co-Op Bank and its parent are forced to restructure and shrink in order to close the bank's capital hole. We really have to find a way of dealing with systemic failures that doesn't involve wrecking healthy banks.
UPDATE - 17th June 2013
It has now been announced that the Co-Op bank will bail in its subordinated debt holders in order to raise part of its capital requirement, now confirmed by the Prudential Regulation Authority as £1.5bn. This will mean that it will no longer be a wholly-owned subsidiary of a mutual. It does not, as some people have suggested, in any way change the mutual status of the Co-Op Group itself, and as the proportion of external shareholders will be small, the Co-Op Group will continue to have a controlling interest. It does mean that holders of the PIBS inherited from the Britannia and the Co-Ops own preference shares, some of whom are very small investors, will take big losses and - perhaps even more importantly for some of them - will lose certainty of income, since the Co-Op Bank is unlikely to issue much in the way of dividends to shareholders until its balance sheet is in better shape and both PIBS and pref shares provide guaranteed interest income.
The remainder of the capital requirement will be met by divestments, primarily of the insurance lines, and by an injection of capital from Co-Op Group itself if necessary. There are no proposals to bail in depositors Cyprus-style.
The Co-Op Bank has already been split internally into good bank and bad bank, like the other damaged banks RBS and Lloyds, and the bad bank will be progressively wound down over time. However, this does mean that the Co-Op Bank will continue to suffer losses on its loan book for some time to come. It is unlikely therefore to be able to do much in the way of risky lending (such as to SMEs) for quite a while, which is unfortunately not helpful to the economy.
The proposed bail-in of bondholders is likely to trigger a further downgrade of the Co-Op Bank's credit rating, since it amounts to a partial default.
Related links:
Moody's statement on Co-Op Bank downgrade
Co-Op woes embarrass regulators and Treasury - Robert Peston
What does Moody's downgrade of Co-Op Bank mean? - Robert Peston
Treasury Committee to inquire into "Project Verde" - HM Government
Co-Op Group 2012 Annual Review
Co-Op Bank 2012 Financial Statements
Co-Op capital hole threatens Lloyds deal - FT (paywall)
Feelings not mutual - Big Issue In The North
Update:
Co-Op Bank's stock market future - Peston
The Co-Op Bank was originally created by the Co-Operative Group, a mutually-owned retailer, primarily but not exclusively to serve the needs of its members. It painstakingly created a brand image around ethical banking and customer service, and aimed to occupy a small unique niche in the UK's high street retail banking landscape. To describe it as a "mutual" in the same way as a building society is misleading. It is not. It is a wholly-owned subsidiary of a mutual, and it is a bank. That is in theory a significant difference.
But in the run-up to the financial crisis, the differences between banks and building societies had become increasingly blurred. Many building societies had converted to banks - floating themselves on the financial markets - and in turn been swallowed up by larger banks. And many of the remaining building societies were acting much more like banks, borrowing large amounts of wholesale funds and doing commercial lending and commercial real estate lending in addition to their traditional residential mortgage lending. Even their mortgage lending was becoming riskier as they lent to less creditworthy borrowers at ever-higher loan-to-value percentages. Short of capital because of their mutual status - and a widespread belief at the time that capital wasn't important anyway - some of them became as highly-leveraged as banks.
In the fallout from the Lehman failure in 2008, followed by the nationalisation of RBS and Lloyds/HBOS, these highly-leveraged building societies got into serious difficulty. One (Dunfermline Building Society) failed and was nationalised. Another (Kent Reliance) was bought by the private equity firm J.C. Flowers. Some were forcibly merged with others - the Nationwide, the UK's largest building society and now its fifth largest lender, swallowed three smaller building societies. And one - the Britannia building society - was bought by the much smaller Co-Op Bank in a deal reminiscent of the RBS takeover of NatWest.
At the time there were no public indications that the Britannia was in trouble. Indeed some people questioned the merger because it didn't seem a particularly good deal for the Britannia's members and staff. Whether, behind the scenes, government did know that the Britannia was in trouble and forced through a merger as part of its strategy of avoiding building society sector meltdown, we may never know. What is clear is that the Co-Op's CEO, Peter Marks, and the Britannia's CEO Neville Richardson, were very happy with the deal. The Co-Op Bank's CEO lost his job in the merger and was replaced with Richardson, who ran the enlarged Co-Op Bank for the next two years. He eventually left in a management shakeout in 2011.
And it was in 2011 that the true state of the Britannia's finances started to emerge. In the 2011 accounts, the Co-Op put £1.45bn of the loans it had inherited from the Britannia on "watchlist". This meant that they were not actually in default but were considered likely to default at some time in the future. And sure enough, in 2012 the Co-Op was forced to account for £0.5bn of new impairments on its ex-Britannia loan portfolio as corporate loan defaults doubled. This, along with provisions for claims on mis-sold PPI insurance, wiped out the Co-Op Bank's entire profits.
In November 2012 the Bank of England's Financial Policy Committee - flexing its newly-acquired regulatory muscle - announced that a number of UK banks were short of capital. And in February 2013 it emerged that the Co-Op bank was one of them. At that time the extent of the capital shortfall was unclear but it was thought to be of the order of £1bn. Since then the estimates have risen and the hole is now around £1.8bn. Because of the mutual status of the Co-Op Bank's parent, plugging this hole was never going to be easy. Mutuals are owned by their members, not by external shareholders, so raising new capital via the financial markets is nigh on impossible to do (though subordinated debt - convertible to equity - can be raised). Consequently, mutuals usually rely on organic growth, cost-cutting and/or divestments to improve their capital position.
Despite concerns about the Co-Op Bank's weak balance sheet, negotiations with Lloyds Banking Group for acquisition of the Verde branches continued. Once again, it seemed, the Co-Op Bank was intent on swallowing something much larger. Acquiring the Verde branches would have trebled its balance sheet size and placed it among the UK's largest lenders. The Verde branches were better capitalised than the Co-Op Bank and came with their own version of the LBG IT platform which the Co-Op Bank would have to adopt. Because of this the Co-Op Bank scrapped its own IT upgrade programme, writing off £1.5bn of sunk cost.
In April 2013, to everyone's consternation, the Co-Op Group decided to pull out of the Verde deal. The Co-Op's statement was terse:
The Co-operative Group announces that it has withdrawn from the process currently being run by Lloyds Banking Group for the disposal of branch assets (“Verde”) after The Co-operative Group and The Co-operative Bank plc Boards decided that it was not in the best interests of the Group’s members to proceed further at this time. This decision reflects the impact of the current economic environment, the worsened outlook for economic growth and the increasing regulatory requirements on the financial services sector in general.The Co-Op's attempt to blame the failure of the deal on the weak economy and unhelpful regulatory stance impressed no-one. Most commentary at the time was along the lines of "wonder what's really behind this"? And the real reason quickly became apparent. On 10th May 2013 the ratings agency Moody's abruptly downgraded the Co-Op Bank's credit rating to junk, citing poor capitalisation and anticipated further losses on its ex-Britannia loan portfolio against which it had insufficient loan provisions.
The departure of the Co-Op Bank's CEO, Barry Tootell, immediately after the downgrade was no surprise to anyone. But it left the Co-Op Bank leaderless at a time when the Co-Op Group was also about to undergo a change of leadership, with Euan Sutherland from Kingfisher Group taking over from Peter Marks.
The Co-Op's difficulty raising capital was the subject of considerable debate. In its statement, Moody's observed that the Co-Op Group's subordinated debt holders might have to take losses. Predictably, the value of those bonds promptly crashed. But Moody's suggestion that the Co-Op Bank might get taxpayer support was promptly squashed by both the Co-Op Group and by the government. Divestment of parts of the business was the focus of most debate. Many people pointed out that the Group was unlikely to raise the needed capital by selling its insurance businesses and would have to look at other divestments. Robert Peston suggested that the Group might even consider selling its bank, because otherwise it might have to divest key parts of its retail business. Frankly this was ridiculous. The present climate is hardly a good one for selling a seriously damaged bank stuffed full of toxic loans: the Co-Op Group would have had to retain a considerable proportion of those loans in order to make the bank remotely attractive to a buyer. And the Co-Op Bank's unusual position in the UK's market made a sale problematic: customers were not likely to be happy with a private equity takeover like Kent Reliance, selling to a high street bank would probably fall foul of competition rules, and the larger mutuals were already suffering from a bad case of indigestion after the last round of takeovers and mergers.
Fortunately the new Co-Op Group's CEO moved swiftly to squash any ideas of a sale, appointing Niall Booker as CEO of the Bank and deputy CEO of the Group. Booker's entire career had been spent in retail and corporate banking, and his most recent job had been restructuring HSBC's North American division after the subprime crisis. Clearly he had experience of rescuing damaged banks. And this was followed up with the appointment of Richard Pym as part-time Chairman of Co-Op Bank in addition to his role as chairman of UKAR, the holding company that manages the run-down of the residual Bradford & Bingley and Northern Rock bad assets. To me these appointments could not make it clearer that the Co-Op intends to keep its bank. And this view is supported by Co-Op statements to date.
So where does this leave us? And how is it that the Co-Op Bank's dreadful situation slipped under the radar? I have a number of thoughts on this.
- In the aftermath of the financial crisis there was a prevalent belief that the crisis was caused by, firstly, investment banks and secondly, big banks. Small banks and specialist lenders were widely believed, both by customers and by people who should have known better, to be "safe". And the Government fostered this illusion, perhaps because admitting that the UK's entire high street banking sector was dangerously leveraged and could fail at any moment would have spooked customers and caused the very disaster they feared. The Co-Op was a small bank and the Britannia a building society. Both, therefore, fitted into the prevailing model that big banks = bad and small banks (and building societies) = good. We now know that this model is flawed: all banks, big and small, including those (like building societies) that aren't called banks but do bank-like things, were damaged in the financial crisis. Arguably, the public's belief that building societies were safer than banks saved that sector from total collapse, because many people moved their money from banks to building societies at that time.
- The Co-Op Bank's "ethical" image created a mistaken belief among its customer base that it would act responsibly. But ethical banking and responsible banking are not the same thing. I was less than impressed by the Co-Op Group's 2012 review, where they presented the operating profit as the headline result for Co-Op Bank and downplayed the fact that the bank had made a loss of £674m due to impairments and provisioning. If RBS - a much bigger bank and one already known to be seriously damaged - had done the same with its 2012 accounts there would have been hell to pay. RBS correctly reported its loss of £5bn as its headline figure, and it took some digging through the accounts to discover a pretty healthy operating profit that had been wiped out by fair value revaluation of its own debt, provisioning against mis-selling claims, and restructuring costs. In contrast, the Co-Op Group headlined the bank's operating profit with - in my opinion - the clear intention of misleading members and investors into believing that it was in better shape than it actually was. This to me is not ethical behaviour. I hope that the new board adopts a more open, honest and transparent approach to financial reporting in future.
- Moody's deserves censure for its failure to downgrade the Co-Op Bank earlier. A 6-notch downgrade at one go smacks of being asleep at the wheel. No institution falls apart as dramatically as that without warning: there should have been an interim downgrade in 2012 after production of the 2011 accounts, in which the watchlist loans were declared. Moody's did look at the Co-Op Bank in 2012 as part of its general review of UK banks at that time - but bizarrely it actually UPGRADED the Co-Op Bank's standalone rating. I can only conclude it did not examine the 2011 accounts properly.
- There are to my mind serious questions over the conduct of both Peter Marks and Neville Richardson. We now know that the Britannia had a huge toxic loan portfolio that would have caused it to fail had the Co-Op merger not gone ahead. But that doesn't appear to have been disclosed at the time - or if it was, Peter Marks must have decided to go ahead with the merger anyway. There are questions that need to be answered about the nature and extent of due diligence prior to the merger going ahead. And why did the Co-Op make no attempt to integrate its Britannia acquisition until after Richardson's departure? In fact it didn't even seem to know what was in the loan book. Call me cynical, but I can't help wondering if Richardson knew perfectly well that the Britannia loan portfolio was a disaster and concealed it from the Co-Op Group management. If that is true, then his behaviour is worse: Marks' megalomania made him foolish, but Richardson's behaviour is verging on criminal. I would like to see a proper inquiry into the circumstances of the Britannia merger and Richardson's subsequent tenure as Co-Op CEO. Unfortunately, as it seems the Co-Op Bank will not be bailed out by taxpayers, I am unlikely to get my wish.
- There are also questions about the conduct of regulators, politicians and Lloyds Banking Group itself in relation to the Verde deal. The true state of the Co-Op Bank's finances was a matter of public record. But the Chancellor was an ardent supporter of the deal, hailing the prospect of an enlarged Co-Op Bank as a challenge to the dominance of the big banks on the high street. And the FSA, though not a supporter, did not act to prevent it. Lloyds, too, appeared totally bemused by the Co-Op's decision to pull out. It does not seem as if much in the way of due diligence - or even basic financial analysis - was going on anywhere. The Treasury Select Committee has now decided to investigate the circumstances of the failure of the Verde deal, a decision I welcome.
It is all too easy for customers, regulators and politicians to be lulled into a false sense of security by bank management that is determined to hide the real state of affairs. The Co-Op Bank to my mind has systematically deceived everybody. It is unfortunate that a bank which commands such loyalty among its customer base should now have such a tarnished image. I hope that the new team cleans up its act. Because if it does not, it does not deserve the support of its customers. And the UK's banking sector would be the poorer for the loss of such a distinctive brand.
But there is also a wider issue here. This is far from being the first time that a bank has been brought to its knees by acquisitions, smiled upon by regulators and encouraged by politicians, that have turned out to be toxic. Indeed the Co-Op is only the latest in a very sorry list that includes LBG's acquisition of HBOS, RBS's acquisition of ABN AMRO, Barclays' acquisition of part of Lehman and a whole swathe of unwise and toxic mergers among banks in other countries such as Spain. To my mind it is not acceptable that distressed financial firms are rescued at politicians' behest by other financial firms while regulators turn a blind eye and laws are changed or waived to enable deals to go ahead - but that is what happened both in the headline-grabbing bank meltdown of 2008 and in the subsequent building society collapse of 2009. And as RBS, LBG and now the Co-Op show us, we still end up paying. They may have been prevented from collapsing, but they aren't able to support the economy. RBS and LBG have been restricting new lending, particularly to businesses, for the last five years. And the Co-Op Bank has now closed its doors to new business customers. The damage done by the Britannia merger will reverberate for years to come as both the Co-Op Bank and its parent are forced to restructure and shrink in order to close the bank's capital hole. We really have to find a way of dealing with systemic failures that doesn't involve wrecking healthy banks.
UPDATE - 17th June 2013
It has now been announced that the Co-Op bank will bail in its subordinated debt holders in order to raise part of its capital requirement, now confirmed by the Prudential Regulation Authority as £1.5bn. This will mean that it will no longer be a wholly-owned subsidiary of a mutual. It does not, as some people have suggested, in any way change the mutual status of the Co-Op Group itself, and as the proportion of external shareholders will be small, the Co-Op Group will continue to have a controlling interest. It does mean that holders of the PIBS inherited from the Britannia and the Co-Ops own preference shares, some of whom are very small investors, will take big losses and - perhaps even more importantly for some of them - will lose certainty of income, since the Co-Op Bank is unlikely to issue much in the way of dividends to shareholders until its balance sheet is in better shape and both PIBS and pref shares provide guaranteed interest income.
The remainder of the capital requirement will be met by divestments, primarily of the insurance lines, and by an injection of capital from Co-Op Group itself if necessary. There are no proposals to bail in depositors Cyprus-style.
The Co-Op Bank has already been split internally into good bank and bad bank, like the other damaged banks RBS and Lloyds, and the bad bank will be progressively wound down over time. However, this does mean that the Co-Op Bank will continue to suffer losses on its loan book for some time to come. It is unlikely therefore to be able to do much in the way of risky lending (such as to SMEs) for quite a while, which is unfortunately not helpful to the economy.
The proposed bail-in of bondholders is likely to trigger a further downgrade of the Co-Op Bank's credit rating, since it amounts to a partial default.
Related links:
Moody's statement on Co-Op Bank downgrade
Co-Op woes embarrass regulators and Treasury - Robert Peston
What does Moody's downgrade of Co-Op Bank mean? - Robert Peston
Treasury Committee to inquire into "Project Verde" - HM Government
Co-Op Group 2012 Annual Review
Co-Op Bank 2012 Financial Statements
Co-Op capital hole threatens Lloyds deal - FT (paywall)
Feelings not mutual - Big Issue In The North
Update:
Co-Op Bank's stock market future - Peston
Sunday, 9 June 2013
The zero-sum trade in people
The problem that I identified for the Eurozone in my previous posts is already well-documented on a smaller scale within countries - migration from rural areas to cities. And as various people have pointed out, we are also seeing it in the US and UK, which are currency unions. It's also a particularly worrying feature of the Baltic states and other Eastern European members of the European Union. In short, it's not just a problem peculiar to the Eurozone.
The theory behind free movement of labour runs as follows. Consider countries within an economic union where there are no legal barriers to the movement of people. When a country undergoes internal devaluation which causes wages to fall and increases unemployment, the result is migration of the young, able and skilled to other countries where there is more work and higher wages. We can regard this as export of labour, and the countries receiving the migrants can be said to be importing labour.
We assume that importing countries are attracting labour that they need, and exporting countries are shedding labour that they don't need. Migration of labour from low-wage to high-wage areas is an essential part of the internal devaluation process. For any given job, a worker will wish to receive a high wage, while an employer will wish to pay a low wage. The market-clearing price is somewhere between the two depending on their relative power: where there is a shortage of labour the price will be nearer to the worker's demand, while a glut of labour will enable employers to control the price. (Yes, I know this is a bit simplistic!) Clearly, therefore, the low-wage country has more labour than it needs, and the high-wage country does't have enough. If workers can move from low-wage to high-wage countries, therefore, the supply of labour increases in the high-wage country, putting downwards pressure on labour costs, and decreases in the low-wage country, putting upwards pressure on labour costs. And concurrently, when the cost of moving is lower than the benefit to be gained by relocating in a low-wage country, firms will move into that country. As the demand for labour falls in the high-wage country due to firms relocating, wages fall, and conversely as more firms relocate in low-wage country, wages rise. Eventually the two countries reach equilibrium, wages stabilise, labour stops migrating and firms stop relocating.
That's the theory. Like all theories, it assumes a lot of things. Firstly, it assumes that for both workers and firms, price is the only consideration. That isn't the case: for example, for firms, availability of natural resources may be a key consideration in deciding whether or not to relocate. And workers may be put off migrating by language barriers or family ties. Also, local regulations may discourage firms from relocating and/or workers from migrating: free movement of both capital and labour may exist in theory but not necessarily in practice.
More importantly, it assumes that the labour supply is homogenous and that there are no GENERAL shortages of skills. But this is not the case. There are general shortages of some skills - and it is always the people with scarce skills who leave first. Migration of people with skills that are generally in short supply can continue until the supply in the exporting country is completely exhausted, regardless of whether local firms need those skills: local firms are simply not going to be able to pay the wages available in the receiving country. This is because high wages usually mean a richer economy: people spend more, which generates income and profits for firms. Firms that are located in a depressed economy simply cannot match the wages paid by firms in more prosperous areas. Eventually this either forces them out of business or encourages them to move TO higher-wage areas in search of skills - exactly the opposite of the effect that forcing down wages is supposed to have on firms's behaviour.
The usual political response to the "brain drain" of people with scarce skills away from less prosperous countries is to demand that the education system delivers workers with skills that are in short supply. But this is impossible. If industry cannot recruit people with the skills it needs because of competition from richer countries, how on earth is the education system supposed to recruit teachers with those skills? In fact the drain of skilled workers away from low-wage areas affects the education system as much as industry. Teachers can migrate too.
Along with skills shortages, there may be skills gluts which can make it almost impossible for redundant workers to find jobs that use their skills. For example, when the reason for a particular area suffering a serious fall in employment is that a major industry has collapsed, there are likely to be a large number of people with skills that are no longer needed in that area. Their chances of getting equivalent work elsewhere are vanishingly small: often the only work they can hope for is unskilled, poorly-paid and highly insecure. If the costs of migrating are high, these workers may not be able to afford to move. This is what happened in the UK in the 1980s and 1990s: despite the advice from a Government minister at the time to "get on your bike", the reality was that there were few jobs anywhere within cycling distance. Skills gluts perversely increase demand for unskilled jobs, as those who are unable to find work appropriate to their skills take unskilled jobs: this forces out the genuinely unskilled, who can find it almost impossible to find ANY work. Skills gluts are largely responsible for the prevalence of unskilled people among the long-term unemployed in many countries.
The third assumption is that the labour supply remains constant - in other words, that as fast as people migrate, other people replace them. Now, in countries with a birth rate at or above replacement level, this is true. But if the country that is losing its young and skilled ALSO has a falling birth rate, it is in serious trouble. As the young and skilled leave and are not replaced, the age profile of the population increases, the proportion of sick and disabled increases and the proportion of unskilled to skilled increases. This amounts to a form of hysteresis. The attractiveness of the remaining labour force to firms declines as both skills and productivity fall: consequently firms are less likely to relocate to the country, which removes the brake on migration that relocation of firms would be expected to create (assuming of course that if jobs are available and wages equivalent, people will prefer to stay put). Migration would therefore continue until the only people left are those who either can't or won't leave. This problem is more immediate in those countries like Portugal that have had a falling birth rate for some years: but even if a country doesn't have a falling birth rate at the time that the young start to leave, by the time the migration has continued for a few years it will have.
Someone suggested that the loss of the young & skilled would be offset by immigration, so the population profile wouldn't change that much and firms would still relocate. I find this bizarre. Why would skilled immigrants come to a country from which people with the same skills were leaving? Surely they, too, would go to the higher-wage countries?
The problem of internal devaluation where there are skills shortages, skills gluts, labour market rigidities and a falling birth rate looks insoluble. But I don't think it is. I'd turn this round and look at it another way. I recently wrote an article comparing free workers with slaves, in which I noted that slaves are capital assets - firms have to pay for them upfront - whereas cheap, unskilled and insecure labour incurs no capital cost so can be a much cheaper alternative to a slave, and this is not necessarily beneficial to the free worker......in Roman times, people used to sell themselves into slavery, if the alternative was starvation. The migration problem within economic unions is actually a variation of the same thing, but it is perhaps more immediately comprehensible to view it as a balance of trade problem.
I noted above that the country from which people are migrating can be regarded as exporting labour, while the country receiving the migrants is importing labour. And the receiving country unquestionably benefits. Immigrants plug skills gaps, benefiting its industries: immigrants spend their wages, benefiting economic activity: immigrants pay tax, benefiting public finances. Now, if the migrants were unemployed in their country of origin, then in the short term their departure is also beneficial to the fiscal finances in the exporting country. But skilled migrants leaving in search of higher wages may not be unemployed in their country of origin, and the gaps they leave may be hard to fill: and over time, migration of the young - even unemployed ones - creates a demographic problem for the exporting country. On balance, I would say that the importing country generally does better out of the people trade than the exporting one does. Considerably better. In fact, if the export of people means that the exporting country goes into terminal decline due to loss of the young & skilled and hysteresis in the remaining population, then I would regard the trade in people as zero-sum. The importing country benefits at the expense of the exporting one.
Which invites the question - why is this export free? After all, imports usually have to be paid for. Exporting countries receive inflows of money in payment for the goods and services they provide - unless the export is people. Well, not quite though - if we export footballers, we get paid for them. And in days gone by, the trade in people could be extremely lucrative (though it's fair to say it probably benefited the intermediaries most). But we've abolished slavery now.....
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And I'm certainly not advocating bringing back slavery! But there is a strong argument to my mind that countries that export labour as part of an internal devaluation programme within an economic union should receive payment from the importing countries. The labour they export for nothing contributes to the GDP and the tax revenue of the importing countries. It seems only right and proper that they should share in that benefit.
Now, before anyone suggests this is not a "real" trade imbalance, let me remind you that the cost of supporting an ageing and poorly skilled population when GDP is falling means increasing levels of public debt....just as would be the case if this were a real trade imbalance. The loss of productive labour is disastrous for the fiscal finances.
To my mind the normal riposte to this - that migrant workers will of course send money back to their families - is inadequate. Migrants make those payments out of taxed income: the exporting country does not share in that tax payment. And as I've noted previously, if migrants believe that the state will support the old and frail, they may not send much back at all. Voluntary remittance is no substitute for a system of payments to compensate exporting countries for the loss of productive labour. Or, if you like, to reverse the implicit fiscal transfers from low-wage countries to high-wage ones that are the inevitable consequence of economic migration.
Of course, our rich young migrants might send money back to their countries of origin - to buy themselves retirement homes for their old age. I suppose this would stimulate the construction industry and increase house prices. I'm not entirely clear in what way raising house prices for an impoverished population is supposed to stimulate the economy. It is more likely, surely. to make it even harder for these people to afford basic necessities such as a roof over their heads. Nor is it reasonable to assume, as some have, that the inexorable march of technology will somehow make an ageing and increasingly unproductive workforce more affordable for states that are already highly indebted and whose GDP is falling. On the contrary, it seems more likely that technological improvements - which require capital investment that these countries are unlikely to be able to afford - will simply pass them by.
So where does this leave us? Most currency unions have some kind of system of fiscal transfers, though these are usually flawed and inadequate, not least because the importing countries/states/cities resent sending money back to exporters. But the European Union is not a currency union. Yet it still needs somehow to staunch the flow of people from countries such as the Baltic states if they are to avoid going into a death spiral.
There are, of course, real issues here concerning the rights of the individual. It would be very easy to suggest that where there is no fiscal union, states should be free to prevent people leaving if they so wish. But this could result in a Kafkaesque nightmare, where people that aren't needed in the workforce can leave but others can't.....Though I find myself asking why states should be free to prevent certain people coming IN if they so please, but not free to prevent certain people LEAVING? To its credit, the European Union - in theory at least - does not allow member states to prevent people coming in, either. But this doesn't help the states that are slowly bleeding to death.
I am forced to the conclusion that free movement of people within any economic union requires a commitment from all members of that union to ensure economic prosperity for all the people within the union, even if that means giving up cherished ideas of fiscal independence. Fiscal transfers to countries that are suffering the consequences of large-scale emigration are not "aid" or "bailouts". They are simply a recognition by more prosperous states that their prosperity is not entirely due to their own efforts. It is simply not acceptable for some states within a union to obtain competitive advantage by bleeding other states of productive capital and labour. For what kind of "economic union" is it if the prosperity of some is bought at the expense of the impoverishment of others?
Related links:
The creeping desert - Coppola Comment
The movement of people (and its consequences) - Coppola Comment
Increasing returns and economic geography - Paul Krugman
Memo to Paul Krugman on the Eurozone: read your own research! - Nathan Tankus (Naked Capitalism)
Ubi solitudinem faciunt, pacem appellant - Jonathan Portes (NIESR)
The shortage of Bulgarians inside Bulgaria - Edward Hugh (Economonitor)
The financialisation of labour - Frances Coppola (Pieria)
From huddled masses to property investors - From Arse to Elbow
Thursday, 6 June 2013
The creeping desert
I wrote a post the other day that caused something of a stir. In it I argued that migration of the young & skilled from southern European countries could mean that those left behind face a very bleak future. Several people took issue with this, arguing that the migrants would send back enough money to support their parents and regenerate the economy. This to my mind ignores current demographic reality, and perhaps more importantly, the particular structural problems in the Eurozone. And some people seemed unclear about my argument. So in this post, I shall explain the reasoning behind my bleak assessment of the future for the Eurozone periphery.
I am emphatically NOT arguing that there is anything intrinsically wrong with young, skilled people leaving in search of a better life elsewhere. Migration benefits both the migrants and the receiving countries. Immigration is a GOOD thing for countries that have ageing populations and skills shortages - as most Western countries do. Germany, for example, would unquestionably benefit from inflows of skilled young people from the Southern European countries. And it would be quite wrong in my view to prevent young people faced with high unemployment in their home country from going elsewhere to find work. Nor would it be right to prevent skilled people facing falling wages in their home country from going to countries where the pay is better. But where people can freely move to other countries, as is the case in the European Union, the sort of "Internal devaluation" that forces down wages in search of "competitiveness" inevitably causes migration when the same jobs in Greece and Germany pay vastly different wages. Unfortunately it is this sort of "internal devaluation" that has been forced on the Eurozone periphery because their membership of the Euro prevents them from devaluing their currencies vis-a-vis their main trading partners, which is the usual means by which countries restore competitiveness.
Traditionally, young migrants send money back to their parents. This is because the traditional social contract is that children are cared for by their parents when they are young, and in turn are then responsible for supporting their parents in their old age. But in the West, with pension and healthcare systems that support the old, the explicit contract between children and parents is weakened. Children are a direct cost to their parents, but children's financial support of parents in their old age now comes largely through payment of taxes, and the old expect to provide for their own retirements by saving and paying taxes during their working lives. I think this is at least partly the cause of the falling birth rate. And I think it severely weakens the ties between older and younger generations. Older generations hold on to wealth rather than redistributing it to the young, because they need that wealth to support them in their old age. Meanwhile the young don't see the need to support the old directly - and the old don't expect to be supported directly - because the old have much more wealth and are extensively supported by the state. This last is the most poisonous as far as young migrants supporting the elderly back home is concerned. I don't have evidence to support this but I think that young migrants are much more likely to send money home when there is little state pension or healthcare provision in their country of origin. If they believe that the state will support their parents, they may not send money home.
In the Eurozone, therefore, we would expect to see migration of young skilled people from areas of high youth unemployment and falling wages. And indeed this does appear to be happening. The problem is that the people left behind are older, less able and lower skilled, which makes these countries less attractive to businesses. After all, why would a business choose to locate itself somewhere where the local workforce is ageing and poorly skilled? So businesses would go elsewhere too. That would cause GDP to shrink further. The population's need for state support would actually increase as it ages and gets sicker, but tax revenue would fall as working people and businesses leave. That adds up to long-term decline and a growing burden on the state's finances. Young people sending money back would mitigate this to some extent but it wouldn't compensate fully for falling GDP: I really don't see how inflows of money from young people to enable their parents to survive could possibly prop up aggregate demand enough to make the country attractive to business. And old people and long-term disabled don't generally pay taxes. So where will the taxes come from to support the welfare systems that these people depend on?
That's bad enough. But there is one final ingredient in this poisonous mixture. Most of these states are already highly indebted. With a growing burden on their healthcare and pension systems and falling tax take due to GDP decline, their debts can only get worse. The fiscal compact gives primacy to debt service over maintaining public services. As I see it, therefore, these states will eventually be forced to dismantle their welfare systems - the pensions and healthcare required by their ageing populations - to avoid debt default. Eventually, I suppose, the old and the unskilled will also leave - if they can, and if any country will receive them. For although the European Union is in theory committed to the free movement of people, I wonder how real that commitment would turn out to be in the face of large-scale migration of pensioners and benefit claimants from the Eurozone periphery. I suspect that free movement of people might turn out to be another of those European laws that are binding in good times but illusory in bad.
Therefore as Krugman said, the combination of labour mobility with internal devaluation and lack of fiscal union in the Eurozone is potentially lethal. There is no possibility of recovery for countries caught in the deadly embrace of high public debt and youth migration. For them, "internal devaluation" actually means creeping desertification.
Related links:
The movement of people (and its consequences) - Coppola Comment
The triumph of Peter Kenen, the revenge of Robert Mundell - Paul Krugman
No country for young men....or young women either - Crooked Timber
Ubi solitudinem faciunt, pacem appellant - Jonathan Portes (NIESR)
Sunday, 2 June 2013
The movement of people (and its consequences)
This chart shows the "slow train wreck" that is Eurozone youth unemployment - courtesy of Pedro da Costa of Reuters:
(larger version here)
This adds up to an aggregate youth unemployment figure of 23.3% (in March 2013) for the Eurozone as a whole.
This is what the European Commission plans to do about it:
And with GDP crashing in the countries with the highest youth unemployment, where are these jobs going to come from anyway?
The BBC's Newsnight programme recently interviewed the CEO of the Berlin Stock Exchange, Artur Fischer. Newsnight tweeted the following:
Ireland
The chart shows a downturn in Ireland's youth unemployment, from over 30% in early 2012 to 26% now. This is why:
The migration of people from Portugal - of all ages, but particularly the young and talented - has become a national emergency.
Spain currently has the second highest youth unemployment in the Eurozone. But its general unemployment level is very high too. According to El Pais, the largest exodus has been among young professionals aged 25-35. They are not strictly "youth"....but the younger ones are starting to go too:
Related links:
Portugal - immigration statistics
Latvia struggles with "demographic disaster" - France24 (h/t Andrew Lainton)
The Shortage of Bulgarians inside Bulgaria - A Fistful of Euros
* Sadly it did not last long....he was called up to serve in the Anzacs in WW1, was wounded at Gallipoli then killed on the Somme. He was my great-grandparents' only son....Like most people in the UK, my family lost members not just through emigration but through war.
(larger version here)
This adds up to an aggregate youth unemployment figure of 23.3% (in March 2013) for the Eurozone as a whole.
This is what the European Commission plans to do about it:
The Youth Employment Initiative was proposed by the 7-8 February 2013 European Council with a budget of €6 billion for the period 2014-20.
The Youth Employment Initiative would particularly support young people not in education, employment or training in the Union's regions with a youth unemployment rate in 2012 at above 25% by integrating them into the labour market.
The money under the Youth Employment Initiative would therefore be used to reinforce and accelerate measures outlined in the December 2012 Youth Employment Package. In particular, the funds would be available for EU countries to finance measures to implement in the eligible regions the Youth Guarantee Recommendation agreed by the EU's Council of Employment and Social Affairs Ministers on 28 February. Under the Youth Guarantee, Member States should put in place measures to ensure that young people up to age 25 receive a good quality offer of employment, continued education, an apprenticeship or a traineeship within four months of leaving school or becoming unemployed.
The Youth Employment Initiative would be complementary to other projects undertaken at national level, including those with European Social Fund (ESF) support, with a view to setting up or implementing the youth guarantee schemes, such as reforming the relevant institutions and services.
Of the funding, €3 billion would come from a dedicated Youth Employment budget line complemented by at least €3 billion more from the ESF. Given Member States' current budgetary difficulties due to the economic crisis, only the European Social Fund contribution would require Member States to top up with their own financial contribution.Is €6 billion, of which part must come from the Member States with the most serious youth unemployment problems, really going to do any more than just scratch the surface of this problem?
And with GDP crashing in the countries with the highest youth unemployment, where are these jobs going to come from anyway?
The BBC's Newsnight programme recently interviewed the CEO of the Berlin Stock Exchange, Artur Fischer. Newsnight tweeted the following:
CEO of Berlin Stock Exchange Artur Fischer has told #newsnight most jobs will not be available in Greece, Greeks need to leave the countryIt's already happening, and not just from Greece. Here's a selection of news reports this year about the emigration of young people from the hardest hit Eurozone countries:
— BBC Newsnight (@BBCNewsnight) May 10, 2013
Ireland
The chart shows a downturn in Ireland's youth unemployment, from over 30% in early 2012 to 26% now. This is why:
"In the past four years, over 300,000 people have emigrated from Ireland; 40% were aged between 15 and 24".- RTE News, 9 May2013Portugal
The migration of people from Portugal - of all ages, but particularly the young and talented - has become a national emergency.
"More than 2% of Portugal's population have emigrated in the past two years....Most were young, highly-educated people fleeing to Switzerland or the oil-rich former Portuguese colony Angola."- BBC News, 25 January 2013Spain
Spain currently has the second highest youth unemployment in the Eurozone. But its general unemployment level is very high too. According to El Pais, the largest exodus has been among young professionals aged 25-35. They are not strictly "youth"....but the younger ones are starting to go too:
"Spain's jump in unemployment has seen an exodus of youth, with tens of thousand of young Spaniards, many of them university graduates, looking for better opportunities in countries such as Germany and Britain and former Spanish colonies in Latin America......"A study by analyst Real Instituto Elcano in February shows 70 percent of Spaniards younger than 30 have considered moving abroad."- Al Jazeera English, 7 April 2013
Italy
As I shall explain shortly, Italy has a history of economic emigration. The difference is that whereas in the past emigration has mainly been from the poor South - and is one of the principal reasons why the South has remained poor - this time it is from the richer North.
"Emigration from Italy rose by nearly a third last year to 79,000, with a growing number of young people choosing to leave the crisis-hit country, Italian media reported on Sunday, citing official data....with those aged 20 to 40 making up 44.8 percent of the total, from 28.3 percent in 2011."- The Daily Star, Lebanon, 7 April 2013
Greece
It's not just how many young Greeks are leaving, it's who they are. Brain drain:
"Greek emigration to Germany jumped by more than 40% last year....."A recent study by the University of Thessaloniki found that more than 120,000 professionals, including doctors, engineers and scientists, have left Greece since the start of the crisis in 2010."- BBC News, 30 May 2013
I do not wish anyone to think that I am bewailing the "terrible fate" of young people having to leave their homes in search of work. I certainly am not. There is nothing new - and nothing intrinsically undesirable - about young people emigrating to seek their fortunes in another country. To give a personal example, my great-uncle, Henry Dodson Noon, left the UK for Australia in the first decade of the twentieth century. His family were farmers, but he saw no future in farming in the UK at that time, so he went to Australia to carve out a new life for himself as a sheep farmer.* He was one of many young British men who left at that time. And my ex-husband's family are among a sizeable number of Italians who left a depressed Italy to seek new lives as hotel, cafe and small shop owners in Scotland (the most famous of them was Lord Forte of "Trusthouse Forte" fame, whose first hotel was opposite my father-in-law's cafe in Alloa). To this day they maintain links both with their Italian origins and with their adopted country, even though many of them - including my ex-husband - no longer live in Scotland either. I am sure my readers can come up with plenty of examples of their own. In human history, the movement of people is a feature, not a bug. It is how we create new lives for ourselves and how we develop and grow new economies. It is not, of itself, a bad thing.
The problem is that the migration of young people from European countries may create even more difficulties for those left behind. The demographic timebomb awaiting Europe is nicely explained in this video from Reuters, which focuses on Latvia - which has already suffered a huge exodus of young people, as have other Eastern European countries. Are our family ties still strong enough for these highly-educated young people to send money back to the older generation that they leave behind, as young migrants in the past have done, and still do in many other parts of the world? Because if not, the future looks very bleak indeed for ageing populations in depressed countries in the South of Europe.....
Related links:
Portugal - immigration statistics
Latvia struggles with "demographic disaster" - France24 (h/t Andrew Lainton)
The Shortage of Bulgarians inside Bulgaria - A Fistful of Euros
* Sadly it did not last long....he was called up to serve in the Anzacs in WW1, was wounded at Gallipoli then killed on the Somme. He was my great-grandparents' only son....Like most people in the UK, my family lost members not just through emigration but through war.
Friday, 31 May 2013
There's a problem with the transmission....
In my last post, I pointed out that QE does not work when the transmission mechanism for monetary policy is impaired because of a damaged and risk-averse financial sector. This caused some confusion among those who think that throwing money at banks automatically makes them lend, so I attempted to explain it on twitter. Predictably, I ended up in an extended discussion first with David Beckworth and then with Andrew Lilico, in the course of which it became clear - to me, at any rate - that not only does QE fail when damaged banks aren't lending normally, but it actually impairs the transmission mechanism itself. This might explain why QE seems to become less effective the more of it you do. It's like hard water. It gradually clogs up its own pipes.
To explain this, let me first go through the money creation process in our fiat money system and the ways in which QE influences that process.
The monetary base, M0, is created by the central bank. It consists of notes & coins, and bank reserves - the money that banks use to settle payments. M0 makes up maybe 10-15% of the total money in circulation. The rest - "broad money" - is created in the course of lending both by banks and by non-banks that do bank-like things. It should be remembered that non-banks are the customers of banks: cash held by non-banks always finds its way into banks.
Bank reserves never leave the banking system. They are not "lent out", as is often claimed. When a bank lends, it creates a deposit "from nothing", which is placed in the customer's demand deposit account. When that loan is drawn down, the bank must obtain reserves to settle that payment - but the payment simply goes to another bank (or even the same one), either directly through an interbank settlement process, or indirectly via cash withdrawal and subsequent deposit. The total amount of reserves in the system DOES NOT CHANGE as a consequence of bank lending. Only the central bank can change the total amount of reserves in the system. This is usually done by means of "open market operations" - buying and selling securities in return for cash.
Because banks create deposits from nothing when they lend, the availability of reserves at the time of loan creation is not a constraint on lending. When the financial system is functioning normally, banks borrow reserves from each other to settle payment requests, and if there is a shortage of reserves in the system the central bank will create more: alternatively if there are more reserves in the system than are needed to settle payments, the central bank would normally drain them by selling securities back into the market. Some central banks impose a "reserve requirement" of, say, 10% of eligible deposits: this is a liquidity buffer to ensure that banks can meet most payment requests without having to borrow from each other or from the central bank. If there is a positive reserve requirement, it is the central bank's responsibility to ensure that there are sufficient reserves in the system to enable all banks to meet the reserve requirement.
It should be apparent from this that the monetary base RESPONDS TO lending demand. It does not drive it. This is borne out by evidence that if anything, M0 creation lags broad money creation.
That's the basic mechanics of the system. However, it is not quite that simple. Monetary policy may influence lending demand by means of reserve adjustments. If the central bank decides to reduce the total amount of reserves in the system, scarcity of reserves pushes up the interest rate at which banks will lend to each other: conversely, increasing the amount of reserves pushes down the lending rate. The increased cost of reserves is supposed to act as a brake on lending. Unfortunately, when banks are chasing market share instead of margin - as they were in the early to mid-2000s - increasing the cost of reserves is not a particularly effective brake on lending unless the increase is very large. Increasing market share can compensate for loss of margin to quite an extent (this is why low-margin retail lending is only really viable as a high-volume business). And in the end, no central bank is going to allow payments to fail because of scarcity of reserves. Indeed in Europe, reserve creation by the Eurosystem to facilitate payments is automated.
QE can be regarded to an extent as large-scale open market operations. The central bank buys securities in return for newly-created cash. If the securities are bought directly from banks, then the banks simply replace riskier and less liquid assets with cash. If the securities are bought from institutional investors or individuals, the cash still ends up in banks in the form of deposits. Either way, though, the total amount of reserves in the system increases.
The UK, US and Japan have all done extensive QE, and as a consequence the banking system is now awash with US dollar, sterling and yen reserves far in excess of the amount needed to settle payments. Increasing the amount of reserves in the system was supposed to encourage banks to lend. But the financial sector is badly damaged in all three countries: bank balance sheets are full of non-performing loans that tie up capital and are not easy to unwind. Additionally, there is regulatory pressure on banks to reduce their risks and shrink their balance sheets. Shrinking a bank balance sheet means selling or unwinding unwanted loan portfolios. If a lot of banks are doing this all at once, the effect must be a reduction in overall lending volume. Remember I said that money is created when banks lend? When loans are paid off - or written off - money is destroyed. So general deleveraging in the banking sector, as we have been seeing for the last five years in the US and UK and for the last fifteen years in Japan, means that broad money supply is likely to be stagnant or actually falling. Now, it may be that QE encourages some banks to maintain higher levels of lending than they would otherwise have done, because in theory it reduces their funding costs (though that may not actually be true in practice, as I shall discuss shortly). We simply don't know. But what is clear is that the size of the monetary base has nothing whatsoever to do with broad money supply. When banks are deleveraging, broad money may still fall even when the monetary base is increasing.
To be fair, the Bank of England and the Fed both noted that damaged banks were not likely to increase lending and QE should achieve its effects mainly in other ways. But what they both missed was the damaging effects of QE on the flow of money through the financial system and the consequences for monetary policy transmission.
QE increases the amount of reserves in the system and reduces the amount of other forms of safe security, particularly various forms of government debt. Since the financial crisis, borrowing and lending between banks and non-banks has become more-or-less completely collateralised, with the debt of highly-rated sovereigns being the preferred choice of collateral. There is also a scarcity of collateral due to collapse of US MBS issuance, increasing shortages of high-quality sovereign debt due to sovereign downgrades, and regulatory changes encouraging buildup of safe asset reserves and hoarding of collateral. One of QE's effects is to reduce even further availability of safe collateral and therefore increase its price. THIS IS DELIBERATE. The stated intention of QE is to depress government bond yields to make them less attractive to investors and therefore nudge those investors towards riskier assets. Unfortunately this also increases the cost of the collateral needed by banks and non-banks to obtain funding, including from central banks. It could be argued that whatever encouragement increased reserves give to banks to lend is offset by the increasing cost and scarcity of the collateral needed to obtain the funds to settle lending. It's a wash.
Which brings me to the problems with monetary policy. The first thing to note is that as the increased availability of funds is balanced by increased cost and scarcity of collateral needed to obtain funds, QE makes no difference to liquidity in the financial system. This point has been brilliantly (and repeatedly) made by Peter Stella and the IMF's Manmohan Singh, but it seems no-one is listening. The extra reserves provided by QE are in no sense expansionary. If anything, QE is contractionary, because it reduces the velocity of money in the financial system. When collateral is scarce, funding flows are impeded. There may be more actual funds available, but if they aren't moving, they aren't any use.
The second point concerns the means by which central banks influence the behaviour of banks. Because the fundamental driver of lending is the risk versus return profile for both lenders and borrowers, lending is intrinsically cyclical. Central banks attempt to dampen the cyclicality of lending by means of macroprudential regulation and monetary policy. Of these, the second is arguably more important: macroprudential regulation historically has had limited success. But large-scale QE fundamentally changes the way monetary policy is transmitted. When the system is awash with excess reserves, central banks cannot use reserve scarcity to drive up the cost of funding. The "funds" rate (Fed Funds in the US, "bank" rate in the UK) becomes useless as a policy measure. When reserves are excessive, therefore, policy must be transmitted via the deposit rate.
Most central banks pay interest on excess reserves placed with them by banks: normally that rate is some distance below the interbank lending rate, to encourage banks to lend excess reserves to each other instead of parking them at the central bank. But as funding rates crash to zero, the deposit rate suddenly becomes far more important. Positive interest on excess reserves is currently used by both the US and the UK to prevent repo rates turning negative and prop up the short end of the Treasury yield curve. But this means that parking funds at the central bank becomes an increasingly attractive proposition for damaged banks that don't want to lend. To "nudge" banks towards productive lending, policy makers are now thinking about cutting central bank deposit rates to zero or even below. The consequences of negative rates are not fully understood, but even the brief look that I had a while ago suggested that they might not be quite what policy makers anticipate. And the problem with relying on deposit rates as the primary means of monetary policy transmission is that they are not underpinned by coherent macroeconomic modelling and their effects are not well understood. Some might argue that this is true of funds rates too, but it's far worse with deposit rates because they have never been used in this way before. Policymakers are making it up as they go along. And the economics profession is not exactly helping. The extent of disagreement among economists about how monetary policy works under these exceptional circumstances is eye-watering. It is telling that many of the most useful contributions to the debate about how best to conduct monetary policy at present have come from the financial blogosphere, not from the economics profession.
In short, monetary policy transmission is weirdly distorted by the effects of excess reserves and it has become extremely difficult for central banks to influence bank behaviour. Because monetary policy is hampered and there is reluctance to use fiscal policy as a complementary toolset, some politicians have been looking to macroprudential regulation to nudge banks towards more productive lending. This is madness. It is not the job of prudential regulators to repair damaged economies by, for example, watering down bank capital requirements intended to reduce the likelihood of catastrophic bank failures. I would rather see acceptance that, as Pozsar and McCulley (among others) have suggested, when interest rates are very low and monetary policy transmission is impeded there is a need for complementary fiscal policies.
There is much that I haven't covered in this post, and even what I have described here is controversial because it rests on an unconventional view of how the monetary system works (although perhaps not that unconventional now, since it is consistent with recent papers by both the Fed and BIS). You may disagree with much of what I have written, and I welcome constructive comments. A huge topic that I have not yet discussed is the whole question of expectations management, not only in relation to QE and its effects but in the transmission of monetary policy. I shall return to this in another post. In the meantime, Woodford is well worth reading on this matter.
Related links:
Inflation, deflation and QE - Coppola Comment
Does the Federal Reserve fully control the money supply? - John Aziz (The Week) (with very cool charts!)
The whole question of collateral shortage, monetary policy transmission and (potentially) negative rates has been extensively covered in the financial blogosphere. Here are some of the best posts.
When safe assets return - FT Alphaville
The decline of safe assets - FT Alphaville
Pledged collateral in an IS/LM framework (part 1) - Manmohan Singh at FT Alphaville
Pledged collateral in an IS/LM framework (part 2) - Manmohan Singh at FT Alphaville
A confederacy of dorks - Interfluidity
(and all the links in this post, plus Interfluidity's previous posts on the "floor" system. A fascinating and important debate)
The roving cavaliers of credit - Steve Keen
When governments become banks - Coppola Comment
The strange world of negative interest rates - Coppola Comment
Central bank reserve creation in the era of negative money multipliers - Stella & Singh (Vox)
The recommendation of this post, as others I have written, is for fiscal & monetary coordination as suggested in this paper:
Helicopter money - Pozsar & McCulley
Implicit in this post is the idea (as spelled out in the Vox link above) that the traditional "money multiplier" does not exist. This was recently confirmed in these papers from the Fed and BIS:
Money, reserves and the transmission of monetary policy - Federal Reserve
The bank lending channel revisited - Disyatat, BIS
This paper from the Hungarian Central Bank documents the lack of connection between size of central bank balance sheet (i.e. reserve expansion) and broad money growth:
The effect of the monetary base on money supply - Andras Komaromi, MNB
For a good description of how endogenous money creation works in a fiat money system, read Cullen Roche's paper:
Understanding the modern monetary system - Roche
This paper has a US focus and it is likely that things work slightly differently in other countries: for example, the European banking model relies much less on disintermediated "shadow" banking. Perhaps we need more papers describing how money creation works in the UK, Europe and Japan.
On expectations, a subject that I haven't addressed at all yet but discussed extensively with David Beckworth - here's Woodford's paper on the importance of forward guidance:
Methods of policy accomodation at the interest-rate lower bound - Woodford
To explain this, let me first go through the money creation process in our fiat money system and the ways in which QE influences that process.
The monetary base, M0, is created by the central bank. It consists of notes & coins, and bank reserves - the money that banks use to settle payments. M0 makes up maybe 10-15% of the total money in circulation. The rest - "broad money" - is created in the course of lending both by banks and by non-banks that do bank-like things. It should be remembered that non-banks are the customers of banks: cash held by non-banks always finds its way into banks.
Bank reserves never leave the banking system. They are not "lent out", as is often claimed. When a bank lends, it creates a deposit "from nothing", which is placed in the customer's demand deposit account. When that loan is drawn down, the bank must obtain reserves to settle that payment - but the payment simply goes to another bank (or even the same one), either directly through an interbank settlement process, or indirectly via cash withdrawal and subsequent deposit. The total amount of reserves in the system DOES NOT CHANGE as a consequence of bank lending. Only the central bank can change the total amount of reserves in the system. This is usually done by means of "open market operations" - buying and selling securities in return for cash.
Because banks create deposits from nothing when they lend, the availability of reserves at the time of loan creation is not a constraint on lending. When the financial system is functioning normally, banks borrow reserves from each other to settle payment requests, and if there is a shortage of reserves in the system the central bank will create more: alternatively if there are more reserves in the system than are needed to settle payments, the central bank would normally drain them by selling securities back into the market. Some central banks impose a "reserve requirement" of, say, 10% of eligible deposits: this is a liquidity buffer to ensure that banks can meet most payment requests without having to borrow from each other or from the central bank. If there is a positive reserve requirement, it is the central bank's responsibility to ensure that there are sufficient reserves in the system to enable all banks to meet the reserve requirement.
It should be apparent from this that the monetary base RESPONDS TO lending demand. It does not drive it. This is borne out by evidence that if anything, M0 creation lags broad money creation.
That's the basic mechanics of the system. However, it is not quite that simple. Monetary policy may influence lending demand by means of reserve adjustments. If the central bank decides to reduce the total amount of reserves in the system, scarcity of reserves pushes up the interest rate at which banks will lend to each other: conversely, increasing the amount of reserves pushes down the lending rate. The increased cost of reserves is supposed to act as a brake on lending. Unfortunately, when banks are chasing market share instead of margin - as they were in the early to mid-2000s - increasing the cost of reserves is not a particularly effective brake on lending unless the increase is very large. Increasing market share can compensate for loss of margin to quite an extent (this is why low-margin retail lending is only really viable as a high-volume business). And in the end, no central bank is going to allow payments to fail because of scarcity of reserves. Indeed in Europe, reserve creation by the Eurosystem to facilitate payments is automated.
QE can be regarded to an extent as large-scale open market operations. The central bank buys securities in return for newly-created cash. If the securities are bought directly from banks, then the banks simply replace riskier and less liquid assets with cash. If the securities are bought from institutional investors or individuals, the cash still ends up in banks in the form of deposits. Either way, though, the total amount of reserves in the system increases.
The UK, US and Japan have all done extensive QE, and as a consequence the banking system is now awash with US dollar, sterling and yen reserves far in excess of the amount needed to settle payments. Increasing the amount of reserves in the system was supposed to encourage banks to lend. But the financial sector is badly damaged in all three countries: bank balance sheets are full of non-performing loans that tie up capital and are not easy to unwind. Additionally, there is regulatory pressure on banks to reduce their risks and shrink their balance sheets. Shrinking a bank balance sheet means selling or unwinding unwanted loan portfolios. If a lot of banks are doing this all at once, the effect must be a reduction in overall lending volume. Remember I said that money is created when banks lend? When loans are paid off - or written off - money is destroyed. So general deleveraging in the banking sector, as we have been seeing for the last five years in the US and UK and for the last fifteen years in Japan, means that broad money supply is likely to be stagnant or actually falling. Now, it may be that QE encourages some banks to maintain higher levels of lending than they would otherwise have done, because in theory it reduces their funding costs (though that may not actually be true in practice, as I shall discuss shortly). We simply don't know. But what is clear is that the size of the monetary base has nothing whatsoever to do with broad money supply. When banks are deleveraging, broad money may still fall even when the monetary base is increasing.
To be fair, the Bank of England and the Fed both noted that damaged banks were not likely to increase lending and QE should achieve its effects mainly in other ways. But what they both missed was the damaging effects of QE on the flow of money through the financial system and the consequences for monetary policy transmission.
QE increases the amount of reserves in the system and reduces the amount of other forms of safe security, particularly various forms of government debt. Since the financial crisis, borrowing and lending between banks and non-banks has become more-or-less completely collateralised, with the debt of highly-rated sovereigns being the preferred choice of collateral. There is also a scarcity of collateral due to collapse of US MBS issuance, increasing shortages of high-quality sovereign debt due to sovereign downgrades, and regulatory changes encouraging buildup of safe asset reserves and hoarding of collateral. One of QE's effects is to reduce even further availability of safe collateral and therefore increase its price. THIS IS DELIBERATE. The stated intention of QE is to depress government bond yields to make them less attractive to investors and therefore nudge those investors towards riskier assets. Unfortunately this also increases the cost of the collateral needed by banks and non-banks to obtain funding, including from central banks. It could be argued that whatever encouragement increased reserves give to banks to lend is offset by the increasing cost and scarcity of the collateral needed to obtain the funds to settle lending. It's a wash.
Which brings me to the problems with monetary policy. The first thing to note is that as the increased availability of funds is balanced by increased cost and scarcity of collateral needed to obtain funds, QE makes no difference to liquidity in the financial system. This point has been brilliantly (and repeatedly) made by Peter Stella and the IMF's Manmohan Singh, but it seems no-one is listening. The extra reserves provided by QE are in no sense expansionary. If anything, QE is contractionary, because it reduces the velocity of money in the financial system. When collateral is scarce, funding flows are impeded. There may be more actual funds available, but if they aren't moving, they aren't any use.
The second point concerns the means by which central banks influence the behaviour of banks. Because the fundamental driver of lending is the risk versus return profile for both lenders and borrowers, lending is intrinsically cyclical. Central banks attempt to dampen the cyclicality of lending by means of macroprudential regulation and monetary policy. Of these, the second is arguably more important: macroprudential regulation historically has had limited success. But large-scale QE fundamentally changes the way monetary policy is transmitted. When the system is awash with excess reserves, central banks cannot use reserve scarcity to drive up the cost of funding. The "funds" rate (Fed Funds in the US, "bank" rate in the UK) becomes useless as a policy measure. When reserves are excessive, therefore, policy must be transmitted via the deposit rate.
Most central banks pay interest on excess reserves placed with them by banks: normally that rate is some distance below the interbank lending rate, to encourage banks to lend excess reserves to each other instead of parking them at the central bank. But as funding rates crash to zero, the deposit rate suddenly becomes far more important. Positive interest on excess reserves is currently used by both the US and the UK to prevent repo rates turning negative and prop up the short end of the Treasury yield curve. But this means that parking funds at the central bank becomes an increasingly attractive proposition for damaged banks that don't want to lend. To "nudge" banks towards productive lending, policy makers are now thinking about cutting central bank deposit rates to zero or even below. The consequences of negative rates are not fully understood, but even the brief look that I had a while ago suggested that they might not be quite what policy makers anticipate. And the problem with relying on deposit rates as the primary means of monetary policy transmission is that they are not underpinned by coherent macroeconomic modelling and their effects are not well understood. Some might argue that this is true of funds rates too, but it's far worse with deposit rates because they have never been used in this way before. Policymakers are making it up as they go along. And the economics profession is not exactly helping. The extent of disagreement among economists about how monetary policy works under these exceptional circumstances is eye-watering. It is telling that many of the most useful contributions to the debate about how best to conduct monetary policy at present have come from the financial blogosphere, not from the economics profession.
In short, monetary policy transmission is weirdly distorted by the effects of excess reserves and it has become extremely difficult for central banks to influence bank behaviour. Because monetary policy is hampered and there is reluctance to use fiscal policy as a complementary toolset, some politicians have been looking to macroprudential regulation to nudge banks towards more productive lending. This is madness. It is not the job of prudential regulators to repair damaged economies by, for example, watering down bank capital requirements intended to reduce the likelihood of catastrophic bank failures. I would rather see acceptance that, as Pozsar and McCulley (among others) have suggested, when interest rates are very low and monetary policy transmission is impeded there is a need for complementary fiscal policies.
There is much that I haven't covered in this post, and even what I have described here is controversial because it rests on an unconventional view of how the monetary system works (although perhaps not that unconventional now, since it is consistent with recent papers by both the Fed and BIS). You may disagree with much of what I have written, and I welcome constructive comments. A huge topic that I have not yet discussed is the whole question of expectations management, not only in relation to QE and its effects but in the transmission of monetary policy. I shall return to this in another post. In the meantime, Woodford is well worth reading on this matter.
Related links:
Inflation, deflation and QE - Coppola Comment
Does the Federal Reserve fully control the money supply? - John Aziz (The Week) (with very cool charts!)
The whole question of collateral shortage, monetary policy transmission and (potentially) negative rates has been extensively covered in the financial blogosphere. Here are some of the best posts.
When safe assets return - FT Alphaville
The decline of safe assets - FT Alphaville
Pledged collateral in an IS/LM framework (part 1) - Manmohan Singh at FT Alphaville
Pledged collateral in an IS/LM framework (part 2) - Manmohan Singh at FT Alphaville
A confederacy of dorks - Interfluidity
(and all the links in this post, plus Interfluidity's previous posts on the "floor" system. A fascinating and important debate)
The roving cavaliers of credit - Steve Keen
When governments become banks - Coppola Comment
The strange world of negative interest rates - Coppola Comment
Central bank reserve creation in the era of negative money multipliers - Stella & Singh (Vox)
The recommendation of this post, as others I have written, is for fiscal & monetary coordination as suggested in this paper:
Helicopter money - Pozsar & McCulley
Implicit in this post is the idea (as spelled out in the Vox link above) that the traditional "money multiplier" does not exist. This was recently confirmed in these papers from the Fed and BIS:
Money, reserves and the transmission of monetary policy - Federal Reserve
The bank lending channel revisited - Disyatat, BIS
This paper from the Hungarian Central Bank documents the lack of connection between size of central bank balance sheet (i.e. reserve expansion) and broad money growth:
The effect of the monetary base on money supply - Andras Komaromi, MNB
For a good description of how endogenous money creation works in a fiat money system, read Cullen Roche's paper:
Understanding the modern monetary system - Roche
This paper has a US focus and it is likely that things work slightly differently in other countries: for example, the European banking model relies much less on disintermediated "shadow" banking. Perhaps we need more papers describing how money creation works in the UK, Europe and Japan.
On expectations, a subject that I haven't addressed at all yet but discussed extensively with David Beckworth - here's Woodford's paper on the importance of forward guidance:
Methods of policy accomodation at the interest-rate lower bound - Woodford
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